JPMorgan and the conceptual confusion of the Volcker rule

Article Highlights

  • $2 Billion should be compared to J.P. Morgan’s $26.7 Billion in pretax #profits for 2011, a 10% reduction in #profits.

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  • Should banks avoid any business which loses $2 Billion in a quarter? If so, they should stop making traditional loans.

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  • To have economic growth, you must take risks. If you take risks, nobody - not even the government - can prevent loses.

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We have certainly heard a lot about the $2 billion "trading loss" at J.P. Morgan, which is of course not at all the same as the bank experiencing a loss on its bottom line. From the perspective of the corporate profit and loss statement, a trading loss is one expense item in the context of all revenues and expenses. So $2 billion should be compared to the bank's $26.7 billion in pretax profits for 2011, suggesting a reduction of something less than 10 percent in annual profit.

So we have discovered that trading and hedging activities can have losses which somewhat reduce overall profits. Eureka! This ranks with the discovery that if you make loans, some of them will default. Does it justify the partisans of the Volcker Rule which would ban banks from taking proprietary risk positions and make them stick to the "traditional" banking business of making loans?

No.

The fatal conceptual confusion of the Volcker Rule is its unstated and false premise that making "traditional" loans is somehow safe and does not involve taking proprietary risk. In fact, as demonstrated by the entire history of banking and finance, making loans-especially in the highly leveraged way "traditional" banks do-is a very risky business indeed.

Every loan is a proprietary risk position taken with the bank's own capital, leveraged by the funds borrowed from depositors and other creditors of the bank. A commercial real estate loan, for example, is a long position in a class of credit risk which over time has caused thousands of banks to fail.

Should J.P. Morgan get out of any business which can have losses of $2 billion in a quarter? Well, consider how much in losses on bad loans it has charged off in the last five quarters, from the first quarter of 2011 to the first quarter of 2012: $3.7 billion, $3.1 billion, $2.5 billion, $2.9 billion, and $2.4 billion, per quarter, respectively. Looks like we ought to make them get out of the lending business! Oh, I forgot: the government is encouraging banks to make more loans.

If you want economic growth, you have to take risks. If you take risks, nobody-not the government, not Chairman Paul Volcker, not Chairman Jamie Dimon-can make it so there will be no losses.

 

 

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About the Author

 

Alex J.
Pollock
  • Alex J. Pollock is a resident fellow at the American Enterprise Institute (AEI), where he studies and writes about housing finance; government-sponsored enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; retirement finance; and banking and central banks. He also works on corporate governance and accounting standards issues.


    Pollock has had a 35-year career in banking and was president and CEO of the Federal Home Loan Bank of Chicago for more than 12 years immediately before joining AEI. A prolific writer, he has written numerous articles on financial systems and is the author of the book “Boom and Bust: Financial Cycles and Human Prosperity” (AEI Press, 2011). He has also created a one-page mortgage form to help borrowers understand their mortgage obligations.


    The lead director of CME Group, Pollock is also a director of the Great Lakes Higher Education Corporation and the chairman of the board of the Great Books Foundation. He is a past president of the International Union for Housing Finance.


    He has an M.P.A. in international relations from Princeton University, an M.A. in philosophy from the University of Chicago, and a B.A. from Williams College.


  • Phone: 202.862.7190
    Email: apollock@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: (202) 419-5212
    Email: emily.rapp@aei.org

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