The Need For An Independent Investigation Into JP Morgan Chase

By Simon Johnson

JPMorgan Chase is too big to fail. As the largest bank-holding company in the United States, with assets approaching $2.5 trillion as reported under standard American accounting principles, it is inconceivable that JPMorgan Chase would be allowed to collapse now or in the near future. The damage to the American economy and to the world would be too great.

The company’s recent trading losses therefore call for greater public scrutiny than would be case for most private enterprise – and demand an independent investigation into exactly what happened. (Dennis Kelleher of Better Markets has already called for exactly this.) The investigation begun by the F.B.I. is unlikely to be sufficiently public.  Given the strong political connections between JP Morgan and the Obama administration, it would also be better to have an investigation led by a completely independent counsel.

Hopefully, too-big-to-fail is not forever. The Federal Deposit Insurance Corporation is working on a mechanism that could conceivably allow that agency to handle the “failure” of a bank-holding company while protecting the creditors of operating subsidiaries – limiting the potential contagion effect.

But this mechanism is not yet in place, it does not currently apply to cross-border banking (remember that JPMorgan Chase’s losses are in London), and even the F.D.I.C.’s acting chairman, Martin J. Gruenberg, was careful in describing its likely efficacy in a speech last week.

(Disclosure: I’m on the F.D.I.C.’s Systemic Resolution Advisory Committee, and I’ve helped the F.D.I.C. with some outreach activities, designed to help them receive constructive feedback on resolution. I am not paid by the F.D.I.C.)

In effect, JPMorgan Chase operates with the implicit backing of the United States government – primarily in the form of actual and potential access to borrowing from the Federal Reserve, with the implication that the Treasury could also provide support. Being effectively backed by the full faith and credit of the government is a great help; it lowers a bank’s funding costs because it reduces the risk to creditors. JPMorgan Chase and the other big banks in the American economy are effectively government-sponsored (and subsidized) enterprises.

There is no kind of market involved in determining the franchise value of mega-banks; this is a government subsidy scheme, pure and simple. People on the right of the political spectrum understand this, as do people on the left; see my blog post last week on the extent of cross-partisan agreement on this issue.

I would add to that list former Gov. Mike Huckabee of Arkansas. When I appeared on his radio show on Monday afternoon, we were in complete agreement on the need to break up or otherwise constrain the size of big banks.

There are many unanswered questions about the JPMorgan Chase losses and a great deal of informed guesswork about exactly what went wrong. By his own admission, Jamie Dimon, the chief executive, was unaware of what was happening on the relevant trading desk until Bloomberg News reporters brought it to his attention.

At that time he dismissed any concerns as a “tempest in a teapot.” In the weeks that followed, this supposed “hedge” – or risk-reduction strategy – blew up badly.

The question is not why a trader made a mistake; this can happen anywhere. The issue is how this was handled and reported by JPMorgan Chase’s risk-management professionals and their systems – believed by many insiders to be the best in the business.

Here are five questions that an independent investigation should consider:

1. What exactly was the trade? Who approved and reviewed the trade?

2. To what extent were the mistakes encouraged or condoned by particular quantitative models, for example those popularly known as Value-at-Risk? (For a critique, see Pablo Triana’s book, “The Number That Killed Us.”)

3. What did Mr. Dimon know and when did he know it? Was there disclosure to the board and to shareholders with appropriate timing? This is among the specific concerns raised by Mr. Kelleher.

4. Does the board have adequate depth of experience along the relevant dimensions of risk management?

5. What interactions did Mr. Dimon or any of his colleagues have with the Federal Reserve Bank of New York before and during these losses were incurred? Mr. Dimon is on the board of that institution, where his role is described as “advisory.” But on what exactly did he advise them in recent months and years, particularly with regard to risk management and capital levels in systemically important banks?

On the one hand, we hear from bankers that supervisors are watching them closely – and even undermining their business. On the other hand, clearly someone was not paying attention. Why not?

This is not about conducting a witch hunt. It is about establishing the facts and understanding if anything about standard operating procedures and emergency protocols should be examined.

The right analogy is National Transportation Safety Board investigations – a suggestion that has been made by Andrew Lo, my colleague at M.I.T., and his co-authors. We learn a great deal when companies actually go bankrupt; e.g., about Enron (see the excellent book “The Smartest Guys in the Room,” by Bethany McLean and Peter Elkind) and about Lehman (see the bankruptcy examiner’s report).

But we need to investigate near-misses as well.

This is awkward for the White House – look at any of Ben White’s recent pieces on the links between Wall Street and the Obama administration. But the power of big banks on Wall Street makes this kind of investigation even more necessary – see the reporting of Matt Taibbi for some graphic details.

Congress may also want to get involved, at least to understand if Dodd-Frank has been at all helpful. The Volcker Rule is not yet in effect but, if it were, would this have made a difference?

Mr. Dimon contends not, and he has been a consistent and vociferous opponent of the rule from the very beginning. It would seem foolhardy to accept Mr. Dimon’s view on this matter at face value. I testified in favor of the Volcker Rule before the Senate Banking committee in early 2010; Barry Zubrow, then chief risk officer of JPMorgan Chase, testified and strongly opposed it.

Some people in the private sector and within the banking community will push back, asserting that this would further expand the scope of government vis-à-vis legitimate private business. This misses the point — that it is the people who run our largest banks who have undermined the viability of the private sector and who threaten its future.

Cam Fine, president of the Independent Community Bankers of America, has shown strong leadership on this point over the last week (you can follow him @Cam_Fine on Twitter).

In the end, we may well come to the same conclusion as Elizabeth Warren – who has brilliantly seized the political moment and put her opponent for the Massachusetts senate seat, the Republican incumbent Scott Brown, on the defensive.

Ms. Warren is calling for the re-imposition of Glass-Steagall – separating commercial from investment banking. Mr. Fine is already pushing in the same direction. This position should be appealing across the political spectrum.

An edited version of this post appeared on the NYT.com’s Economix blog on Thursday; it is reproduced here with permission.  If you would like to reproduce the entire column, please contact the New York Times.