JPMorgan and the Volcker Rule
JPMorgan’s $2 billion loss has put a fresh focus on one of Dodd-Frank’s most controversial reforms: a ban on banks from engaging in proprietary trading, also known as the “Volcker Rule.” For all its famed complexity, the law simply states that “a banking entity shall not engage in proprietary trading.” But the law goes on to create an exemption for “[r]isk-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.”1
In simpler terms, the issue is whether a bank uses a large trade to hedge risks in other investments, which is allowed, or whether a bank uses a large trade to speculate for profit, which is forbidden. Still, the multi-billion dollar loss puts the spotlight squarely on the issue of how to distinguish between hedges and proprietary trades. And the SEC is still no closer to issuing a final rule on the matter.
JPMorgan is attempting to cast doubt on whether the Volcker Rule would have precluded its trading activity, and has insisted that the bank was not speculating under the guise of hedging. But its fierce opposition to the Volcker Rule over the last several months begs the question: if its trading was not proprietary, then why oppose the legislation?
JPMorgan’s CEO Jamie Dimon made it clear exactly how JPMorgan was using the trades. At a hearing before the U.S. Senate Committee on Banking, Housing and Urban Affairs on June 13, 2012, Mr. Dimon admitted that the purchase of credit default swaps was “designed to generate modest returns in a benign credit environment and more substantial returns in a stressed environment.”2 Reports now indicate that JPMorgan’s losses may reach as high as $9 billion.3
On February 13, 2012, JPMorgan sent the SEC a 65-page comment letter on implementing the Volcker Rule, blasting it as “flawed” and doing “unnecessary harm” to U.S. firms and investors.4 The SEC’s draft rule on the law states that a transaction would count as a hedge only if it satisfied certain substantive requirements, including that the hedge must be “reasonably correlated” to the risks the transaction is intended to hedge.5 Despite this broad language, JPMorgan vigorously contested these restrictions and it is now much clearer why it did.
The term “reasonable” is one of the vaguest words in the law, which can be stretched to cover almost any eventuality. Still, JPMorgan thought the language was too restrictive and insisted that the bank should be able to claim a hedging exemption if it can “reasonably demonstrate through its stress testing program that the position reduces tail risks.”6 This type of exemption would be highly convenient for JPMorgan, especially given that the most alarming aspect of this entire episode is the simple fact that JPMorgan managed to pass the Federal Reserve’s stress test in March, despite having a ticking time bomb sitting on its balance sheet.
JPMorgan’s disaster not only raises questions about whether broad regulatory actions will be effective enough to address the potential disasters that are still lurking throughout Wall Street, but also raises questions about whether the Volcker Rule would be effective enough to prevent losses associated with specific trading activity. While JPMorgan has thus far survived the losses, those losses are expected to continue to rise. Further losses may not be sustainable, and regulations may not be strong enough to prevent another collapse.
1 See 12 USC §1851(a)(1)(A) and (d)(1)(C).
2 See Testimony of Jamie Dimon, Chairman & CEO, JPMorgan Chase & Co., Before the U.S. Senate Committee on Banking, Housing and Urban Affairs, Washington, D.C., June 13, 2012, available at: http://www.sec.gov/Archives/edgar/data/19617/000119312512268992/d366030dex991.htm.
3 See Jessica Silver-Greenberg and Susanne Craig, JPMorgan Trading Loss May Reach $9 Billion, The New York Times DealBook Blog (June 28, 2012), available at: http://dealbook.nytimes.com/2012/06/28/jpmorgan-trading-loss-may-reach-9-billion.
4 See JPMorgan Chase & Co., Comment Letter on the Notice of Proposed Rulemaking Implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, dated February 13, 2012.
5 See 76 Fed. Reg. 68948 and 77 Fed. Reg. 8427.
6 See John Kemp, RPT-COLUMN-JPMorgan’s fight against hedging restriction: Kemp, Reuters (May 22, 2012), available at: http://www.reuters.com/article/2012/05/22/column-jpmorgan-portfolio-hedging-idUSL5E8GM3Q220120522.