WILL BANKS BE SAFER IF THE LONDON WHALE GETS HARPOONED ? / THE FINANCAL TIMES COMMENT & ANALYSIS

August 15, 2013 5:00 pm

 

Will banks be safer if the London whale gets harpooned?

 

By Mark Roe

 

The JPMorgan Chase indictments risk inducing a false sense of security, writes Mark Roe

 

©EPA

 

 

And so the drama moves on to a courtroom. Two prime traders in JPMorgan Chase’s “London whale” misadventure have been indicted.

 

Side plots may unfold, perhaps via extradition proceedings. But here is the big question: will the indictments lead to better, stronger financial markets? Well, yes and no.

 

Recall the problem: JPMorgan’s London trading desk made trades that would be profitable if the post-crisis American economy remained weak. As the economy improved, the traders sought to reverse the investments, but could not, ultimately losing the bank and its shareholders $6bn.

The indictments are not for the loss, but for deliberately misstating the size of the loss to higher-ups at the bank. That, in turn, led to misstated financial statements to the public and the bank’s regulators. Whether higher-ups pushed for lower reported losses remains to be seen.

 

Misleading the regulators is serious: if the losses threatened the bank itself, the regulators would have needed to know early so they could act. True, JPMorgan is well capitalised so a $6bn loss was painful but not life-threatening; and, the indictment says, the deception was sized in hundreds of millions of dollars.

 

But regulators still want to be alerted, to see if other big institutions were making similar bets. The financial crisis hit in 2008 because too many made similar (bad) bets on the American housing market’s ability to support its massive levels of poor-quality mortgage securities. An early warning system will not work if financiers hide problems.

 

Indeed, not a small part of the financial reform embedded in the Dodd-Frank Act, passed in response to the financial crisis, is to relay reliable information to regulators fast enough for them to assess how to handle an emerging problem. If financial executives hide problems, hoping that they will disappear, they undermine regulators’ ability to head off economic risks. Regulators should take the deception seriously.

The financial debacles of the past half-dozen years have led to few criminal actions. The typical denouement in an American financial scandal, however, is jailing: Ivan Boesky in the insider trading scandals; Michael Milken on junk bonds; Jeffrey Skilling and others in the Enron scandal.

 

Were prosecutors searching for malefactors to jail and, unable to find indictable offences in the transactions, did they instead indict the traders for failure to disclose accurately? Prosecutors have long acted similarly, with Al Capone’s jailing perhaps the most famous: the mobster, readers may recall, was indicted for tax fraud because the authorities lacked evidence to convict him for the way he made his money. But JPMorgan’s underlying trades were not illegal.

These risky trades are a normal part of the financial landscape. Indicting the JPMorgan traders for the failure to disclose was not a way at getting at activity that was at base illegal, because it was not. This type of risk to the financial system would persist and would have been legal, even if the traders had reported their losses accurately.

Thus, dramatic as these indictments may become, they do not strike close to the heart of our financial problems, because a $6bn trading loss at the best-managed big US bank tells us that banks do not yet have their risk-management house in order. Corporate structures at the big banks are unwieldy and prone to problems: they are sprawling businesses, often with limited synergies. The loss might have sunk another systemically important, but weaker bank.

Much needs to be done to make financial markets safe. So the whale indictments may – perversely – hold us back from where we should be: with strong capital requirements in place for big financial companies, incentivising them to use less debt overall and less of the overnight money market in particular, reducing the size of the riskiest businesses that can take whale-type risks, and making it possible for big financial organisations to fail without taking the overall economy with them.

The indictments run the risk of giving some lawmakers and the public a breather: “we nailed them”, some may think, “so we can relax”. The danger is that the indictments fulfil the public’s urge for a satisfying conclusion – and relieve lawmakers from pressure to build a sounder financial system.

The writer is a professor of law at Harvard University
 

Copyright The Financial Times Limited 2013.