JPMorgan's Madoff settlement: Are banks too big to manage?

After the financial collapse plunged the global economy into a Great Recession, requiring billions of dollars in taxpayer bailouts for behemoth Wall Street banks, many debates centered on whether these financial institutions were “too big to fail.”

But after JPMorgan Chase watched Bernie Madoff bilk billions from investors – prompting the US Justice Department to penalize America’s largest bank a record $1.7 billion criminal penalty for its failure to warn regulators of the Ponzi scheme percolating within its coffers – some are beginning to ask: Are these colossal banks also too complex to manage, let alone to regulate?

While new restrictions, including the Dodd-Frank act (2010) and the Volcker rule, continue to alter banking’s regulatory landscape, federal agencies can only investigate so much, experts say, leaving a bank’s own internal protocols and compliance regimes the first line of defense against practices that can harm the economy.

Indeed, the lynchpin of the “deferred prosecution agreement,” announced Tuesday by Justice officials, is not only the record fine, but also the requirement that JPMorgan overhaul its own safeguards, ensuring that laws and regulations are followed properly. The deferred prosecution puts the bank, with assets of $2.4 trillion, on a two-year probation – and serves as a deterrent for other banks.

But in such massive organizations, a bank’s regulatory safeguards can often take a back seat to the incentives to bring in enormous amounts of cash, financial experts say.

“They’ve gotten hugely complex: They are just massive organizations with massive governance and legal structures, and there are incredibly siloed interests within these firms,” says Kurt Schacht, managing director at the CFA Institute, an organization promoting financial industry ethics.

“And these fines don’t seem to have much of an impact one way or the other on these firms – either their business practices, or their profitability, or what they’re paying out, in terms of compensation,” Mr. Schacht continues. “So it looks like just a cost of doing business, almost.”

In just the past year, JPMorgan has paid out a staggering $20 billion-plus in penalties, including $13 billion in November for its role in the mortgage-backed securities fiasco and nearly $1 billion from the “London whale” incident, in which rogue traders tried to hide a $6.3 billion loss. Yet they still have billions more on reserve to settle future fines, while still bringing in record profits.

Some industry insiders point to a highly competitive, zero-sum ethos among many of those on Wall Street. For those adept at managing risk, the odds of getting caught can be figured into the odds of making a huge score.

“Internally, what happens, people running the business units ultimately run roughshod over those within the compliance and risk management divisions,” says Larry Doyle, a former national sales manager for securitized products at JPMorgan from 2000 to 2006. “And I think that’s probably exactly what happened in this JPMorgan situation with Madoff.”

“Do you know what happens when a hundred million bucks gets questioned by compliance or risk management?” continues Mr. Doyle, who later wrote “In Bed With Wall Street: The Conspiracy Crippling Our Global Economy,” a narrative describing the regulatory system. “I’ll tell you: Money talks.”

These financial temptations are especially acute in the kinds of complex organizations that banks have become. And as more and more banks consolidate and spread their financial tendrils through the economy, the stakes become enormous, too.  

“I do know from my time on the Financial Crisis commission that there was a certain pervasive decline in the quality of internal risk management,” says Douglas Holtz-Eakin, president of American Action Forum, a conservative policy institute in Washington.

“We saw a lot of internal controls really not performed up to snuff,” he continues, referring to his time on the 10-member Federal Crisis Inquiry Commission. “So I don’t think it was unique to JPMorgan – and as for all their fines recently, I’ll confess I'm not sure why they're being singled out.... The world in general didn’t manage risk very well during that period.”

Mr. Holtz-Eakin, also the former chief economist of the president's Council of Economic Advisers under George W. Bush, sees the origins of the financial crisis in this kind of failure to follow the standards and regulations already in place at the time. Also, he’s critical of the Volcker Rule and much of Dodd-Frank, which do not address the fundamental problem of front-line compliance issues.

“Despite whether [JPMorgan CEO] Jamie Dimon is the most ethical guy on the planet, and he is trying to lead the JPMorgan ship in the proper direction, there are so many decks on that ship and so many activities going on that it is impossible to monitor those things, and as a regulatory matter, it’s become impossible to regulate and impossible to oversee,” says CFA's Schacht. 

“So there are a lot of people who think that, short of breaking up these businesses into more manageable pieces, they will not solve this problem of the scofflaw nature in the financial services world, where these firms are just subject to one fine, one violation after another,” he says.

And such fines may have little effect, given the resources of many large banks.

“The regulatory actions and fines against JP Morgan is the single best piece of evidence out there that some banks are simply too massive for them to supervise themselves,” e-mails Andrew Stoltmann, a Chicago-based securities attorney. “Given the range of conduct engaged in by JP Morgan both in the US and overseas, it is clear the bank, and others like it, must be broken down into smaller parts to protect society. Unfortunately, this is unlikely to happen but that doesn't mean it shouldn't.”

Others, however, still see an important role for behemoth banks in the global economy. Big multinational companies require the broad-based services that such banks provide.

“I think there's a legitimate issue in the scope of some of the activities of financial institutions that can make [regulating] harder, because you have to have a bigger range of expertise,” says Holtz-Eakin. “But I don’t think there’s anything overwhelming about that. I don’t think it makes it impossible to manage, but that’s been a real concern.”