JPMorgan fiasco shows big-bank regulation isn’t working

During JPMorgan Chase & Co.'s quarterly earnings conference call last month, Chief Financial Officer Douglas Braunstein seemed to assure listeners that they shouldn't worry, because regulators knew everything the company was doing.

"We are very comfortable with our positions as they are held today, and I would add that all of those positions are fully transparent to the regulators," Braunstein said on April 13. "They review them, have access to them at any point in time," and "get the information on those positions on a regular and recurring basis as part of our normalized reporting."

In other words: There wasn't a problem, because if there were, the regulators would have seen it. And by all indications, they didn't see it, even though they were embedded in JPMorgan's offices.

On May 10, JPMorgan divulged $2 billion of intra-quarter trading losses and said they might get worse.

Once again, regulators seem to have been oblivious to huge risks at a bank they were supposed to be overseeing. To JPMorgan, however, the regulators have also served a valuable purpose.

Having regulators at JPMorgan around the clock reinforces market expectations that the government has to stand behind the bank should it run into more serious trouble. Also, JPMorgan's chief executive officer, Jamie Dimon, sits on the board of the Federal Reserve Bank of New York, even as the Fed is one of the agencies investigating the trading debacle.

The regulators' very presence also may be of personal benefit to anyone at JPMorgan who might face scrutiny later. Let's say the Securities and Exchange Commission were to consider accusing executives of rule violations. If what Braunstein said is true, there's a chance these people might defend themselves by saying everything they did was under the regulators' noses.

Doubling down

This might be one reason the government hasn't brought a case, criminal or civil, against former executives of Lehman Bros. For several months before it collapsed, regulators were in Lehman's offices full-time, as the company's bankruptcy-court examiner noted in his 2010 report on Lehman's failure.

If Lehman was lying to investors, the bank's regulators should have been able to spot it. However, Lehman's on-site regulators from the SEC may have lacked the expertise to understand the information they were receiving. It didn't occur to them, for example, that Lehman was manipulating its leverage ratios through accounting tricks that weren't disclosed to investors.

We have come to expect similar ineptitude from the Fed, the Office of the Comptroller of the Currency, and other agencies charged with keeping large banks safe. They failed to prevent the last banking crisis; their policies even helped cause it.

Nonetheless, Congress responded by doubling down on regulators' ability to stop the next crisis when it passed the Dodd-Frank Act in 2010. That law expanded the regulators' responsibilities. The biggest banks have gotten bigger since and now enjoy the official distinction of being "systemically important."

There must be a better system for protecting the public. We shouldn't need federal minders permanently camped out at giant banks' offices, and we wouldn't if we didn't have too-big-to-fail banks such as JPMorgan.

Breaking them up is the simplest solution. The trouble is that it might take another spectacular blowup to break the industry's stranglehold on Washington.

Let's start with some basic principles that should be obvious but seem forgotten. Bank employees and regulators should operate at arm's length. They shouldn't be so tight that a regulator's failure to object can be construed as a government seal of approval.

No financial institution should be so large that it could topple the economy. Failed banks should be allowed to fail, which isn't a problem as long as they are too small to cause a worldwide crisis. And if executives break the law, prosecutors should be able to pursue charges against them without worrying that they will assert the regulators' knowledge as a defense.

Break them up

It's no surprise that Fed Chairman Ben Bernanke has rejected calls to break up the big banks. As the largest ones grow larger and more important, so do the bureaucracies overseeing them. No government agency wants to give up power or influence.

The only way we will end too-big-to-fail is to break them all up. Bring back the Glass-Steagall Act, which Congress repealed in 1999, to separate commercial lending from investment banking. Then maximize transparency: The investments that banks make with federally insured deposits shouldn't be a secret. Detailed disclosure of these holdings — at least monthly, maybe even daily — should be mandatory, so that markets can catch whatever the regulators miss.

JPMorgan just gave the country a $2 billion warning. There's no sense waiting for a bigger one.

Jonathan Weil is a Bloomberg View columnist.