When Will We Learn? The Banks Don't Think We Ever Will, But We Must

May 15th, 2012
in Op Ed

by Elliott Morss

hear-see-speak-no-evilSMALLIn 2007, the banks gambled on mortgages and lost, causing the largest global recession since 1929. They then gambled on European sovereign debt and lost. And now we hear J P Morgan Chase (JPM) just lost $2 billion on a derivatives' bet. Should this not be the last straw?

There are important lessons to be learned from all this, lessons the bank lobbyists don’t want anyone to hear.

Click on caption graphic for larger picture of modern bank regulators.

Follow up:

Lesson One – More Regulation Is Not the Answer

The immediate reaction to the JPM fiasco is to look at bank regulatory filings. But note: The New York Times reported that neither the US nor British regulators were even aware of the JPM unit that made the trades until they were tipped off by the media.

Are tougher regulations the answer?  No.  Banks given the latitude to do what they can do now will always be one step ahead of the regulators. We have had Basel I, II, and III standards. And despite these, we have had the US bank collapse, the Euro near bank collapse, and this latest loss.

How about this? In addition to bank presidents signing off and taking responsibility for all bank reports, let’s ask the regulators to take responsibility as well. The regulators would refuse. They have no idea what banks are really doing.

Do they know anything more than they did in 2008? I doubt it. I believe trying to regulate banks as currently constituted will never work. They are simply too complex to be regulated effectively.

Note further: the US banking crisis is not over yet. More than 50% of the 742 banks that borrowed money from the Troubled Asset Relief Program (TARP) had not even started to pay off their debts.

Lesson Two – The Volcker Rule Is Not Enough

The Volcker Rule is in Dodd-Frank: Title VI, Sec. 619, (a)(1) reads:

Unless otherwise provided in this section, a banking entity shall not– (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.…in no case may the aggregate of all of the interests of the banking entity in all such funds exceed 3 percent of the Tier 1 capital of the banking entity.”

And Gabriel Sherman reported that banks were taking steps that made one think 'The Rule' had real teeth:

  • Goldman Sachs – “Months before the Volcker Rule is set to kick in, star traders began to leave in droves.”
  • Morgan Stanley - “…Morgan Stanley announced …it was getting out of prop trading entirely.”
  • Citigroup - “Citigroup announced that it, too, was closing its prop-trading desk.”

And Sherman quoted JPMorgan Chase CEO Jamie Dimon:

Certain products are gone forever….Fancy derivatives are mostly gone. Prop trading is gone. There’s less leverage everywhere. Mortgages are back to old-fashioned conservative mortgages….”

Volcker’s comment:

My experience with ring fences is the gophers go underneath and the deer jump over it, and you get a lot of lawyers to help them.”

I was doubtful too. So I looked at the top three US banks. Table 1 does not suggest all trading is over.

Table 1. – Bank Assets, Trading and Derivative Accounts, end 2011


Source: FDIC

Lesson Three – Dodd Frank Is Just What the Bank Lobbyists Want

Let’s go back to the Dodd Frank text. Right after the Volcker Rule statement, it reads:

Not later than 6 months after the date of enactment of this section, the Financial Stability Oversight Council shall study and make recommendations on implementing the provisions of this section so as to…promote and enhance the safety and soundness of banking entities….”

In short, the bill calls for Federal financial regulators to study the measure, and then issue rules implementing it based on the results of that study. So who will be on this Financial Stability Oversight Council? It will be chaired by the Secretary of the Treasury Geithner – Geithner is looking forward to a job in the financial industry. Other members: the Chairman of the Fed, the Comptroller of the Currency, the Director of the Bureau of Consumer Financial Protection Bureau, the Chairman of the Securities and Exchange Commission, the Chairperson of the Federal Deposit Insurance Corporation, the Chairperson of the Commodity Futures Trading Commission, the Director of the Federal Housing Finance Agency, the Chairman of the National Credit Union Administration Board, an independent member appointed by the President by and with the advice and consent of the Senate. With the exception of Bernanke, this will be a group of politically-driven bureaucrats.

Just after the Bill was enacted, I quoted from an article by Binyamin Appelbaum in the New York Times on what will happen next:

“…Brett P. Barragate, a partner in the financial institutions practice at the law firm Jones Day, estimated that Congress had fixed in place no more than 25 percent of the details of that vast expansion….Interest groups have been preparing for months. When the Consumer Bankers Association convened its annual meeting in early June, there was still plenty of time to lobby Congress. But the group’s president, Richard Hunt, told his board that the group should shift its focus to the rule-making process. The board voted to increase the group’s budget and staff. ‘Now we hope to have a good give and take with the regulators on the best interests of the consumer and the industry,’ said Mr. Hunt….One clear consequence is a surge in the demand for lawyers with expertise in financial regulation, particularly those who have worked for regulatory agencies. Most of the major trade groups are hiring lawyers. The major banks say they are employing more, too.”

So what just happened? According to Senators Carl Levin and Jeff Merkley of Oregon, Dodd-Frank as currently drafted by the agencies charged with carrying out the new law, banks are allowed to amass a single, large bet as a hedge against possible declines in an entire portfolio of securities. Senator Levin:

“[That] …is a big enough loophole that a Mack truck could drive right through it.”

Lesson Four – What Dodd-Frank Missed

In earlier times, banks made money by getting paid more from lenders than they had to pay to attract deposits. In bankers’ parlance, they made money on the spread (the interest rate on loans minus the interest rate paid depositors). Banks knew their survival depended on a positive “spread”, so they were very careful to make low risk loans. And after making them, they stayed in touch and worked with the borrowers to insure interest payments were kept up to date.

Everything changed when banks started selling off their loans. Instead of lending to low risk individuals and firms and worrying about how their borrowers were doing, banks focused on generating commissions by selling off their mortgages and other loans. This constituted a fundamental change in incentive structures – from worrying about the soundness of their loans to writing as many loans as they possibly could for commissions. Think about it: when loans are sold off, repackaged, and sold off again, nobody knows (or cares unless payments stop) who the borrower is. As long as banks are allowed to sell off their loans for commissions, they will not make sound loans. Why should they?

Lesson Five – Why Banks Will Fight Against Any Limits on What They Can Do

The primary job of banks should be to protect our deposits. That is, they should invest them in safe loans and make a modest spread on what they earn on loans. Why has banking changed? It has changed because senior bank officials want to make a lot of money, and they can’t if they only do what banks are supposed to do. Today, taking risks are a win-win proposition for bank executives. If they guess right, they make a lot of money and justify their salaries. If they guess wrong, and the government bails them out. Have any of the big bank presidents lost their jobs as a result of the banking collapse in 2008? No.

I fully agree with Senator Merkley when he suggested to JPM President Dimon:

"If you want to be the head of a hedge fund, be a hedge fund…. Terminate your access to the Fed’s discount window, terminate your access to deposits, and then we have no quarrel.”

Where Do These Lessons Lead Us?

In 1933, Congress required that banks divest their trading arms. In 2012, Congress should insist that “investment banks” divest their banking arms. If you look at the three “banks” in Table 1, their derivative and other trading activities dwarf their deposit banking activities. We should require them to sell off their deposit banking activities. Spin them off in IPOs. This is what investment banks are good at doing. And then require all depository institutions to manage their own loans and not engage in trading for their own accounts. We should not allow banks to engage in any form of trading. It is too risky and regulation will not work.


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About the Author

elliott-morss-photo1Elliott Morss has a broad background in international finance and economics. He holds a Ph.D.in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance


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  1. Frank Li (Member) Email says :

    (1) A private company should be allowed to do whatever it wants, including the loss of $Bs.
    (2) An FDIC bank is not a private company per se.
    (3) An FDIC bank should be banned from trading stocks.

  2. wes favaloro says :

    I wholeheartedly agree with Mr. Morss.Regulation only provides loopholes.In order to participate in the federal banking system,banks should sign charters that limit them to operating the "old fashion way".That is no exotic games,just the ability to serve the marketplace with competent function.

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