Yes, Jamie Dimon should lose his seat on the New York Fed board. But why stop there when America's financial regulation is such a mess?
The $2 billion and counting that JPMorgan Chase’s chief investment office recently lost in London has turned the spotlight on CEO Jamie Dimon’s seat on the board of the Federal Reserve Bank of New York, better known as the New York Fed. Dimon is due to testify on Capitol Hill starting on June 13, and things could get ugly.
It’s about time Dimon felt the heat over his board seat. As one of 12 regional reserve banks that make up the Federal Reserve, the New York Fed’s responsibilities include regulating big Wall Street banks like JPMorgan and Goldman Sachs. If Dimon sitting on the organization’s board sounds like a conflict of interest to you, you’re right: Nearly four years after the implosion of Lehman Brothers triggered a global economic meltdown, the fox is still guarding the henhouse.
JPMorgan‘s trading loss has already prompted many calls for Dimon’s ouster from the Fed board. Treasury Secretary Timothy Geithner, who previously headed the New York Fed, conceded in mid-May that Dimon had a "perception problem," and Senate Democrats have explicitly called on the JPMorgan chief to step down from the board. In late May, Esther George, the president of the Kansas City Fed, made the same point more obliquely, noting that "when an individual no longer meets these [high] standards, the director resigns voluntarily to allow someone who does meet the criteria to serve."
I couldn’t agree with George more. At the same time, her suggestion brings up a larger point: Why stop at Dimon? The entire system by which Wall Street banks are regulated needs to change, and urgently.
On June 13 and 19, Dimon will testify in front of the Senate Banking Committee and the House Financial Services Committee and be asked to explain his losses. It won’t be easy. Many details of the loss-generating credit trades that JPMorgan — the largest bank in the United States by assets — engaged in remain unknown. And for good reason: The more information becomes public, the harder it will be for JPMorgan to unwind the deal. (Why? Because if you know which contracts the bank must dump, it’s easy to wait for the price of the contracts to drop, thus adding to JPMorgan‘s losses.)
From the few snippets of information that have become available since the trading loss was first reported in May, it is clear that the bank’s chief investment office bought so many contracts in certain credit indices that it was distorting the market. (Credit index here is shorthand for credit-default-swap index, the opaque and under-regulated "insurance policies" blamed by many for the 2008 financial crisis.) Credit-default swaps (CDSs) do not require that the owner of the derivative contract actually stand to lose from a credit default. When CDSs lack such an insurable interest they are considered "naked" — the financial market’s equivalent to buying insurance on your neighbor’s house.
Although JPMorgan‘s risk positions remain obscure, one particular credit index seems to have been at the heart of the $2 billion loss: the Markit CDX.NA.IG.9. In less than a few months, the bank’s position in the index almost doubled from under $80 billion to a whopping $145 billion, which makes one wonder where regulators were in all of this. The Depository Trust Company, a data warehouse, keeps information on 99 percent of all CDS trades all of which is accessible by the bank’s regulators. Each and every regulator could easily have looked up who was moving the market and made further inquiries.
Dimon’s problem, in other words, stems from a lack of oversight by both his bank and his regulators. But it’s also problematic that Dimon sits on the board of the organization that’s supposed to supervise his bank. It is entirely possible that officials at the New York Fed, which collects and reports data on individual banks’ credit exposure, raised alarm bells about JPMorgan but somehow got rebuffed by Dimon, in much the same way that he brushed off initial press reports about a JPMorgan trader taking outsized positions as a "tempest in a teapot."
Turns out it was a pretty big teapot.
Even if JPMorgan‘s loss completely blindsided regulators, as supposedly happened to Dimon himself, there is still a conflict of interest. The Fed is tasked with implementing financial regulation to guarantee financial stability and prevent a new financial crisis from happening. But JPMorgan‘s chief has done everything in his power to preserve the old system, where the too-big-to-fail banks were able to make outsized profits by taking gargantuan risks thanks to taxpayers’ backing.
Dimon has ranted against the Volcker rule, which prohibits banks from making bets for their own gain, and the Basel III bank capital rules, which prescribe the minimum ratio of equity to debt on a bank’s balance sheet (last September, Dimon told the Financial Times that the latter were "anti-American"). And while Dimon has asserted that JPMorgan‘s money-losing trade did not violate the Volcker rule, it is close to impossible to lose more than $2 billion in a little over a month with a simple credit index, as the Financial Times‘s Lisa Pollack has pointed out. The bet that turned sour was most likely aimed at beating the market and earning big bucks for the bank, which is considered proprietary trading and banned under the Volcker rule. (Luckily for Dimon, the Federal Reserve announced in April that enforcement of the Volcker rule will be delayed until at least 2014, rendering the question of whether JPMorgan‘s trades violated the regulation moot.)
As the economist Willem Buiter noted in his keynote address at the Federal Reserve’s Jackson Hole conference in 2008, the Fed listens to Wall Street and believes what it hears. Call it "cognitive regulatory capture" — instead of special interests buying, blackmailing, or bribing the government, the big banks have somehow persuaded their ostensible regulators not to do their jobs properly. The Fed, under both Alan Greenspan and his successor, Ben Bernanke, has treated the stability, well-being, and profitability of the financial sector as an objective in its own right, regardless of whether this goal contributes to the Fed’s dual mandate of maximum employment and stable prices.
So let’s not stop with ousting Dimon from the New York Fed board. Groupthink, cognitive capture, and even direct capture (in the form of corruption) are ever-present threats for central banks, not only in terms of financial oversight but also with respect to monetary policy. And today they’re out of control.
If we want to further reduce the hold that the big Wall Street banks have on central bankers and supervisors, we should make an eight-year, non-renewable term the maximum anyone can serve in any capacity as a regulator, supervisor, or member of the interest rate-setting committee. Greenspan served as chairman of the Federal Reserve from 1987 to 2006, more than twice what would be allowed under the term limits I propose. Bernanke is now serving a second four-year term as Fed chairman, and would be barred from reappointment if term limits were in place.
Since proximity tends to blur vision, it might be wise to place the financial supervision of the big Wall Street banks at a geographic distance as well — say, with a regional reserve bank such as the Kansas City Fed. The New York Fed is literally too close to Wall Street for comfort. When he was the New York Fed president, Treasury Secretary Timothy Geithner was extremely close to Wall Street CEOs, enjoying private dinners at Jamie Dimon’s home. Not coincidentally, Geithner shrugged at President Barack Obama’s suggestion that banks that are too big to fail need to be broken up.
On the regulatory front, it is time to outlaw naked credit default swaps, for which there is no better economic rationale than horse betting. China took this step right after the 2008 financial crisis and the European Union has restricted naked CDSs on sovereign debt (though this appears to be more of a futile attempt to contain the debt crisis in the eurozone). Had naked CDSs been outlawed, JPMorgan would not have incurred its massive trading loss.
Smaller steps like demanding more coordination among regulators would also help. The Commodity Futures Trade Commission is now examining how JPMorgan‘s trading affected the market for credit derivatives and the Security and Exchange Commission is looking into the bank’s public disclosures regarding the troubled trades. Neither agency, however, supervises banks like JPMorgan. That is left to the New York Fed and the Office of the Controller of the Currency, a little-known branch of the U.S. Treasury. When I asked both agencies which entity was primarily responsible for spotting exposures like the one incurred by JPMorgan, each organization discreetly pointed at the other.
Many a commentator has said that the 2008 financial crisis exposed the flaws of free-market capitalism. But the crisis could just as easily be attributed to a political system where people and corporations with deep pockets have an outsized influence on public policy and tilt the playing field in their favor. Under the right rules, capitalism works just fine. Maybe it’s American democracy that’s the real problem.