By James Kwak
Jonathan Macey, a former professor of mine at Yale Law School,* recently wrote an op-ed for the Wall Street Journal (paywall; excerpts here) arguing that we shouldn’t worry about JPMorgan’s recent trading loss because market forces will ensure that the bank does a better job next time. Here’s a key paragraph:
“Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan’s losses should be treated as further proof that markets work. J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.”
Macey’s central point is that companies don’t like losing money, so losing $2 billion means that they will do a better job of figuring out how not to lose money in the future. That’s obvious. But it’s also beside the point.
Bankers don’t ask, “Do I want to gain or lose money today?” That’s not the relevant point at which incentives apply. Instead, they ask: “Do I want to engage in this specific class of activities that has a certain expected payout structure?” In the JPMorgan case, the question is: “Do I want to engage in trades that are, roughly, portfolio hedges but that also take significant long or short positions on the credit market as a whole, with the conscious intention of making money?” And what we care about is whether the bankers’ decisions are producing the socially optimal level of risk.
We know that Jamie Dimon pushed the Chief Investment Office to take more risk in pursuit of profits. We also know that the trade in question was not really a true hedge; if it were, there would be no news, because the
$2 billion $3 billion loss would have been exactly balanced by a $2 billion $3 billion gain somewhere else, and Dimon wouldn’t be calling his own lieutenants “stupid.”
The problem is that two factors distort bankers’ incentives in the direction of excessive risk-taking (where “excessive” means greater than the socially optimal level). One is that JPMorgan is too big to fail. Macey himself has advocated in the Yale Law Journal for breaking up the largest banks, on exactly the same grounds as the rest of us: banks that are too big to fail have a distorted set of incentives because they can count on the ability to shift losses to the government in a pinch. That means that they have the incentive to engage in riskier activities than they would otherwise.
The other factor is that individual traders have skewed incentives: they get huge bonuses if they their trades make money, with no corresponding downside if their trades lose money. This also encourages bankers to take on excessive risk. And it’s not hard to see that if the payoffs are big enough, the potential loss of your job isn’t going to deter you from taking on that risk.
Now, it’s true, as Steven Davidoff has explained, that the traders in question at JPMorgan may also face clawbacks of their previous stock-based compensation. That is good, because it helps make the incentives symmetric: you get big bonuses if your trades make money, but you lose money you already had if they don’t. But JPMorgan’s clawback policy is a direct result of the reform pressures that resulted from the financial crisis; without the kind of pressure from regulators and reformers that Macey decries, JPMorgan would have no clawback policy at all, and its bankers’ incentives would be even more distorted than they are.
Obviously Jamie Dimon doesn’t like losing money. But he also likes making money, and for that reason he’s going to keep on pushing his people to take on additional risk in pursuit of profits. He can talk all he wants about how this trade went badly, but that doesn’t change the fact that he and his traders want to continue engaging in this class of trades—highly risky, proprietary, macro bets dressed up for as hedges for public consumption. The fact that one went bad is just a cost of doing business. “Markets” aren’t going to solve that problem because those markets are distorted. As long as those distortions exist, JPMorgan’s strategy isn’t going to change.
If you look at Macey’s YLJ article, you’ll see that he and I agree on the big picture: too-big-to-fail distorts incentives and therefore the big banks should be broken up. Do that, and I agree with Macey that we don’t need the Volcker Rule, since at that point I don’t really care what JPMorgan’s Chief Investment Office does, just like I don’t care what Small Hedge Fund X does.
But in this second-best world where we have TBTF banks, we have to do what we can around the edges (like the Volcker Rule) to reduce the distortions they create. Otherwise, losing $3 billion on a “hedge” is not an anomalous mistake that market pressures will eliminate; it’s the natural result of the dominant strategy for TBTF banks and traders with short-term incentives.
* Fans of 13 Bankers owe a debt to Jon Macey, since he was the professor who enabled me to get credit for writing it during my second year of law school.