Chase’s big loss: What’s the right safeguard?

This week JPMorgan Chase disclosed that bumbling by its traders caused $2 billion in losses in about six weeks, with potentially more to come. But the bank’s chief executive, James Dimon, said Thursday that the company still expects to earn more than twice that amount after taxes this quarter. Those earnings won’t match the $5.38 billion the bank took in from January through March, but it’s not meager either.

In other words, the loss that sent the bank’s shares down about 10% Friday won’t actually leave the company in the red. It just won’t be printing money quite so rapidly.

You won’t find much discussion of Chase’s financial health in many of the articles about the bank popping up around the Web. Instead, the focus is on whether the losses help justify the new bank regulations Congress enacted last year -- and in particular, the “Volcker rule” advocated by former Federal Reserve Chairman Paul Volcker. That rule, which goes into effect July 21, 2014, bars banks from using their own funds -- including the federally insured deposits they collect from customers -- to trade securities, derivatives and other risky financial instruments.

Some critics of the new regulations argue that Chase’s magical money disappearing act proves the pointlessness of the Volcker rule. That’s because Chase supposedly racked up those losses through its hedging activities (that is, investments it made to offset risks elsewhere in its portfolio), which are permitted by the rule. The lawmakers who helped put the rule into the 2011 Dodd-Frank law, however, countered that the hedging exemption shouldn’t extend to broad bets on the market like the ones Chase made. Instead, they said, it should be limited to strategies designed to counter the risks posed by a specific holding.

What the public wants, though, is something more basic: the assurance that banks can’t gamble recklessly with insured deposits (i.e., their customers’ money) or threaten to take down the entire economy if they fail.

From that perspective, Chase’s size is both a good thing and a bad thing. On the plus side, its earnings are so enormous, it can absorb a $2-billion hit and still turn a profit. On the downside, its traders could operate on such a large scale, they were in a position to lose $2 billion in a matter of weeks.

In the wake of Chase’s news, some analysts and policymakers on both sides of the political spectrum have called on the government to break up the country’s largest banks. Rather than counting on regulators to head off problems caused by “too big to fail” banks, they argue, why not divide those banks into units that are small enough to collapse without damaging the economy?

I’m sympathetic to that position, but as Chase’s experience shows, a very big bank may have the wherewithal to shrug off a loss that would devastate a small bank. Rather than capping a bank’s size, the same goal could be accomplished by requiring banks to maintain increasingly large financial reserves the bigger they become. That’s both a safeguard against a company collapsing and a deterrent against excessive growth. The more that a bank has to hold in reserve, the less it can put at risk.

Barring banks from making high-risk, high-reward bets with their customers’ deposits is another important element of the solution. But the Volcker rule isn’t worth having if there are loopholes large enough to lose billions of dollars through. The Fed needs to draw boundaries for banks that are as clear as the principle Volcker articulated. If a bank is going to accept federally insured deposits, it shouldn’t be allowed to speculate with those dollars for the sake of its own profits.

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