JPMorgan fiasco shows it's time to shrink big banks

(MoneyWatch) COMMENTARY JPMorgan Chase (JPM) CEO Jamie Dimon has defended the securities trades that led the banking giant to lose at least $2 billion by saying that they were hedges against other financial risks. Financial industry critics, such as Senate Democrat Carl Levin of Michigan, say the trades amounted to the kind of reckless gambling that required U.S. taxpayers to bail out Wall Street banks following the housing crash.

In some ways, who cares? The bigger point is this: Big banks can't manage their risks. After all, a hedge is supposed to reduce risk, not explode in your portfolio like a hand grenade. Yet following the financial crisis, and now with JPMorgan, the constant refrain among banking executives is that they had internal controls in place to guard against large losses and that those controls failed. It's like having a fire alarm at home that keeps switching off the moment there's smoke -- you know it's a problem when your house burns down for the third time.

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If big banks can't manage their risks, it is equally clear that government regulators can't be counted on to defuse the bombs ticking within large financial institutions. Former IMF chief economist Simon Johnson, now a professor of entrepreneurship at the MIT Sloan School of Management, notes that JPMorgan only in March passed a Federal Reserve "stress test" aimed at assessing the health of 19 big banks. "[T]he regulators also have no idea about what is going on," he writes. "Attempts to oversee these banks in a sophisticated and nuanced way are not working."

The distinction between whether the "London whale," the JPMorgan trader said to be chiefly responsible for the loss, was a hedge or a bet does matter in one sense -- figuring out if the trades in question would've been kosher under the Dodd-Frank financial reform law.

The problem with laws is that they can be delayed, weakened, skirted, or rolled back altogether. To stake the safety of the U.S. banking system on the Volcker Rule, the part of Dodd-Frank that is supposed to deter banks from rolling the dice by barring them from trading for their own accounts, is to anchor that system in sand.

That isn't to dismiss the importance of strong laws, of course. Glass-Steagall -- the 1933 law that for more than six decades kept banks out of the securities game until it was struck down in the late-90s following years of Wall Street lobbying -- worked (as even famous bankers who helped dismantle it later admitted). But Glass-Steagall was a much tougher law than Dodd-Frank, and the government agencies in charge of enforcing it were much more aggressive that today's financial regulators.

Anyone got a better idea? Actually, yes. Sen. Sherrod Brown, D-Ohio, last week proposed a bill that would shrink the nation's four largest banks. That wouldn't keep these firms from periodically setting themselves ablaze, but it would help contain the inevitable fire.