The Future of Finance and the Lessons of JPMorgan

A couple of good articles today in the WSJ. The market can usually take care of inefficient scale in firm size, i.e., the too-big-to-fail syndrome in banking. The policy hurdle will be figuring out how to let banks realize failure. Markets will do the rest.

The most important lesson from the JPMorgan snafu is this:

Central banks everywhere, trying to goose sluggish economies and prop up fragile banking systems, are creating giant pools of liquidity that must go somewhere.

Big Banks Are Not the Future

As leading financial firms face market and regulatory challenges, the likelihood of their managers responding deftly seems slim at best.


The halcyon days of large financial conglomerates are over.

This assertion may seem surprising in light of the growing power—and profitability—of the leading financial institutions in recent years. The trend toward oligopoly, already in full swing during the 1980s and ’90s, only accelerated during the financial crisis of 2008, as faltering firms were absorbed by a handful of burgeoning survivors.

Coming out of the crisis, those at the top seemed unassailable.

Today, a mere 10 highly diversified financial institutions are responsible for 75% of total financial assets under management. Not only are they too big to fail, if the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act works as intended, they are supposed to become more stable going forward.

Many observers therefore assume that these behemoths will dominate into the foreseeable future.

Or will they? The same crisis that shrank the number of leading players also exposed many of their frailties.

Giant diversified financial institutions operate on both sides of the market—as portfolio managers and institutional investors on the buy side, as underwriters and dealers on the sell side, and as financial advisers on both sides. These conflicts, which are built into the firms’ structures, strategies and decision-making dynamics, often bring them into conflict with the public interest.

The diversified financial giants also suffer from structural weaknesses that undermine the ability of their senior executives to govern them effectively. Increasingly, power resides in middle managers, who are highly motivated by various incentive formulas to take (sometimes irresponsible) risks. Top executives must navigate through a blizzard of arcane formulas and oversee activities in far-flung operating units in order to assess and manage overall risk properly. Because they often lack the time and tools to monitor diligently, they must rely on the veracity of others.

Dodd-Frank includes various provisions to discourage recklessness among the giants, but regulation is not the solution. While enshrining the leading financial firms as “too big to fail,” the new legislation imposes on them a long list of strictures—of “dos” and “don’ts”—for controlling their behavior. But a well-run financial system cannot be micromanaged through elaborate regulatory codes. As the trend continues—as the huge financial conglomerates operate under continuous and rigorous scrutiny—they will become financial public utilities. Meanwhile, the crucial job of competitively allocating credit will be relegated to a shrinking portion of the financial markets.

Imposing higher capital requirements on these big institutions also is not the way to go. Will such higher requirements actually remove or minimize the many conflicts of interest noted earlier? I don’t believe so. Indeed, higher capital requirements may well encourage more risk-taking.

The power of leading financial conglomerates is being narrowed in other ways. Their inventiveness in introducing new financial products and marshaling new technology allowed them to outrun regulators for decades. The gap is now narrowing. Even though supervisory authorities initially were slow to perceive the implications of securitization and to respond appropriately to the rapid growth of derivatives, the landscape is much clearer now. In the wake of the 2008 crisis, neither regulators nor investors see these innovations as reliable ways to diversify risk. Large financial institutions will need to work hard to develop new techniques for expanding credit that are acceptable to regulators.

Information technology, once the handmaiden of leading financial conglomerates, now serves regulators. It is not difficult to imagine a day in the near future when credit flow information—data on trades, loans, investments, changes in liabilities, and so on—will flow instantaneously from financial institutions to official regulators.

In the somewhat more distant future, the entire demand deposit function probably could be taken over by governments through a network of computer facilities in “the cloud.” Even more likely, within a generation branch banking will become obsolete as the general population (not just early adopters) conducts all its banking on hand-held devices. McDonald’s or Starbucks or some other retailing chain will gobble up the bank branches for remodeling.

As leading financial firms have challenges to their dominance from several directions, the likelihood of their managers responding deftly seems slim at best. Change is seldom attractive for incumbents, especially when they enjoy such a predominant position in a major sector of the economy. Rather, shareholders need to push for action.

The most critical measure shareholders should insist on is divestiture. The financial conglomerates need to shed some of their activities and become more focused. That strategy would bring several major benefits, for the firms as well as for our financial markets and our economy. It would reduce their operations to manageable proportions. It would declassify them as “too big to fail.” It would lessen the role of government in the marketplace. And, in a win-win dynamic, it would enhance stockholder value significantly. All are reasons not to lament the sunset of the giant financial conglomerates.


The J.P. Morgan Distraction

The real backstory to the trading snafu are the actions of the world’s central banks.


Many now wonder why J.P. Morgan’s Jamie Dimon didn’t just bury the few billion in trading losses from a hedge gone awry in the bank’s giant books. At some decent interval, a footnote could have disclosed that the bank was reorganizing its chief investment office. Anybody who wondered why could have asked. Then at least we wouldn’t be distracted by this overblown episode even more overblown in light of a pending meltdown in Europe.

In February, during an investor presentation, J.P. Morgan revealed that anticipated losses in its current loan portfolio amounted to $27.6 billion. The result was not hysteria.

In May, Mr. Dimon called a press conference to announce a $2 billion loss on a misguided hedge and the result was hysteria.

The problem can’t be that a bank had a loss. Banks will have losses. The problem can’t be that J.P. Morgan has failed and taxpayers are on the hook. J.P. Morgan hasn’t failed.

Perhaps the problem is that the bank lost money doing the “wrong” thing? The bank itself flatly says an activity meant to hedge a portfolio of corporate bonds morphed improperly into a directional bet on corporate credit. That is, through a failure of management, the bank did something it meant not to do, and suffered losses as a result. Isn’t this as it should be? With the result that J.P. Morgan will overhaul its processes, with the requisite rolling of heads?

Nor is it clear how the Volcker rule would have prevented an activity J.P. Morgan’s own CEO discovered and stopped only after his rogue trader (a term we use advisedly, though it increasingly seems to fit) so roiled the London markets that even the press began to take notice.

In the deluge of I-told-you-so’s, the critics have one unassailable tautology on their side: Government can ban losses from particular activities by banning those activities. But that just leaves banks turning to other activities that are also risky. At what can banks make money without risk of losing it? The answer is “nothing.”

And before you say, banks should be making plain loans, remember that plain loans have been a root of every banking mess in recent decades. In 2008, it was loans to home buyers. In the late 1970s and in Europe again today, it was loans to sovereign governments. In the S&L disaster, it was loans to real-estate developers.

In any case, it’s not bad loans but creeping doubts about the government’s own guarantees that prompt the really disastrous episodes, as in 2008.

To voice a heresy, if we’re going to have a government-insured banking system that repeatedly encounters and perhaps causes financial turbulence, then having most of the risk concentrated in a handful of very large banks is a regulatory convenience. It makes it easier for Washington to stabilize the system by stabilizing just a few institutions.

Not that a different approach is difficult to conceive of, if anyone were interested. Cut back on deposit insurance—say, by requiring that government-guaranteed deposits be backed 100% by assets already guaranteed by government, like Treasury bills. Uninsured bank creditors who now free-ride on the deposit insurance system would be less certain of being bailed out too. Markets would be less willing to finance large and complex banks. Those banks would likely have to get smaller.

Would the result be fewer bubbles and less financial turbulence? Who knows? Undeniable is that guarantees were operating at many levels in the housing bubble, including Fannie and Freddie.

But this is idle speculation. The U.S. is committed to a system resting on a small number of giant, government-aligned institutions. And unsung is perhaps the most important factor in the J.P. Morgan snafu. Central banks everywhere, trying to goose sluggish economies and prop up fragile banking systems, are creating giant pools of liquidity that must go somewhere. That some pooled up at J.P. Morgan, finding its way into a large, hedgeable portfolio of relatively safe corporate bonds, is hardly surprising.

Central banking’s oligarchs have a variety of motives: In Europe, liquidity is being dished out to support the bonds of spendthrift governments. In the U.S., the Federal Reserve hopes that suppressing interest rates will reawaken animal spirits. In China, the ruling party hopes to maintain employment and ward off social chaos.

Not part of their plan has been the actual result—stimulating a global bubble in “safe” assets as investors see all this and fear a coming financial havoc.

By “safe,” we mean assets that may be totally unproductive, like government bonds, but that governments would print money to redeem if necessary. Guess what? Any claim on J.P. Morgan, as a “too big to fail” bank, is such an asset too. Why else would investors and depositors be paying J.P. Morgan to hold corporate bonds for them? This is the real backstory to the bank’s hedging bungle. Don’t expect to hear much about it when Mr. Dimon is summoned before Congress next week.


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