What is the Volcker Rule?
The Volcker Rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It got its name from the former Chairman of the Federal Reserve, Paul Volcker. The rule aims to put an end to proprietary trading by banks on their own accounts. Prop trading is when a company trades stocks, commodities, derivatives etc. using its own cash reserves to make a profit for itself. The goal of the rule is to simply stop the banks trading for profit because the taxpayer will have be responsible for terrible mistakes. The Volcker rule is meant to come into effect on July 21st 2012.
JPMorgan's $5 billion loss
JPMorgan's (JPM) CEO Jamie Dimon announced on May 10th that the company had made a $2 billion trading loss on faulty derivatives bets in London. This has since spiraled into a potential $5 billion trading loss. It has since been revealed that the risk officer, Irv Goldman, who oversaw the risky trades had been fired previously by another Wall Street for money-losing bets.
The reality of JPMorgan's loss in that it is just a drop in an ocean of derivatives exposure. The top 4 banks in the U.S. (JPMorgan Chase , Goldman Sachs (GS), Citibank (C), Bank of America (BAC)) have a combined nominal derivatives exposure of more than $210 trillion. However, one would be correct in saying that these derivatives are hedged against each other so the actual exposure is much less. Nevertheless, when you are making trillion dollar bets even the banks can make huge errors, JPMorgan proved that with its faulty bet. Therefore, I am less inclined than I was before to believe the reports that thee derivatives trades are for the most part, safe.
Did JPMorgan violate the Volcker Rule?
There is uncertainty about whether the trade would have been allowed to occur if the Volcker Rule was in place. Some lawmakers are saying it would have and some are saying it wouldn't have. There is no doubt it would have violated the intended purpose of the Rule, however, it might have slipped through the net.
The point is under some new additions the Obama Administration is considering, post-JPM's loss, JPM would not have been able to make the trade. Senator Bob Corker, the Senator who has led the drive to punish JPM for their loss, has said that 'policies are going to be derived out of what happened.'
My personal take on the derivatives bet is that, as it was done on the company own books and with company money, it was intended as a prop trade to make a profit for JPMorgan. Consequently, it was violation of the Volcker Rule.
Consequently, is the Volcker Rule necessary?
The Volcker Rule is more necessary than ever because the banks have shown their complete lack of regard for fragility of the current economic environment. Making risky trades on the scale that they do is very dangerous no matter the situation but the fact is that we are recovering from a recession right now and the markets are very volatile. I would also argue for changes to the Volcker Rule to close any holes in the net that might have let JPMorgan make the bet even when the Volcker Rule was in effect.
Apparently the banks cannot make intelligent decisions for themselves, therefore, regulation is a necessity and one of the key parts of that regulation should be the Volcker Rule. You would have thought that after the financial crisis, even the banks would be taking less risks and assuming more responsibility. Sadly that is not the case and they should face the consequences.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
