JPMorgan Chase trading fiasco: What to do about big banks?

The fallout from a massive investment loss at JPMorgan Chase continued to spread Wednesday, as shareholders filed lawsuits against the bank and members of Congress used the incident to defend strong bank regulation – or to promote more of it.

Investors filed two lawsuits against the firm, alleging that the firm took undue risks and made misreprentations to shareholders prior to last week, when the firm announced the losses. Chief executive officer Jamie Dimon called the trading errors "egregious" and the losses "self-inflicted."

In Congress, lawmakers used a hearing on bank regulation to raise concerns about the JPMorgan investments that went awry. Some lawmakers argued for breaking up the largest banks, which include JPMorgan. 

And Sen. Bernie Sanders (I) of Vermont called for new legislation to remove conflicts of interest between regulators and Wall Street banks. Two-thirds of the Federal Reserve's regional-bank board members are appointed by the banking industry, Senator Sanders noted in a letter to his fellow lawmakers. Mr. Dimon is now serving as a director of the Federal Reserve Bank of New York.

All these developments are signs that, more than three years after a financial crisis plunged America into a deep recession, the question of how to maintain a healthy bank system is still a hot one – and that industry's risks remain at least partially untamed by new laws or managerial self-discipline.

Even before the loss made headlines, congressional hearings were under way on how to implement the Dodd-Frank banking reforms of 2010, and whether additional changes should be made to financial-system oversight. 

Among the important questions being considered:

• How to implement the so-called "Volcker rule" in Dodd-Frank to limit banks' investment activity.
• Whether to break up large banks – a legislative long shot, supported by some lawmakers.
• Whether some broader constraints on financial risk are needed.

Now, the JPMorgan loss has colored all these conversations, with both sides employing it for their arguments. 

Sen. Bob Corker (R) of Tennessee last Friday urged the Senate Banking Committee to hold a hearing on what the debacle implies for bank-system soundness. JPMorgan's loss arose from credit-derivative bets on European corporate debt, involving a trader who became known in credit markets as the "London Whale." 

Rep. Ed Royce (R) of California on Wednesday used the JPMorgan affair to defend a post-crisis boost in the capital cushion that big banks are required to hold – a shift that some critics have said is harming economic growth. "I hope that recent incidents put that argument at rest," Congressman Royce said at a House Financial Services Committee hearing, eliciting agreement from one of the regulators testifying.

At the same hearing, Rep. Brad Miller (D) of North Carolina said the JPMorgan loss was evidence of the need for a tougher regulatory regime than Dodd-Frank has imposed so far. "What sense does it make to create banks this big?" he asked. "And they're actually even bigger now than they were before.... Why not have smaller banks?"

The JPMorgan losses could also come up at a hearing on derivatives regulation, set for the Senate Banking Committee on May 22.

Although massive, the loss doesn't put JPMorgan or the US banking system at any immediate risk. But it served as an alarm bell, given that the bank and its CEO had cultivated a sterling reputation. Dimon had been Wall Street's lead spokesman for the idea that Congress should take a lighter regulatory approach to the industry.

The loss is a reminder that smart people, in sophisticated transactions, can sometimes go wildly wrong. If a large number of firms do this simultaneously, as occurred with investments related to the housing market prior to 2008, the whole financial system can be at risk.

In an election-year, the politicking is sure to spread beyond congressional hearings.

It's an issue in the presidential race, where Republican Mitt Romney has been raking in donations from Wall Street, while remaining largely silent about bank regulation. And it figures prominently the Massachusetts Senate race in which Democrat Elizabeth Warren is seeking to oust Sen. Scott Brown (R).

The voting public didn't like the bank bailouts crafted by the Bush and Obama administrations in 2008 and 2009. But they were crucial in avoiding an even more precipitous economic collapse, say many economists.  

"When banks can't lend,... the economy doesn't do very well," Northern Trust chief economist Paul Kasriel explained in an interview before his retirement last month. Mr. Kasriel suggests that a bank-credit revival was vital during the Depression, and has been the vital again since 2008.

The Federal Deposit Insurance Corp. reports that US banks, although still facing challenges, are much stronger now than they were a couple of years ago. After sharply tightening the flow of credit during the recession, banks have have begun to ease a bit on loan conditions.

The challenge, which policymakers know but haven't fully solved, is how to maintain a banking system that is both vibrant and safe – not allowing implicit government backstops to become licenses for risky behavior by bankers.

One such backstop contained in the Dodd-Frank law is the designation of the biggest banks as "systemically important," which some lawmakers see as confirmation that those banks will be bailed out should they get in trouble again.