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Monday, December 09, 2019 {{ new Date().getDay() }}

Celebrations Of Too Big To Fail’s Demise Are Premature

Dec. 9 (Bloomberg) — In a major speech last week, Treasury Secretary Jack Lew argued that we need to keep pushing forward with financial reform. He made some encouraging points about the need to reduce systemic risks arising from money-market mutual funds and for appropriate funding levels at the Securities and Exchange Commission and the Commodity Futures Trading Commission, and he spoke clearly about the need for accountability of regulators and of bank executives. But a huge misconception in his remarks threatens to swamp everything.

Lew argued that the problem of “too-big-to-fail” banks is well on its way to being fixed.

“Earlier this year, I said if we could not with a straight face say we ended ‘too big to fail,’ we would have to look at other options,” Lew said. “Based on the totality of reforms we are putting in place, I believe we will meet that test, but to be clear, there is no precise point at which you can prove with certainty that we have done enough. If, in the future, we need to take further action, we will not hesitate.”

So Lew is arguing that we are on the verge of making it possible for large complex financial institutions — really the six biggest U.S. banks — to fail. Could these entities now really go bankrupt, unencumbered by any kind of government support, with their shareholders wiped out and major potential losses for their creditors, as is the case with almost all other private-sector companies? (In July, Lew set the end of 2013 as a deadline for the disappearance of too big to fail; this seems to be another red line that the administration won’t enforce.)

It is very difficult to find anyone in the private sector — in finance or elsewhere — who shares Lew’s view. (With the exception, of course, of people working for the Big Six or supported by them financially.)

Lew’s logic breaks down in three places.

First, he says the Wall Street Reform and Consumer Protection Act states “clearly that no financial institution is ‘too big to fail.’”

Actually, it doesn’t. The legislation makes it illegal to provide some forms of support to specific companies (for example, the kind of loan that American International Group Inc. (AIG) received in September 2008 probably wouldn’t be allowed). But this prohibition would hardly strain the creativity of the New York Fed the next time it wants to prop up a failing institution. As long as support is available to a broad class of assets or to a set of companies, almost anything remains possible. (Yes, I know that there is a change in some procedures for authorizing support, but anyone who has lived through financial crises can tell you that such formalities are meaningless when the people in charge decide that a bailout is in order.)

The next bailout won’t come from Congress — no one would try to repeat the Troubled Asset Relief Program in this political environment. It will come from, or at least via, the Fed.

Furthermore, with regard to “living wills” — the largest banks’ plans for going bankrupt without causing worldwide financial panic — Lew said “regulators will require firms to rework these plans if they are not credible.”

If the companies “are unable to provide a credible plan,” he said, “regulators can impose remedies, including requiring firms to divest or realign their businesses.”

In truth, there has been no sign of either credible plans or any kind of “remedies.” To suggest that the regulators are really going to use this power is hardly plausible.

In particular, there is no indication that the staff or governors of the Federal Reserve System are moving in this direction.

Lew also puts great stock in the new — and unproven — resolution powers of the Federal Deposit Insurance Corp. The Treasury secretary misses the crucial legal point: This authority is supposed to be a backup, only used if bankruptcy suddenly becomes unappealing.

And he completely ignores (at least in this speech) the inherent difficulties of cross-border resolution, which requires — but can never achieve — cooperation between courts and regulators in different countries. Under present conditions, it would cause another destabilizing scramble for assets.

I favor resolution as a fallback (I’m a member of the FDIC’s Systemic Resolution Advisory Committee, which meets again this week), and the law clearly says it shouldn’t be a first resort (a point that Lew missed). But cross-border resolution won’t work for the megabanks, not unless you offer a U.S. bailout that fully protects all creditors in foreign jurisdictions. But if that occurs, it will no longer be the case that “shareholders, creditors, and executives — not taxpayers — will be responsible if a large financial institution fails.”

I could go on. Lew claims that equity capital is now high enough to make a difference, but he doesn’t provide any relevant numbers — for example, comparing current equity levels with the extent of losses that we have observed or are likely to observe in crises.

Lew says the Volcker rule, the final version of which will be released this week, will make a big difference. I doubt there is enough transparency in the global megabanks for anyone to see the new ways in which proprietary bets are disguised.

There is a real danger that senior officials are ready to declare victory, while changing essentially nothing about the reality of what makes a global megabank too big to fail.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.)

AFP Photo/Jim Watson

JPMorgan Is Too Big To Whine

Oct. 21 (Bloomberg) — A new injustice plagues the land, at least according to people who take the side of JPMorgan Chase & Co. and its chief executive officer, Jamie Dimon, after the bank’s tentative agreement to pay a record $13 billion to end civil claims related to its sales of mortgage bonds. The bank and its leader are now — it is claimed — subject to Politically Motivated Prosecution.

This is pointless whining, for three reasons.

First, when pressed, advocates for big banks readily concede that “no one is above the law.” What else can they say in a democracy? When Attorney General Eric Holder and his criminal division chief at the time, Lanny Breuer, suggested last year that very large companies were too big to prosecute, there was even some feeling of embarrassment in the big bank camp -– as well as a great deal of pressure on Holder to walk back his congressional testimony on this point.

Now that charges have been brought and a settlement is almost signed, Dimon’s allies can’t stop complaining.

So no one is above the law, but no charges should be brought? Dimon’s camp wants regulation and law enforcement by lip service, which would just be an invitation to further lawless behavior.

Second, JPMorgan is the largest U.S. bank, and one of the most powerful politically. Dimon met with the attorney general to discuss the charges in September. (He spoke again with Holder at the end of last week.) Most people don’t get such an opportunity — in fact, the Justice Department can’t remember the last time a CEO had this kind of access.

The Supreme Court isn’t known to be anti-business. If there is anything unreasonable or unjustified in the charges, JPMorgan should fight them all the way up.

To suggest that JPMorgan has no legal recourse is to completely misrepresent the way the legal and political systems work. JPMorgan makes big political donations and has powerful protectors in Congress. The bank employs some of the best lawyers, too.

Third, JPMorgan bears responsibility in two ways: the actions by companies it bought (Washington Mutual Inc. and Bear Stearns Cos.) and the actions by JPMorgan itself.

If buying a company could absolve that entity and its employees of all sins, imagine the merger wave we would have.

As Peter Eavis wrote in the New York Times, JPMorgan’s executives knew what they were buying, and expected the kind of legal problems that materialized. After the Washington Mutual deal closed, Dimon said, “There are always uncertainties in deals,” and “our eyes are not closed on this one.”

Assets at both Bear Stearns and Washington Mutual were — justifiably — sharply marked down upon acquisition, presumably to reflect mortgage-related issues.

Blaming the government is a way of saying crisis management by merger isn’t a good idea; creating the largest U.S. bank in this fashion wasn’t such a smart idea for anyone. But at the time, Dimon was keen to make a deal, including one with Federal Reserve financing, in the case of Bear Stearns.

Banking is a regulated industry. But we all observe rules and regulations in our lives. If someone breaks the law, does that mean it is solely the fault of the legislator or the regulator? This is very strange logic.

And “Fannie Mae made me do it,” sounds like a line from Monty Python. But that’s exactly what some of Dimon’s supporters are saying.

More broadly, the list of JPMorgan’s own wrongdoings grows longer and includes illegal foreclosure practices. Nina Strochlic at the Daily Beast calculates that since 2011 the bank has been fined $8 billion (before the latest settlement) in almost a dozen separate instances of illegal and improper behavior. For more background, I recommend Josh Rosner’s recent analysis.

Did Dimon and his colleagues break the law on purpose? Presumably not; otherwise, the board of directors surely would have made a change by now.

Are the allegations of a pattern of illegal behavior by JPMorgan just a politically motivated prosecution, a vast left-wing conspiracy? Anyone making such a claim is just being silly and lacks credibility.

The most plausible explanation is that JPMorgan has become so large and so sprawling that management has lost control. Dimon’s attention to detail and risk management were once legendary. It is impossible look at him now without also remembering that he carries the London Whale derivatives fiasco on his shoulders. This impression was reinforced last week when JPMorgan admitted to a form of market manipulation in connection with the London Whale (this was a separate settlement with the U.S. Commodity Futures Trading Commission).

At a debate in New York last week, a proponent of big banks argued that the resolution of the London Whale episode showed that the system works.

Was he referring to the system in which our largest bank repeatedly breaks the law, is slapped on the wrist and whines about it?

JPMorgan has lost control of its legal risks. What other risks will it mismanage next?

(Simon Johnson is a Bloomberg View columnist.)

Photo: Steve Jurvetson via Wikimedia Commons

Brown-Vitter Recasts Financial-Reform Battlefield

April 29 (Bloomberg) — A year ago, the big U.S. banks were focused on repealing, or at least eliminating large parts of, the Dodd-Frank financial-reform law.

They poured money into the campaign of the Republican presidential nominee, Mitt Romney, and gave generously to opponents of pro-reform Senate candidates Sherrod Brown and Elizabeth Warren. At the same time, lobbyists devised creative tactics to delay implementation of Dodd-Frank — filing lawsuits, mobilizing international pressure, hiring former regulators, writing opinion articles and comment letters, and commissioning faux research pieces. It was a tour de force by one of the great lobbies at the top of its game.

And it failed.

On April 23, I attended a forum organized by American Banker, a trade publication, to discuss the legislative proposal crafted by Brown, an Ohio Democrat, and Senator David Vitter, a Louisiana Republican. In attendance was a Who’s Who of the industry lobby, with all the major groups represented at a senior level, including the Financial Services Forum, the Clearing House and the American Bankers Association.

They let it be known that the line from big banks and their allies had shifted and that their new refrain is “let’s implement Dodd-Frank.”

This sounds like a significant change in rhetoric, but don’t fall for it. The reality remains the same — a very powerful lobby is working flat-out to ensure that the industry keeps its dangerous, nontransparent and unfair subsidies. Yet the winds are shifting against the megabanks for three main reasons.

First, the Brown-Vitter legislation, which was introduced April 24, changes everything. The news isn’t that Brown wants to make the financial system safer. That has been a top priority of his since the spring of 2010, when he co-wrote the Brown-Kaufman amendment, which would have imposed a binding size cap on the largest banks. (It failed on the Senate floor.)

Now, however, he has a Republican co-sponsor, and they have converged on a strong message. Vitter, who is on the right of the political spectrum, articulates well the case for ending the implicit subsidies that exist because creditors understand that the government and the Federal Reserve won’t allow a megabank to fail. This broad and sensible message resonates across the political spectrum.

Second, small banks are increasingly focused on the ways megabanks have achieved an unfair competitive advantage — primarily through implicit government subsidies.

The most compelling voice at the forum last week was Terry Jorde, a senior executive vice president of the Independent Community Bankers of America. She made clear that small banks are being undermined by the reckless behavior of megabanks that are seen as “too big to fail.” There is no market at work here, just a hugely unfair and inefficient government-subsidy scheme. The U.S. economy wasn’t built on megabanks and there is no good reason to continue to accept the risks they pose.

The megabanks have more money to spend on politics than the community banks. And as the biggest banks become even larger, they acquire more clout, spreading branches and other largesse across congressional districts. But for the moment, in all 50 states, community bankers are strong enough — both directly and as leaders in their communities — to effectively stand up to the six largest banks that are at the heart of the problem.

Camden Fine, the chief executive officer of the Independent Community Bankers of America, has made clear that he strongly endorses Brown-Vitter. Expect to see a lot more community bankers in senators’ offices.

Third, what Brown, Vitter and Fine express isn’t populist anger, but rather a thought-out plan for making the financial system safer. Read the bill and the section-by-section guidance (available here). Brown-Vitter blends some powerful thinking. For example, it reflects the ideas of Richard Fisher and Harvey Rosenblum of the Dallas Federal Reserve on how to remove government guarantees; the critique of Basel III from Tom Hoenig of the Federal Deposit Insurance Corporation; and the lessons of Sheila Bair, a former chairman of the FDIC, on the failures of supposedly smart regulation (her book “Bull by the Horns,” is a must-read; see, for example, the material in Chapter 3 on who pushed for the Basel II capital standards and why this almost proved disastrous).

Bair, Fisher, Hoenig, Rosenblum and the people who work with them aren’t populists. They are thoughtful and experienced technocrats who have worked long and hard in the sphere of practical policy.

Intellectually, the tide has turned. The dangers of reckless behavior by global megabanks are now understood much more broadly. And Brown-Vitter provides an appropriate roadmap for addressing some of the core problems and making the financial system significantly safer.

(Simon Johnson, a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You. The opinions expressed are his own.)

Photo: Ohio AFL-CIO via Flickr.com

Goldman’s Big Guns Fire Dud To Defend Megabanks

April 15 (Bloomberg) — The six very large U.S. bank holding companies — JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley — share a pressing intellectual problem: They need to explain why they should be allowed to continue with their dangerous business model.

So far their justifications have been weak, and the latest analysis on this topic from Goldman Sachs may even help make the case for breaking up the financial institutions and making them safer.

Legislative proposals from two senators, Democrat Sherrod Brown of Ohio and Republican David Vitter of Louisiana, have grabbed attention and could move the consensus against the modern megabanks. Under intense pressure from Democratic senator Elizabeth Warren of Massachusetts, Federal Reserve Chairman Ben S. Bernanke conceded recently that the U.S. still has a problem with financial institutions that are seen as too big to fail. Pressed by Republican senator Chuck Grassley of Iowa, among others, Attorney General Eric Holder is sticking to his story that these companies are too big to prosecute. Cyprus offers another vivid reminder of what happens when banks become too big to save.

In this context, it is no surprise to see the financial sector wheel out its own intellectual big guns. A frisson no doubt rippled through the financial-lobbying community last week with the release of a report (PDF) from Goldman Sachs’ equity research team, “Brown-Vitter bill: The impact of potential new capital rules.” This is the A-team at bat, presumably with clearance from the highest levels of management.

Yet instead of providing any kind of rebuttal to the proposals in Brown-Vitter, the report may strengthen the case for breaking up the six megabanks, while also requiring that they and any successors protect themselves with more equity relative to levels of debt. Read the report with five main points in mind.

First, notice the lack of sophistication about bank capital itself. The authors write of banks being required to “hold” capital, as if it were on the asset side of the balance sheet. They go on to construct a mechanistic link that implies that “holding” capital prevents lending.

Banks don’t hold capital. The proposals are concerned with the liability side of the balance sheet — specifically, the extent to which banks fund themselves with debt relative to equity (a synonym for capital in this context). Higher capital requirements push companies to increase their relative reliance on equity funding, thus increasing their ability to absorb losses without becoming distressed or failing. If the transition is properly handled, there is no reason that more equity funding would translate into lower lending.

Second, the Goldman Sachs analysts seem completely unaware of the recent book by Anat Admati and Martin Hellwig, The Bankers’ New Clothes, in which those authors — who are top finance professors — debunk the way many bank representatives (including the authors of the Goldman Sachs note) look at issues around capital.

More equity relative to debt on a bank’s balance sheet means that equity and debt become safer: The bigger buffer against losses helps both.

Goldman Sachs makes much of the implications for return on equity, without mentioning any adjustment for risk. Bankers are generally paid based on return on equity without proper risk adjustment. Naturally, they like a great deal of leverage, but the reasoning they use to justify this is fallacious (see Chapter 8 in Admati and Hellwig).

Admati and Hellwig make the broader case that we can run our system much more safely. Goldman Sachs made a big mistake by refusing to take them on directly.

The bank is correct in its assessment that bank equity is higher than it was before the 2007-08 crisis, but this is the natural reaction to a near-death experience. Over the cycle, big banks will again become more leveraged (meaning they will have less equity relative to debt). As a result, Goldman is far too optimistic in its projection of the capital levels that will be needed when the next crisis hits. Current — and likely future – – levels of equity capital are insufficient for our intensely interconnected financial system.

Contrast Goldman Sachs’ note with this excellent speech last week by Tom Hoenig, vice chairman at the Federal Deposit Insurance Corp., on the illusion of the Basel III rules in particular and the right way to think about capital more generally.

Third, while the Goldman Sachs analysts get some points for stating the obvious about Brown-Vitter — “In our view such a bill would incent the largest banks to break up” — they fail to explain why this would be a bad thing.

They do, however, have a line about how banks could only be broken up along existing divisional lines, though they fail to make clear why they believe this is the case or how it would be the best deal for shareholders. Also, once the too-big-to-fail subsidies fade, these new companies would probably be smaller than projected by Goldman Sachs. Less complex, easier to govern and more transparent to supervisors sounds pretty attractive, to officials and investors. (Any client can request a copy of Goldman’s May 2010 report, “U.S. Banks: Regulation.” See Page 32, where it explains how JPMorgan and Bank of America would be worth more if broken up. Richard Ramsden is the lead author of both this report and the one cited above.)

Fourth, the analysts express concern that these smaller companies will be less diversified and therefore more fragile than the megabanks. Delusions of diversification are precisely what brought us to the brink of catastrophe in September 2008. Have the smartest people on Wall Street really learned so little?

From a social perspective, we want a system in which some companies can fail while others prosper, more like the conditions under which hedge funds operate. For macroeconomic purposes, we want diversity within the financial sector, not diversification within Citigroup (which has come close to failing three times since 1982 precisely because of this misperception).

Fifth, on supposed progress to eliminate too big to fail, Goldman’s arguments fall under the heading of what Winston Churchill called terminological inexactitude. The Orderly Liquidation Authority under the Dodd-Frank financial reform law won’t work for complex cross-border banks, such as Goldman, because there is no cross-border resolution authority. Living wills have so far proved to be a joke, and annual stress tests show every sign of becoming a meaningless ritual that undermines serious supervision.

What will move forward the debate? Will it be another money-laundering scandal, another disaster in the European financial system, or further revelations about the London Whale and Libor?

Or will it be thoughtful people sitting down to evaluate the best in-depth arguments for both sides? If it’s Admati and Hellwig v. Goldman Sachs in the court of informed public opinion, reformers win in a landslide.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You. The opinions expressed are his own.)

Photo by Fortune Live Media via Flickr.com

Money-Laundering Banks Still Get A Pass From U.S.

April 1 (Bloomberg) — Money laundering by large international banks has reached epidemic proportions, and U.S. authorities are supposedly looking into Citigroup Inc. and JPMorgan Chase & Co.

Governor Jerome Powell, on behalf of the Board of Governors of the Federal Reserve System, recently testified to Congress on the issue, and he sounded serious. But international criminals and terrorists needn’t worry. This is window dressing: Complicit bankers have nothing to fear from the U.S. justice system.

To be on the safe side, though, miscreants should be sure to use a really large global bank for all their money-laundering needs.

There may be fines, but the largest financial companies are unlikely to face criminal actions or meaningful sanctions. The Department of Justice has decided that these banks are too big to prosecute to the full extent of the law, though why this also gets employees and executives off the hook remains a mystery. And the Federal Reserve refuses to rescind bank licenses, undermining the credibility, legitimacy and stability of the financial system.

To see this perverse incentive program in action, consider the recent case of a big money-laundering bank that violated a deferred prosecution agreement with the Justice Department, openly broke U.S. securities law and stuck its finger in the eye of the Fed. This is what John Peace, the chairman of Standard Chartered Plc, and his colleagues managed to get away with on March 5. The meaningful consequences for him or his company are precisely zero.

At one level, this is farce. Standard Chartered has long conceded that it broke U.S. money-laundering laws in spectacular and prolonged fashion. In late 2012, it entered into a deferred prosecution agreement with the Justice Department, agreeing to pay a fine that amounts to little more than a slap on the wrist (in any case, such penalties are paid by shareholders, not management).

Then, on a March 5 conference call with investors, Peace denied that his bank and its employees had willfully broken U.S. law with their money-laundering activities. This statement was a clear breach of the deferred prosecution agreement (see paragraph 12 on page 10, where the bank agreed that none of its officers should make “any public statement contradicting the acceptance of responsibility by SCB set forth above or the facts described in the Factual Statement”). Any such statement constitutes a willful and material breach of the agreement.

This is where the theater of the absurd begins. For some reason, it took the bank 11 business days, not the required five, to issue a retraction. No doubt a number of people, in the private and public sectors, were asleep at the switch. (The Justice Department and Standard Chartered rebuffed my requests for details on the timeline.)

The implications of the affair are twofold. First, with his eventual retraction, Peace admitted that he misled investors. It also was an implicit admission that he had failed to issue a timely correction. Waiting 11 days to correct a material factual error is a serious breach of U.S. securities law for any nonfinancial company. Wake me when the Securities and Exchange Commission brings a case against Standard Chartered.

Of course, it’s possible that Peace didn’t deliberately violate the deferred prosecution agreement because he hadn’t read it, or at least not all the way to page 10. Peace is an accomplished professional with a long and distinguished track record. Everyone can have a forgetful moment. That still doesn’t explain why the bank took so long to correct the facts.

Tone at the top matters, as reporting around JPMorgan Chase and its relationship with regulators makes clear. Will Chief Executive Officer Jamie Dimon be more cooperative than he was, for example, in August 2011 when he refused to provide detailed information on the goings-on in his investment bank?

Why hasn’t Standard Chartered’s board, which is made up of talented and experienced individuals, forced out Peace as a result of this bungling? (I called for his resignation on my blog last week.)

The only possible explanation is that the board thinks Peace did nothing wrong. They may even regard U.S. laws as onerous and the Department of Justice as heavy-handed.

They would be entitled to their opinions, of course. But if they would like their bank to do business in the U.S., the rules are (supposedly) the rules. If used appropriately, permission to operate a bank in the U.S. grants the opportunity to earn a great deal of profit.

At a recent congressional hearing, Senator Elizabeth Warren of Massachusetts asked what it would take for a company to lose its U.S. banking license. Specifically, “How many billions of dollars do you have to launder for drug lords?”

Powell, the Fed governor, replied that pulling a bank’s license may be “appropriate when there’s a criminal conviction.”

I have failed to find any cases of the Fed ordering the termination of banking activities in the U.S. for a foreign bank after a criminal conviction for money laundering. Nor, for that matter, has the Fed taken action to shut down a bank that signed a deferred prosecution agreement, which, in the case of Standard Chartered, was an acknowledgment of criminal wrongdoing. Nor has it taken action when such an agreement was violated.

To see what the Fed is empowered to do under the International Banking Act, and working with state authorities, look at the case of Daiwa Bank, which received an Order to Terminate United States Banking Activities in 1995. Note to big banks: Don’t allow illegal trading in the U.S. Treasury market; on this, we may still have standards. By the way, in the case of Daiwa, there was no criminal conviction.

Last summer, when Barclays’ Chief Executive Officer Robert Diamond was less than fully cooperative with the Bank of England in providing details of the Libor scandal, he was gone within 24 hours. Any bank supervisor has the right and the obligation to force out a manager who impedes the proper functioning of the financial system.

The new CEO of Barclays is trying to clean house. The obstreperous approach of the previous management set the tone for the entire organization, creating a mess of macroeconomic proportions.

Will any senior executives at Standard Chartered be forced out? Could the bank lose its ability to operate in the U.S.? Based on what we have seen so far, neither seems plausible.

If Standard Chartered violates its cease-and-desist order with the Fed, would it then lose its license? Not according to what Powell said in his congressional testimony. The Fed has no teeth whatsoever, at least when it comes to global megabanks, hence the continuing pattern of defiance from JPMorgan and Dimon.

If you or I tried to launder money, even on a small scale, we would probably go to jail. But when the employees of a very big bank do so — on a grand scale and over many years — there are no meaningful consequences.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You. The opinions expressed are his own.)

Photo: Tomkasing/Wikimedia Commons

Simon Johnson: A Plan To Keep Wall Street From Blowing Everything Up Again

May 29 (Bloomberg) — There are growing concerns that the regulatory bodies overseeing the financial sector are incapable of understanding, preventing or even properly investigating excessive risk taking that threatens to ruin the economy.

This issue was raised before the 2008 financial crisis and received more attention during the debate that led to the 2010 Dodd-Frank financial-reform law. Some tweaks were made in various parts of the regulatory apparatus, including the governance of the Federal Reserve Bank of New York, to reduce the influence of Wall Street.

In light of the $2 billion-and-counting trading losses at JPMorgan Chase & Co., the issue is back on the table. If anything, the key points have been sharpened both by what we know and don’t know about JPMorgan’s losses. It is time to consider establishing the equivalent of a National Transportation Safety Board for the financial sector, along the lines suggested by Eric Fielding, Andrew W. Lo and Jian Helen Yang. (Andrew Lo is my colleague at the MIT Sloan School of Management.)

In 2008, many things went wrong to create a true systemic crisis. The Financial Crisis Inquiry Commission spent a great deal of time poring over the details; in the end its conclusions split along party lines. In my assessment, deregulation allowed big financial companies to take on and mismanage excessive risks. They blew themselves up at great cost to the economy, and then received arguably the most generous bailout in history.

I blame the regulators and the banks, and the ways in which the latter captured the hearts and minds of the former (as well as politicians of both parties). Other people, particularly those who like such firms, disagree — and prefer to put the entire onus on the regulators.

The JPMorgan trading losses of 2012 are much more specific and focused. We know that something went badly wrong in a high- profile trading unit, staffed with people who were considered to be the best in the business. We know that Jamie Dimon, the chief executive officer, approved in general what was happening, yet appears not to have been informed about key decisions.

We don’t know the exact nature of the initial mistake or mistakes. We don’t know the details of reporting within the JPMorgan management structure. And we also don’t know what Dimon knew and when he knew it. There are press accounts on all these points — with some stories appearing to contain more or less guidance from JPMorgan’s public-relations team.

In essence, a serious accident occurred at JPMorgan. Or we might call it a “near miss” in terms of systemic implications. Major banks don’t fail in benign periods, and this isn’t the worst quarter in recent memory, nor the worst we are likely to face in the near future. (I’m thinking of a rolling series of likely debacles in the euro area.)

It is in the public interest to have a proper, independent investigation of the losses at JPMorgan. But here we run into a number of practical and political difficulties.

First, the obvious parties to conduct an investigation are also the regulators and supervisors of JPMorgan — and thus face a potential conflict of interest. Would the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency or the Federal Reserve really want to uncover and explain what they previously overlooked?

The Federal Bureau of Investigation has launched a probe, but its focus is presumably on whether to bring charges, rather than to figure out how to make the financial system safer. The Office of Financial Research, established by Dodd-Frank to monitor financial risk in the larger picture, so far has had no discernible effect.

Second, Dimon has the best possible political connections, including at the White House, where one of his former executives, Bill Daley, was until recently the chief of staff. Dimon also sits on the board of the Federal Reserve Bank of New York, a supervisor of large banks and the source of expertise on financial markets within the Federal Reserve system.

There is an active debate in and around official circles about whether Dimon’s position on the New York Fed creates the perception of a conflict of interest, or worse, the reality. Even Treasury Secretary Timothy Geithner suggested recently that Dimon should resign from that role. This is striking given that Geithner isn’t known to be unfriendly to very large banks.

If the CEO of an airplane manufacturer or a major airline sat on the NTSB board, would that make you more or less concerned about the safety of air travel? The board is a federal agency charged solely with investigating transportation accidents. Its members are appointed by the president, subject to confirmation by the Senate. Board members can’t be executives or employees of airline or other transportation-related companies. They are also not allowed to have any financial interest in such companies. (All these details and more are in the paper by Fielding, Lo and Yang.)

At the same time, the board members have long and relevant work experience. Their biographies are impressive. They have substantial political, regulatory, industry and practical experience (at least three are pilots, but I’m also impressed that the chairman is licensed to drive a school bus). One board member is an expert on human fatigue.

In most parts of U.S. public life, we care greatly about governance. This makes sense, given that the U.S.’s legal tradition is partly based on a long-standing and well-founded suspicion that strong executives can behave in an irresponsible and socially damaging manner. That was, of course, the problem the Founding Fathers had with King George III — and a perspective that motivated and informed the Constitutional Convention of 1787.

The board is a small agency (about 400 employees). Its area of expertise is disaster investigations. It also consults widely with all relevant parties after a crash or similar event, including with the people who built and operated the relevant systems. But there are clear rules regarding transparency for both the reporting of facts and deliberation of what happened (again, see Fielding, Lo and Yang for the details).

We need finance to run a modern economy, just as we need transportation. Finance has become more complex and more prone to major disasters; just ask JPMorgan shareholders. We should learn from accidents and mistakes and figure out how to make the system safer.

The point isn’t to eliminate risk from the financial sector, air travel or our lives; that is impossible and a fool’s errand. But we should better understand those risks and how to control them. When the supposedly best risk managers on Wall Street suddenly announce billions of dollars in unexpected losses, we need to know exactly what happened and why.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is a co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

Europe: It's Still Likely to End Badly

Jan. 23 (Bloomberg) — There are two main schools of thought on what may happen next with Europe’s debt crisis. Some well-informed people strongly believe that everything will work out just fine, and without much of an economic slowdown. Other, equally well-informed people believe just as strongly that the euro area will break apart in a traumatic manner. When it comes to predicting Europe’s future, not many people occupy the middle ground.

The two poles now agree that the severity of the crisis largely comes down to Italy and the European Central Bank. The optimists argue that Mario Monti will save the day. Not only will Italy’s new prime minister push through some reasonable austerity measures, the optimists insist, he will also persuade Germany not to demand yet more budget cuts. The sympathy and support of the German government matters a great deal, primarily because of its influence with the ECB.

If we were still living under the “no bailout” conditions of the gold standard, as it actually operated before 1914, Italy would have no hope. The market has decided that Italy has too much debt and too little growth. As these expectations become more negative and interest rates rise, it becomes harder for Italy to issue new debt and make the required payments on existing obligations. Projected government debt levels become explosive.

Today’s world, of course, has moved far from the gold standard because central banks can provide credit and create money. The central banks are limited only by their credibility, or the level of confidence by the financial system that policy makers will keep inflation in check.

The ECB has, in the jargon of the day, a big bazooka. It can provide a great deal of cheap credit to Italy and other troubled European sovereigns. If Italy doesn’t need to borrow from private markets for the next few years, the reasoning goes, an economic recovery can take hold. There may also be sensible changes at the level of euro-area governance, including perhaps a greater degree of fiscal union. And Germany could throw some fiscal stimulus into the mix.

My colleagues at the Peterson Institute for International Economics, Fred Bergsten and Jacob Kirkegaard, have a new paper: “The Coming Resolution of the European Crisis,” which argues that such outcomes constitute the most likely scenario.

They quote Jean Monnet, a driving force behind European integration, who said “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” Politicians, Bergsten and Kirkegaard believe, will rise to meet the occasion.

I’m in the more skeptical camp. Peter Boone and I also have a new paper, “The European Crisis Deepens,” which reviews a range of scenarios and concludes that the euro area is likely to end badly.

If this were just an exchange system on the brink of collapse, we wouldn’t care that much. History is full of fixed exchange-rate arrangements that broke down. In fact, a cynic might even point out that all attempts to fix exchange rates, whether against gold, the dollar or other currencies, ultimately fail.

Think about the gold standard in its various permutations: the post-World War II Bretton Woods system, attempts by East Asian countries to peg their exchange rates in the 1990s, or even the ultimately disastrous Argentine currency peg from 1991 to 2002. They all illustrate that holding on to an exchange peg for too long is a classic policy mistake. Usually when it ends, there is a great deal of concern about the future, but such worries are often overblown: A depreciation in the exchange rate can help an economic recovery, as long as the lid can be kept on inflation.

But Europe’s problem isn’t just that some countries have the wrong exchange rate, and no way to adjust it within the existing system. The main issue is that governments borrowed heavily during the good times, which are most definitely at an end.

Italy has more than 1.9 trillion euros ($2.5 trillion) in debt outstanding. Bringing this under control through austerity alone is unlikely to work. In countries such as Greece and Ireland, the economic contraction is further undermining fiscal sustainability.

If the ECB buys a great deal of Italian debt or finances banks that are willing to do the same, it might stabilize the situation for a while. But how much can the ECB really do without jeopardizing its credibility? How long will long-term interest rates stay low, even if short-term inflation accelerates? What will happen to inflation expectations if the ECB continues to expand credit in this fashion?

Many people, including leading bankers and those with access to the highest levels of government, want to prevent any kind of Italian debt restructuring. But at some point in every fixed exchange-rate regime, even the most powerful people have to confront basic arithmetic. When budget deficits cannot be financed, when enough capital is flowing out, and when the central bank has gone beyond the limits of what is responsible, it is always time to move the exchange rate.

When the country that devalues has borrowed heavily in a foreign currency — as the euro effectively is for Italy at this point — there is a sovereign debt crisis and usually a restructuring of the government’s obligations. Avoiding some version of this in the euro area will be hard.

(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008 and is now a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)

Copyright 2012 Bloomberg

Bank Of America Is Too Much Of A Behemoth To Fail

Oct. 24 (Bloomberg) — The Obama administration says the Dodd-Frank financial reform law ends “too big to fail,” meaning that no financial institution will ever again need to be bailed out. The promise is alluring, but it’s already proving to be false.

The argument rests on the premise that bank capital is now high enough to withstand serious shocks, so a calamity is less likely. It also assumes that Dodd-Frank’s new resolution authority allows global financial institutions to be wound down in an orderly fashion, and that the law’s call for “living wills” ensures that banks provide all the necessary technical details regulators might need to take prompt pre-emptive action.

Consider the law’s promise in the context of Bank of America Corp. Through the back door, U.S. regulators are facilitating another round of implicit bailouts, putting more taxpayer money on the line in the form of guarantees. Bloomberg News reported on Oct. 18 that regulators have allowed Bank of America to move highly risky derivatives contracts — and the associated downside risk — from Merrill Lynch into the insured retail deposit-taking part of the bank.

The move puts the Federal Deposit Insurance Corp. on the hook for any losses. The FDIC’s deposit-insurance funds come from its member banks, but because the agency can tap a U.S. Treasury line of credit if the fund runs dry, taxpayers could be at risk, too.

This condones the continuation, or perhaps escalation, of taxpayer-backed gambling on a grand scale — and by people who aren’t very good at it. The U.S. is heading in the direction of Western Europe, where state-backed banks repeatedly bring everyone to the brink of disaster. Consider, for example, UBS AG’s recent rogue-trading episode.

Bank of America is a behemoth beyond control. The destruction of shareholder value in its recent history is shocking. The Wall Street Journal reported on Oct. 19 that the bank has spent $148 billion on acquisitions since 1998 and today its market value is only about $65 billion.

Bank of America is also a badly managed bank. In 2008, Ken Lewis, then the chief executive officer, agreed to pay about $4 billion to buy Countrywide, a disastrous foray into mortgage origination and distribution that will probably end up costing shareholders more than $60 billion. Eric Schneiderman, the New York state attorney general, is calling for a full investigation of mortgage abuses; egregious and allegedly illegal behavior at Countrywide must be very much in his sights.

Lewis bought Countrywide after a year’s worth of due diligence — what was he thinking? — and then grabbed Merrill Lynch over a weekend in September 2008, apparently without much thought. Significant additional losses were the result.

Why the FDIC would agree to escalate taxpayer subsidies now is a puzzle. According to people familiar with the situation, the Federal Reserve pressed for this move, which required an exemption from the usual rules. This outrage demands immediate congressional investigation.

Does Bank of America have enough capital to avert disaster? From its third-quarter results, it has $2.2 trillion in assets, making it the second-largest bank in the U.S. The book value of its tier-one common equity is about $117.7 billion — hardly a robust buffer against the shocks that appear likely from mortgage litigation and from the European debt disaster. Investors believe that much of this capital will be wiped out — hence the lower market valuation.

A large chunk of its most recently reported profit actually turns out to be due to the decline in the market value of its debt, precisely because investors realize it is in so much trouble. This ludicrous application of accounting standards should raise major flags for regulators.

If Bank of America really had enough capital, it wouldn’t have needed to move its derivatives risk onto its FDIC-insured deposit business. Nor would the Obama administration be strenuously resisting the New York attorney general’s efforts to organize a full and fair mortgage settlement based on all the facts.

Could the resolution authority be used on Bank of America? Definitely not in a way that would bring calm to the markets. Merrill Lynch is a global business and the resolution authority is purely domestic. I have discussed this point repeatedly with U.S. legal and financial experts and with members of the Group of 20 nations. Their opinion on this point is unanimous: The Dodd-Frank resolution authority doesn’t help manage the orderly liquidation of a global bank.

There could be a conservatorship, but that is just a long word for full creditor bailout. Or there could be a bankruptcy, with the kind of disorganized collapse seen after the failure of Lehman Brothers Holdings Inc. Those are the choices.

Could the living-will provision make a difference? The FDIC claims it would have handled the problems at Lehman differently if the Dodd-Frank powers had been in effect and if it had full and timely information. But the essence of the argument is that the FDIC would have acted before the problems got out of control. Given the politics of the regulatory process and the predisposition of Treasury not to act early, I am skeptical.

So here is a fair test for this part of Dodd-Frank. Bank of America should clearly be broken up into pieces, spinning off Merrill Lynch along with other structural changes. Will the regulators pursue this course of action? Breaking up the bank would be good for the country, should help stabilize the financial system and could even create value for its shareholders.

Such an action would draw support from both the right and the left. Republican presidential candidates should be drawn to this position (apart from Mitt Romney, who has already taken a lot of money from big banks). So far, the only one to have identified “too big to fail” as a problem, and proposed a course of action, is Jon Huntsman.

When will other politicians and regulators awake from their current complacency? Bank of America should be forced to break itself up. Make the pieces small enough and simple enough to fail. Then let the market decide.

(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)