The report by the US Senate staff on JPMorgan Chase’s “London Whale” trades, delivered last Friday, excoriates the bank for failing to make the full extent of the problem known to regulators and the public. But a focus on who knew what when can result in missing the big point: the cost of our too-big-to-fail banks is even heftier than is widely appreciated.

The conventional wisdom in many circles is that the losses caused by the trades are regrettable but we can all move on. After all, JPMorgan’s equity cushion can readily absorb it. Private shareholders and managers have paid the price – shareholders lost $6bn and several senior managers have black marks against their names. The episode is embarrassing but the bank can earn more than $20bn a year. “A tempest in a teapot,” said Jamie Dimon, its chief executive, last year.

But before the London Whale sinks from view, consider what would befall a conventional industrial company that suffered such a horrendous, expensive managerial lapse. If JPMorgan were in the business of making things, it would have already attracted significant corporate governance activity. The loss might be the trigger for a takeover and break-up effort.

…continue reading: London Whale is the Cost of Too Big to Fail

In the first presidential debate, Mitt Romney identified the Dodd-Frank Act as the “biggest kiss” to Wall Street, opening a topic that has received too little attention in this election season. Supporters of the act argue that it ends bailouts, but this is true only if bailouts are defined narrowly as the use of taxpayer funds to rescue a failing financial institution. However, the source of funds for a bailout is not the real issue. The possibility of a creditor bailout creates moral hazard, no matter where the bailout funds originate, and it is moral hazard that provides the largest banks or other large financial firms with competitive advantages. The same is true of the special “stringent” regulation required by the act for banks and other firms deemed systemically important. These provisions create moral hazard by reassuring creditors that there is less risk in lending to these large firms than to small ones, and thus provide the biggest firms with a continuing competitive advantage in the form of lower funding costs. Romney is correct to see this as a subsidy to big banks and other large financial institutions. Title I invokes stringent regulation for systemically important firms, Title II provides a mechanism for bailing out creditors if a systemically important firm should fail, and Title VIII authorizes Federal Reserve funding for an unlimited number of additional financial institutions. If President Obama is re-elected, Dodd-Frank is likely to continue in its current form, adding materially to the problem of moral hazard and TBTF in the US financial system.

At its enactment, the Dodd-Frank Act (DFA) was advertised as legislation that would end financial bailouts. When signing the legislation on July 21, 2010, President Obama said, “There will be no more tax-funded bailouts—period.” But this is an accurate depiction of the act only because the president and the act’s other proponents define bailouts as the use of public funds for rescuing failing financial institutions.

…continue reading: The Future of Bailouts and Dodd-Frank

Breaking up the biggest banks is said to have growing support in Congress, but the idea’s supporters—even those who are respected commentators—do not appear to have given it any deep thought. Without any serious discussion, it should come as no surprise that the idea has bipartisan support among the American people. But Martin Baily of Brookings, always levelheaded in his judgments, calls it “nuts.”

Obviously, for the United States to break up its largest banks would be a very consequential step with significant implications for our economy and financial system. Before proceeding, we should have a reasoned debate on the costs and benefits. Instead, what we have had thus far is a surprising chorus of commentators calling for breaking up the banks without seeming to give any attention to the most elementary issues such a step would entail.

This article will lay out some of those issues. These are not technical matters; they are the simple, first-order questions that ought to occur immediately to anyone who supports the idea of breaking up the largest banks—and they have been largely ignored. Ultimately, this is a depressing commentary on how our discourse on important matters of financial regulation and financial structure has descended—in this era of 24/7 media and instant reaction—to the level of slogans and bumper-strip opinionating.

…continue reading: Breaking Up the Big Banks: Is Anybody Thinking?

If timing is everything, this is not an auspicious time to argue against the Volcker Rule, given the recent London trading and investment misadventures of JPMorgan Chase. Predictably, there has been a hue and cry over this situation, and the bank regulators will be under heavy political pressure to toughen the Volcker Rule. In turn, the regulatory agencies probably will stiffen the Volcker Rule’s implementing regulations when they are adopted later this year (perhaps). For that reason, now is a good time to take a critical look at the Volcker Rule’s utility in improving regulatory oversight and preventing future financial crises.

In fact, the Volcker Rule continues to exist in a parallel universe that has little relation either to the recent financial crisis, the functional realities of the modern financial markets, or to the ongoing efforts to strengthen our financial system. Nothing that JPMorgan Chase, or any other too-big-to-fail bank, has or has not done changes that essential fact. Here is why:

…continue reading: The Parallel Universe of the Volcker Rule

The first wave filers – the largest and most complex domestic and foreign bank holding companies – have now filed their living wills and the public portions have been posted on the FDIC’s and the Federal Reserve’s websites. Based on our experience advising a number of banking institutions on their resolution plans, and based on the public portions of the plans, we believe there are lessons to be learned for second and third wave filers, even in this early stage of an iterative process. At the same time, these lessons should be drawn carefully in light of the fact that the business models and legal structures of the second wave filers are somewhat different from the first wave filers, and those of the third wave filers are very different. Any lessons learned from the first wave should also be tempered by the fact that the standard format for the living wills that the regulators required in the first wave is likely to change for second and third wave filers. With that in mind, we suggest the following key lessons from the first wave filers based on what is known immediately after their public filings.

…continue reading: Living Wills: Key Lessons from the First Wave

Since JPMorgan Chase announced a trading loss of at least $2 billion, reporters, analysts, and politicians have focused anew on the Wall Street Reform and Consumer Protection Act. President Obama signed this financial-regulation law, known as Dodd-Frank, into law nearly two years ago, on July 21, 2010.

Recently, observers have placed most of their attention on Dodd Frank’s Section 619: “The Volcker Rule.” The Volcker Rule, when it goes into effect as early as July 2012, will prohibit banks such as JPMorgan from engaging in “proprietary trading,” or speculation.

In the aftermath of the JPMorgan Chase announcement, the Volcker Rule proponents’ position has been as follows. Were the Volcker Rule in place already, the rule would have prevented JPMorgan from engaging in the trading that resulted in the loss, as such trading, they say, was “proprietary.” Although details are unclear, JPMorgan appears to have taken its loss in using “excess deposits” to invest in debt securities and attempt to hedge those investments. (“Excess deposits” are the difference between the amount of money a bank has taken in from depositors and the amount of money it has loaned out to borrowers.) As Sen. Carl Levin (D-MI), who helped write the Volcker Rule language, said four days after the bank’s announcement, the Volcker Rule would have prohibited such activities: “If this law were in effect when they made these trades, I believe that these trades violated or were inconsistent with Dodd-Frank, yes.” [1]

Yet it is far from clear that the Volcker Rule would have prevented JPMorgan from engaging in the activities that led to its loss. Among other things, the Volcker Rule allows banks to engage in securities and derivatives trading to hedge risk, as JPMorgan claims this particular activity was intended to do. Moreover, it is far from clear that preventing financial-industry losses—even losses that lead to financial-firm failure—should be the goal of financial regulation. Instead, the goal should be for financial firms to be able to fail without endangering the broader economy.

…continue reading: The Volcker Rule Distraction

Recently, the Financial Stability Oversight Council (“Council”) unanimously approved a final rule (the “Final Rule”) and related interpretive guidance (the “Final Guidance”) under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), [1] regarding the designation of systemically important nonbank financial companies (often referred to as nonbank “SIFIs”). The Final Rule and Final Guidance describe how the Council will apply the statutory designation standards and the procedures it intends to employ in exercising this authority. Designated companies are required to comply with enhanced prudential standards and are subject to consolidated supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Federal Reserve’s recent proposal regarding these enhanced standards suggests that this will be a comprehensive and rigorous regulatory regime. [2]

The Final Rule and Final Guidance, which are substantially similar to the Council’s October 2011 proposed rule and guidance (the “October 2011 Proposal”), [3] do not provide significant new insight as to which companies will ultimately be designated. Nonetheless, it is an important initial procedural step to enable the actual designation process to begin. Secretary of the Treasury Geithner, who chairs the Council, has indicated that the first of these designations will be made this year.

…continue reading: Final Rule on Designation of Systemically Important Companies

The Federal Reserve’s approval recently of Capital One’s application to acquire ING Bank, fsb, taken together with its December approval of PNC’s proposed acquisition of RBC Bank (USA), marks a path forward for bank acquisitions. Despite broad industry concerns about unrealistic capital expectations by the regulators and Dodd-Frank’s mandate that the Federal Reserve consider financial stability risk factors in M&A applications, Capital One and PNC demonstrate that with advance preparation and thoughtful structuring, it is possible for large banks to navigate the regulatory process and make strategic acquisitions. However, the regulatory process has clearly changed post-crisis, and larger banks should be prepared for a more extended and thorough vetting of their acquisitions by the regulators.

The Federal Reserve processing of the Capital One and PNC filings took approximately seven months and four-and-a-half months, respectively. The Capital One processing was extended as a result of a large number of internet-based protests organized by certain community groups, three public hearings and the Federal Reserve’s refinement of its framework for evaluating financial stability risk. Going forward, acquirors should expect renewed regulatory focus on consumer and CRA compliance matters and inquiries concerning all allegations raised by community groups and others, even those that may be regarded as non-substantive. Acquirors will need to demonstrate the sufficiency of their compliance and other risk-management systems, including in connection with their expanded operations and increased size.

…continue reading: A Path Forward for Bank Acquisitions

In the paper, The Case Against the Dodd-Frank Act’s Living Wills: Contingency Planning Following the Financial Crisis, forthcoming in the Berkeley Business Law Journal, I focus on the Dodd-Frank Act’s “living will” requirement that mandates that systemically important financial institutions (SIFIs) develop business strategic analyses, and submit plans for reorganization or resolution of their operations to regulators. The goal of this regulation is to mitigate risks to the financial stability of the US and encourage last-resort planning – in order to enable a rapid and efficient response in the event of an emergency – for multinational financial institutions that are so large that their insolvency could shake the entire financial system and the economy. Nearly everyone believes that living wills are just about the perfect solution to the problems highlighted in the recent financial crisis; regulators from all over the world strongly support the concept and have been advocating for its implementation. Nevertheless, I argue that this solution is ill-designed to address the too-big-to-fail problem, and that living wills are not the silver bullet that regulators seem to think they are. My paper shows that there are a lot of open issues concerning living wills, and that there are real questions as to how effective they can be.

…continue reading: The Case Against the Dodd-Frank Act’s Living Wills

Two and half years removed from the worst financial crisis since the Great Depression, the investing public has grown increasingly frustrated with the lack of criminal prosecutions of, and absence of truly significant fines levied against, the senior executives and companies responsible for igniting the subprime meltdown. Pundits have criticized the Securities and Exchange Commission (the “SEC”) and the Department of Justice (the “DOJ”) as capitulating to the interests of “big finance,” citing SEC settlements that have been characterized as mere “slaps on the wrist” and the DOJ’s failure to convict a single executive responsible for creating the “great recession” despite significant evidence of intentional misconduct.

For decades, the public’s trust in the integrity of U.S. capital markets was a source of economic stability and unparalleled prosperity. To maintain this trust, investors must believe that they compete on a relatively equal playing field and that the laws governing the markets will be strictly enforced. In furtherance of these goals, violators of federal rules face civil penalties from the SEC or criminal prosecution by the DOJ. In connection with previous corporate scandals, the government held a significant number of the principal wrongdoers civilly and criminally accountable for their misconduct. In the wake of the current financial crisis, however, many argue that the lack of such accountability has eroded the public’s faith in U.S. capital markets.

…continue reading: Too Big to Fail or Too Big to Change