More federal regulation? JPMorgan case bolsters critics of banking system.

JPMorgan executives have opposed tough banking regulations, saying they would be a 'shock to the US financial system.' But the firm's $2 billion trading loss weakens that argument.

Over the past year, JPMorgan Chase’s chairman, Jamie Dimon, became a poster child for arguing that America’s big banks should not be hobbled by regulation.

He and his executives have written Congress and federal regulators, opposing tough standards that would bar the banks from trading for their own account (that is, betting their own money). Such restrictions, they say, would be a “shock to the US financial system.”

Now, by announcing an unexpected $2 billion trading loss, Mr. Dimon has given his critics new ammunition – that the banks actually need more supervision, not less.

“The loss smoothes the path for those who wish to seriously limit the trading operations of banks and makes it more difficult for others to raise the myriad objections, many of them quite valid, about the specific proposals,” said Doug Elliott, a fellow at the Brookings Institution in Washington and a former employee at JPMorgan, in a written analysis.

One of the critics of the banks is Sen. Carl Levin (D) of Michigan, who was the co-author of the legislation establishing the so-called Volcker rule – that banks should not trade for their account if they are considered “too big to fail.” In a statement Thursday, Senator Levin argued that the regulators should establish “tough, effective standards to implement” the legislation, which is being phased in.

Another high-profile bank critic, John Makin of the American Enterprise Institute in Washington, argued in a statement Friday that the “JP Morgan fiasco demonstrates the ineffectiveness of Dodd-Frank [banking reform legislation] as a viable guardian of financial stability.”

He wants the rules tightened and the Volcker rule implemented. Under the legislation, the Volcker rule does not need to be implemented until July 16, 2013.

But even if the Volcker rule were implemented, Mr. Elliott says, JPMorgan may not have been prohibited from making the trades.

“JPMorgan has indicated that these activities were ‘hedges,’ meaning they were undertaken to reduce the total risk of the bank,” writes Elliott. “We want the banks to hedge and all the proposals are careful to try to allow banks to continue their hedging activities.”

In hedging, financial corporations employ strategies to mitigate their risk. According to news reports, JPMorgan lost money when the economy softened last month and the corporate bonds that the bank held moved against the firm. As Elliott observes, “These particular hedges were poorly executed and went spectacularly wrong.”

Dimon, in a conference call with securities analysts on Thursday, said much the same. “Just because we’re stupid doesn’t mean everyone else was,” he said.

Even if JPMorgan was stupid, it’s important to put the mistake in context, Elliott says. Yes, $2 billion is a large number. But, he points out, it represents less than 10 percent of the bank’s pretax earnings last year, one-hundredth of the $189 billion value of the company, and one-thousandth of its $2.3 trillion in assets.

The bank has indicated the $2 billion loss will cost it 25 cents a share. For the quarter, it anticipates reporting about $4 billion in pretax earnings, after the loss.

However, some financial experts say, how well banks are capitalized is hard to know because financial derivatives are accounted for off their balance sheets. Under the Dodd-Frank legislation, trading in sophisticated financial instruments is supposed to go through clearinghouses, which will make them more transparent. But that is just beginning.

“You have to be a forensic sleuth in order to know what’s going on,” says Mayra Rodríguez Valladares, managing principal and financial trainer at MRV Associates, a financial consulting firm in New York. “You can’t just download the latest financial report and see what’s going on with financial derivatives.”

In JPMorgan’s case, she says, it appears they were betting the economy would get better faster. But, she adds, “It is not clear what their strategy was.”