JPMorgan's Loss Provides Lessons for Reformers

NEW YORK (TheStreet) -- Jamie Dimon is properly embarrassed and apologetic about JPMorgan's (JPM) $2 billion trading loss in European credit derivative securities. Although Congress, the regulators and the public are all properly concerned and seeking to discover how America's best-run bank could have made such an error, each of them must bear in mind that there is no cause for panic because of this loss.

For example, $2 billion or $3 billion is a lot of money even on Wall Street. But when judged relative to JPMorgan's size, the loss is not as onerous. A loss of $3 billion would equal about 2.2% of JPMorgan's stock market capitalization of $131.25 billion and less than 0.15% of its assets, which total over $2 trillion. Similarly, although this loss will reduce the profits earned this quarter by JPMorgan, the bank will still be in the black this quarter, even after the impact of the trading loss.

This is not another Lehman Brothers moment.

Some in Congress and elsewhere are saying that had the "Volcker rule" (part of the Dodd-Frank legislation aimed at restricting the proprietary trading of banks) been in place, this loss never would have happened. How can those critics be so certain? There will always be percentages of trades (and loans for that matter) that go awry, even if they are put on as legal hedges.

The current hysteria in Congress is en route to making prescience the new standard of any bank lending and trading activity. Dodd-Frank is already more than 2,000 pages in length, and the Volcker rule has yet to be implemented after two years of trying to define acceptable vs. excessively-risky trading.

Rather than insisting on prescience or even more complex regulations, it would be more productive for the regulators to focus on two aspects of bank activity that can more efficiently protect taxpayers from the necessity of bailing out banks, such as JPMorgan, which are systemically too important to fail: leverage and alignment of executive compensation.

Excessive leverage is generally agreed to have been one of the critical factors that created the 2007-2009 banking crisis. Leverage for the largest banks in the U.S. banking system has been greatly reduced since then. This reduction in leverage, however, has come about not through Dodd-Frank or any other U.S. law but rather from the international regulator of the largest banks, the Bank of International Settlements in its Basel III directive. This directive now requires banks such as JPMorgan to have equity capital equal to 10.5% of their assets.

Other countries where banking represents a vital part of their economy have gone significantly further than the Basel directive. If Congress were to set a similar super standard for the largest U.S. banks, each of the banks would have as much as twice as big a cushion to absorb losses and thus be half as likely to ever require public assistance.

Another major contributing factor to the crisis of last decade was the normal human behavior of people being more tolerant of taking risk when the money involved is someone else's and not their own. Banking executives are human, and their appetite for risk increases when the funds at risk are undertaken with other people's money. When Congress, as a condition of TARP, required the compensation of banking executives to be less weighted toward bonuses than was the practice, it moved the incentives in the wrong direction. Now, with a greater percentage of an executive's total compensation being guaranteed as a salary as opposed to an incentive bonus, if a trade goes bad resulting in lower earnings, the executive suffers less than would have been the case of more heavily weighted incentive bonuses.

Dodd-Frank does take a step in the right direction by enabling "clawbacks" of previously paid compensation when trades put on in an earlier pay period later go bad. In the current case of JPMorgan, Jamie Dimon has indicated that he intends to pursue just such clawbacks.

An even better alignment of incentives would be to make the equity compensation (options, etc.) that the most senior executives receive in the form of "elevator equity," meaning that in the event of extremely negative results with a delayed fuse, not only would the value of the equity go to zero, but the clawback would permit attachment of the personal assets (beyond their equity in the bank) of the executives. Just as Sarbanes-Oxley's requirement of CEOs and CFOs personally attesting to the accuracy of financial disclosures under the threat of criminal penalties made senior executives of public companies much more vigilant in their financial disclosures, the threat of losing assets outside of the bank will make senior bankers less reckless with the capital they trade.

A return to the world of Glass-Steagall is nice in theory, but we are living in a world much more complex than it was in 1933. Micro-managing banks through increasingly detailed regulation is a fool's errand. Simpler regulation aimed at less leverage and curbing executives imprudent trading is a better solution for today's financial markets

William R. Gruver is a member of the board of directors at The Street, a professor at Bucknell University and a former general partner at Goldman, Sachs & Co. Previous to his work on Wall Street, Gruver served as a nuclear submarine officer.

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