August 1, 2012

Volcker, Dimon and Financial System Risk

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The recent financial press obsession with the multibillion dollar in-house trading loss at JP Morgan Chase & Co. has brought into sharp relief the competing philosophies at play with respect to the so-called Volcker Rule (named for Paul Volcker).  The Volcker Rule is in large measure a resuscitation of the Banking Act of 1933 – the so-called Glass-Steagall Act – which was a Federal response to the perceived banking system cancers which contributed to the 1929 stock market crash and widespread bank failures.  In the wake of the financial meltdown in the Fall of 2008, many public officials and commentators viewed excessive risk-taking on the part of financial institutions as a principal cause of the financial collapse and they argued for a return to a Glass-Steagall regulatory environment.

The Volcker Rule (part of the Dodd-Frank legislation) dictates that “a banking entity shall not (A) engage in proprietary trading…,” which is defined as “engaging as a principal for the trading account of the banking entity…in any transaction to purchase or sell, or otherwise acquire or dispose of, any security.”  However, the Volcker Rule specifically permits certain hedging activities by authorizing “risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions,contracts, or other holdings.”

The Volcker Rule just became effective on July 21, 2012 (and hence was not applicable to the JP Morgan trading mishap).  Moreover, subject financial institutions have two years within which to conform to the Volcker Rule (and the Federal Reserve Board has the authority to extend that conformance period by as many as three additional one-year periods).

There has been much argument as to whether or not the JP Morgan trading loss would have violated the Volcker Rulehad it been in effect at the time.  While the final regulations to be promulgated could change the analysis, it’s hard in my view to see how the JP Morgan trading stratagem would have run a foul of theVolcker Rule.  It is clear that the tradein question was a hedge transaction.  In particular, the JP Morgan position in question was a “portfolio hedge” where the bank was attempting to hedge its portfolio of corporate bonds against macroeconomic volatility. 

Beyond the issue of a violation of the Volcker Rule is the compelling question of whether such trading is inimical to the soundness of the American financial system, on which score it is important to put in perspective both the magnitude of the loss and the source of the funds in question.  While by any measure the JP Morgan trading loss was a significant sum of money (which could range as high as $9 billion), JP Morgan Chase has total assets approaching $2.5 trillion, and for the Second quarter of this year still realized net earnings of $4.96 billion.

There remain nonetheless public policy and regulatory concerns.  Apart from the fact that the eighty or so Federal Reserve Board and Office of the Comptroller of the Currency staff members resident within JP Morgan Chase at any given time were unaware of this trading activity, it’s clear (in the face of the challenging yield curve confronting all financial institutions) that the trading activities conducted by JP Morgan were viewed as a profit center.  This fact is evidenced by, among other things, the fact that JP Morgan held only about 30 percent of its investment portfolio in US Treasuries or other instruments guaranteed by US Government Agencies while, for example, 87 percent of the investment portfolio at Bank of America is invested in such securities. 

In sum, it is far from clear that the JPMorgan trading losses resulted from a transaction that would have violated the Volcker Rule were it applicable at the time.  Nevertheless, while the losses (when kept inperspective) can be viewed as part of the transactional risk of doing business and not placing in jeopardy the monies of depositors, this event also suggests that the federal regulators currently promulgating regulations with respect to the Volcker Rule should consider some restraints on the magnitude of even hedge investments that might be held within the investment portfolios of banks.

By J. David Smith Jr., Stoll Keenon Ogden PLLC