How can we avoid "too big to fail"?

Three executives have resigned at JPMorgan Chase as CEO Jamie Dimon acknowledged federal regulators are investigating if any rules were broken in the loss of $2 billion in risky trades that he called a "terrible, egregious mistake." Jeff Glor spoke with former Wall Street regulator Michael Greenberger to see if this could happen to other banks.

(MoneyWatch) COMMENTARY For supporters of the Volcker rule, JPMorgan's $2 billion loss was further evidence of the need for increased regulation of our nation's largest banks. (The fact that JPMorgan CEO Jamie Dimon has been one of the Volcker Rule's most outspoken opponents was a particularly rich irony for this group.) Volcker opponents, however, point out that it's nowhere near clear that these trades would have been forbidden if the rule were in place. 

Who's right? We might never get a firm answer, but the entire episode highlights the near-impossibility of trying to rely on rule-making to prevent another banking sector meltdown. The problem is that any rule designed to prohibit speculative trading -- no matter how well-written and strictly enforced -- will inevitably have loopholes that will be discovered by bankers with a large financial incentive to find them. The profits produced by such trades can have an enormous impact on the banks' bottom line, which means they also have a large impact on the compensation of the banks' senior managers. Further, all it takes is one or two of our nation's largest banks to aggressively pursue such profits, for doing so will put pressure on the others to follow suit, lest their own profits (and compensation) end up lagging.

What JPMorgan's loss means to you
Time to shrink the big banks
How does anyone lose $2 billion anyway?

As hard as it is to believe, four years after the federal government had to take unprecedented steps to prop up banks that were deemed "too big to fail," we have little to show as evidence that we've learned our lesson. Attempts at reform have been fought tooth-and-nail by a well-entrenched and heavily-financed financial sector, and yesteryear's "too big" banks are even bigger today. What's the answer? One of the best options would probably be to reinstate the Glass-Steagall Act. The Depression-era regulation firmly separated traditional banking from investment banking, which meant that a dumb bet by an investment banker didn't imperil the deposits of millions of mom-and-pop banking customers -- the risk of such behavior was borne entirely by the investment bank's owners. And a recognition that such a risk was real served as a natural governor on the size of those firms.

But Glass-Steagall was repealed in 1999, when Wall Street successfully convinced Washington that this supposedly antiquated relic of a bygone era was imperiling its ability to compete globally. And we all know what happened next. A handful of firms grew to such a size that the mere possibility that they might collapse sent shivers through the global financial markets. Given the amount of money that Wall Street pours into Washington, there's virtually zero chance that we'll see a return of Glass-Steagall. That, combined with the ultimate futility of relying on regulators to prevent another crisis, means that we'll need the market to do some self-correcting. The owners of our largest banks clearly believe today that the federal government will come riding to their rescue in the event of another crisis. Only clear evidence that the government is willing to let those institutions fail -- despite the myriad second- and third-hand casualties that would inflict -- will change this belief.

Is this the best solution to ultimately cutting our nation's largest banks down to size? No, but given how business is done in Washington, it's probably the only option we have left.

  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.