"JPMorgan Chase & Co. Is Far From a Fortress"

Anat Admati is a Professor of Finance and Economics at Stanford University, but she is more widely known for her critically acclaimed book: The Bankers' New Clothes: What's Wrong With Banking and What to Do About It. Alongside her co-author, Martin Hellwig, Professor Admati deconstructs the idea that a safer financial system is inherently damaging to economic growth. 

At an economics conference last month, Professor Admati and I sat down to discuss the central themes of her book (see full video below). Unsurprisingly, the conversation quickly turned to derivatives. Many have asserted that the reason for the financial crash was a banking sector overrun by the sheer volume of derivatives contracts held both on, and off, the balance sheet. However, since the value of these contracts is hinged on the loans and mortgages of ordinary Americans, the damage of a misstep can extend far beyond the bank itself.  

According to Ms. Admati, derivatives were not simply the problem, but also a symptom of deeper issues within the banking culture. Speaking in Toronto last month, she said: "I don't think people appreciate that banks are the only entities that live on single-digit equity [ratios]...I mean the banks wouldn't lend to someone who had their balance sheets."

The argument here is basically the too-big-to-fail line of reasoning. Banks get a pass on low levels of equity because they're protected by a government backstop. And I'm not just talking about deposit insurance, but also the silent understanding that financial integration has made our economy incapable of shouldering the collapse of a large bank.

Invoking the memory of the JPMorgan Chase  (NYSE: JPM  ) $9 billion trading debacle, Ms. Admati says that London Whale was a warning. The very fact it happened at all displayed a mind-boggling lack of internal risk controls, especially considering that we know a relatively small loss by one firm can be leveraged through the interconnected financial system, causing significant damage along the way. While that certainly calls for greater oversight, it's less obvious what the regulation should look like.

Of course, the Federal Reserve and the FDIC have helped big banks like JP Morgan come up with plans for a managed bankruptcy (in case insolvency reemerges as a real threat), but Ms. Admati isn't impressed. "That's not the solution, just like the solution for trucks speeding at 90 miles per hour isn't to say 'I've got ambulances ready' when you can set a speed limit at 60."

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 02, 2014, at 11:50 AM, Rifleman3006 wrote:

    Seriously - 1st of all the trading debacle wasn't $9 billion so get your facts correct. Secondly the bank knocks down almost $2 billion a month in profits. Your obviously not too bright but then again, what FOOL is??

  • Report this Comment On June 02, 2014, at 2:53 PM, Huntman24 wrote:

    Easy there Rifleman. No need to get nasty...

  • Report this Comment On June 02, 2014, at 9:34 PM, Rifleman3006 wrote:

    Huntman - You're right I apologize. But how many companies make the kind of money JPM makes. You can count them on one hand.

  • Report this Comment On June 02, 2014, at 10:28 PM, slightlywonkish wrote:

    Hi Rifleman,

    I'm Gaurav Seetharam, author of the article above. Firstly, the initial reports of the trading loss by Bruno Iksil (otherwise known as the London Whale) put the loss at $2 billion, but were later readjusted to about $6.2 billion. During the subsequent investigation, concerns were raised that the loss was actually deeper -- about $9 billion. Since regulators chose to settle the charges as opposed to pursuing criminal action we'll never know what the real number is, but given the creative accounting standards employed by JPM's Chief Investment Office, I chose not to give them the benefit of the doubt. That may be a subjective decision, but I stand by it.

    Secondly, neither Professor Admati nor myself dispute that JPM is profitable or that they will continue to be profitable in the near term. What is discussed is the fact that JPM and other large banks continue to enjoy the benefits of a government backstop -- both from tax payers and the Federal Reserve. Professor Admati argues that poor decision making is the only outcome when our system of incentives gears banks towards activities that are more risky than traditional banking activities. She even says that "Of course JP Morgan can be profitable...don't forget, 2006 was a very good year for the banks".

    The point isn't whether the London Whale fiasco cost them $6 billion or $9 billion. What we should be concerned about is whether it can happen again and whether it can be larger. Given that 2008 is still in the rearview, and that we've consistently seen skeletons fall out of banks' closets, AND that past profits don't mean squat about future performance, I think it's reasonable to question the conventional wisdom about JPM being the greatest thing since sliced bread.

    But I have seen some encouraging signs lately -- ie. the sale of JPM's physical commodities business. In any case, you're of course entitled to your opinion, but please be respectful of the Fool's Rules regarding the comments section.

    Thanks and best of luck,

    Gaurav Seetharam

  • Report this Comment On June 03, 2014, at 9:11 PM, Rifleman3006 wrote:

    Gaurav,

    We will respectfully disagree on this one. I don't push my creditability in the good Professor's assessment. First of all this bank was profitable throughout the entire financial crisis, what a feat indeed. Secondly the $6 billiobn they lost was nobody's money other than their own and that of their shareholders, not the governments, although you would think it was based upon their reactions. Not saying it was good, but it was indeed a tempest in the teapot for this financial giant. As I said, they make almost #2 Billion a month and will surpass that figure in time. Who else is in that financial league, only a couple of companies period.

  • Report this Comment On June 03, 2014, at 9:15 PM, Rifleman3006 wrote:

    I obviously typed that response way too fast. The good professor can school me on my typing skills.

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