The recent financial press obsession with the multibillion-dollar in-house trading loss at JPMorgan Chase & Co. has brought into sharp relief the competing philosophies at play with respect to the so-called Volcker Rule. This discussion (which I would submit is healthy in arriving at a public-policy consensus regarding financial-system risk tolerance) frames the dilemma of balancing a free-enterprise system with a financial system dominated by “too big to fail” banks.
To understand the Volcker Rule, one must understand that it is in large measure a resuscitation of the Banking Act of 1933 — the so-called Glass-Steagall Act — which was a federal response to the perceived banking system cancers that contributed to the 1929 stock market crash and widespread bank failures. Prior to the Glass-Steagall Act, the distinction (which has been present through most of our lives) between commercial banking and investment banking was nonexistent, leading to many cases where banks put at risk depositors’ accounts through speculative, investment banking activities.
Over several decades, the distinctions Glass-Steagall created between commercial and investment banking activities eroded, and in the late 1990s, Glass-Steagall was formally revoked. However, in the wake of the financial meltdown in the fall of 2008, many public officials and commentators viewed excessive risk-taking on the part of financial institutions as a principal cause of the financial collapse, and they argued for a return to a Glass-Steagall regulatory environment. In that vein, President Barack Obama proposed, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, a provision named for former Federal Reserve Chairman Paul Volcker (an outspoken advocate for prohibiting proprietary trading by banks) that would have the effect of imposing Glass-Steagall-like restrictions on American financial institutions.
The Volcker Rule is set forth in 12 U.S.C. § 1851 (a) and dictates that “a banking entity shall not (A) engage in proprietary trading… .” 12 U.S.C.§1851(h)(4) defines proprietary trading as “engaging as a principal for the trading account of the banking entity … in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative ... or any other security or financial instrument that the appropriate Federal banking agencies … may … determine.”
The apparent breadth of the trading prohibition is, however, strongly circumscribed by the definition of “trading account” in 12 U.S.C. §1851(h)(6) where we learn such an account is “any account used for acquiring or taking positions in the securities and instruments described [above] principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements)…” It is important to understand that the statutory trading account definition only covers near-term transactions or transactions involving short-term price movements. Finally, and most importantly for analysis of the JPMorgan trading loss, the Volcker Rule specifically permits certain hedging activities in that 12 U.S.C. § 1851 (d)(1)(C) authorizes “risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts or other holdings.”
It is important to understand that the Volcker Rule is not yet in effect; it is to become effective upon the earlier of (i) two years after its enactment or (ii) twelve months after issuance of final rules by the banking regulators. Inasmuch as the regulators have as yet only published proposed (as opposed to final) rules, the Volcker Rule can be expected to become effective on July 21. Moreover, even once the Volcker Rule becomes effective, subject financial institutions have two years within which to conform to the Volcker Rule (and the Federal Reserve Board has the authority to extend that conformance period by as many as three additional one-year periods).
There has been much division as to whether or not the JPMorgan trading loss would have violated the Volcker Rule had it been in effect at the time. While the final regulations to be promulgated could change the analysis, given the breadth of 12 U.S.C. § 1851 (d)(1)(C), it’s hard in my view to see how the JPMorgan trading stratagem would have run afoul of the Volcker Rule. It is clear that the trade in question was a hedge transaction. In particular, the JPMorgan position in question was a “portfolio hedge,” where the bank was attempting to hedge its portfolio of corporate bonds against macroeconomic volatility. JPMorgan’s Chief Investment Office acquired a series of credit default swaps that would increase in value if the bank’s corporate bonds fell in value. Apparently at some point in 2011, when the general global macroeconomic climate seemed to be improving, JPMorgan in essence set up a second hedge (based on its determination that the original credit default swap position was too large) that bet that the economy would continue to improve. It was with respect to the second hedge that the JPMorgan traders miscalculated and (as the world economic climate darkened) subjected the institution to a loss estimated to range from $3 billion to $5 billion.
Beyond the issue of a violation of the Volcker Rule is the compelling question of whether such trading is inimical to the soundness of the American financial system, on which score it is important to put in perspective both the magnitude of the loss and the source of the funds in question. While by any measure (harkening back to Everett Dirksen’s famous observation in the 1960s that [with respect to the federal budget] “a billion here and a billion there and pretty soon you’re talking about real money”) the JPMorgan trading loss was a significant sum of money, not only does JPMorgan Chase have total assets approaching $2.5 trillion, and not only is JPMorgan Chase for the quarter in question expected to realize net earnings on the order of $4 billion, but the monies under the oversight of the JPMorgan CIO were themselves on the order of $400 billion. The trading loss in the context of the aforementioned metrics should serve to dissipate some of the hysteria evident in much of the financial press reporting of this issue. Another important point to keep in mind is that, as Rudy Guiliani and others have been outspoken in asserting, the money in question was “the bank’s money,” meaning that it was part of the JPMorgan Chase portfolio in excess of the bank’s deposits.
Having said all of that, there still remain public policy and regulatory concerns. Apart from the fact that the 80 or so Federal Reserve Board and Office of the Comptroller of the Currency staff members resident within JPMorgan Chase at any given time were unaware of this trading activity, it’s clear (in the face of the challenging yield curve confronting all financial institutions) that the trading activities conducted by JPMorgan were viewed as a profit center. This fact is evidenced by, among other things, the fact that nearly half of the nearly $400 billion JPMorgan CIO portfolio was invested in corporate bonds, asset-backed securities and mortgage debt not guaranteed by the United States government (as compared with only 7.7 percent of JPMorgan’s portfolio at the end of 2007). Moreover, JPMorgan held only about 30 percent of this investment portfolio in U.S. Treasuries or other instruments guaranteed by U.S. government agencies while, for example, 87 percent of the investment portfolio at Bank of America is invested in such securities.
In sum, it is far from clear that the JPMorgan trading losses resulted from a transaction that would have violated the Volcker Rule, were it applicable at the time. It’s also clear that, in the context of the size of JPMorgan Chase and the scope of its investment portfolio, the losses in question can be viewed as part of the transactional risk of doing business and not placing in jeopardy the monies of depositors. However, this event also reinforces the fact that even hedging is, by its very nature, at some level a gamble and that the federal regulators currently promulgating regulations with respect to the Volcker Rule should consider some restraints on the magnitude of even hedge investments that might be held within the investment portfolios of banks.
J. David Smith Jr. is a member in Stoll Keenon Ogden’s Lexington office. He serves as co-chair of the Business Services Practice with a focus on mergers and acquisitions, public finance and equine. His practice concentrates on corporate and banking law, mergers and acquisitions, securities and equine law.