New laws have made big banks safer

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Article Highlights

  • The Madoff scandal exposed governance problems in a huge range of businesses and charities.

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  • Large banks should not receive any special treatment in response to this and other instances of financial markets' misbehavior.

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  • Regulators and prosecutors should apply the full force of the law to people and institutions of all sizes.

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The Madoff scandal exposed governance problems in a huge range of businesses and charities, making clear that the profit motive can override prudence in big and small enterprises alike. Large banks should not receive any special treatment in response to this and other instances of financial markets' misbehavior. Regulators and prosecutors should apply the full force of the law to people and institutions of all sizes.

With respect to JPMorgan, investors must consider whether the string of penalties it has faced, including the latest $1.7 billion for Madoff-related misbehavior, represents the legacy of the past or is instead a sign of structural issues that portend further losses. This matters a lot for shareholders, whose money is appropriately on the line.

My sense, however, is that there is not a threat to the financial system or economy as a whole. The skein of negative news items and consequent penalties is an enforcement issue, rather than a systemic risk that would be a front-and-center concern for U.S. policy makers.

After all, as noted in The Times, JPMorgan has easily sufficient capital to pay the fines and to take the losses from other problems such as the botched London Whale trades and bad mortgages. The firm is not at risk of collapse.

This hints at progress made since the financial crisis in strengthening the U.S. financial system. U.S. banks are financed with considerably more capital than previously, meaning that they can suffer more losses (or fines) before failing. And if a large bank does fail, the resolution authority in the Dodd-Frank financial regulatory reform legislation provides legal authority not previously available to deal with failing large banks.

The demise of a large bank will be no minor event, but the financial system is safer than previously and so too is the broader economy as a result.

Even if incidents such as Madoff or the Whale do not pose a systemic risk, this still leaves the difficult question of how to ensure that they do not slip past financial supervisors. Even before the financial crisis, regulators already had ample powers to head off harmful behavior. The supervisors simply missed the London Whale, and missed Madoff despite people screaming at them to take notice.

Breaking up large banks would not address the root causes of the problems laid bare by Madoff, and would sacrifice the benefits to society from large financial institutions (yes, I am the usual two-handed economist, seeing both costs and benefits). There is no simple remedy.

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