While J.P. Morgan's painful loss should prove manageable—the bank earned $5.4 billion in the first quarter—it presents a host of issues.
For starters, the surprise announcement gives investors already fearful of big banks stocks yet another reason not to buy them: namely, the seeming impossibility of understanding the risks the banks entail.If JP Morgan had been required to provide ultra transparency, there would have been no surprise announcement. Assuming that the bank still would have put the trade on in the presence of ultra transparency (a very large assumption), the market would have been able to see that the trade was losing money on a daily basis.
If JP Morgan had been required to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details, market participants could have independently assessed the risks of the bank.
To the extent that market participants were overwhelmed trying to assess all the risks, this is an important finding for those participants. It is sure sign they should shouldn't have any exposure to JP Morgan as investing requires knowing what you own and since they would not know what they owned they would just be gambling on JP Morgan.
Even Chief Executive James Dimon acknowledged on a hastily arranged investor call that the trading strategy behind the losses had grown too complex....One of the benefits of ultra transparency is it exposes the banks to market discipline. Trading strategies that are too complex would be seen by the market as risky. As a result, market participants would adjust both the amount and price of their exposure to reflect this risk.
Management tends to respond to market discipline as it increases the bank's cost of funds and decreases its stock price.
That banking king Mr. Dimon could stumble in this way also resurrects the question of whether banking behemoths are too big to manage.If the banks are too big for market participants to assess using ultra transparency, the result will be market discipline to shrink the banks down to a size where they can be assessed.
Meanwhile, J.P. Morgan may have just shot itself in the foot. If the losses were of a greater magnitude, any distress could quickly ripple out through a host of markets—J.P. Morgan, for instance, is a vital part of the market for tri-party repos.
That should stiffen the resolve of regulators such as the Federal Reserve that have proposed measures such as limiting the exposures of big banks to each other. Banks have been fighting such initiatives.The best way to limit the exposures of big banks to each other is to require ultra transparency. With ultra transparency, each bank can assess the other big banks and adjust the amount and price of its exposure according to this assessment.
The big banks have an incentive to do this because with access to ultra transparency they become responsible for all gains and losses on their exposures.
And although J.P. Morgan maintains the Chief Investment Office unit that caused the losses—which critics charge is more akin to an internal hedge—isn't engaged in proprietary bets, the misstep will embolden those calling for stringent application of the "Volcker rule" meant to curtail such activities.
J.P. Morgan has said the unit's activities wouldn't run afoul of Volcker and that it must invest excess deposits. Yet it is easy in doing so to engage in what some may view as proprietary bets. Even Mr. Dimon showed how blurred the lines can be when he said on the call, "None of this has anything to do with clients."
When that is the case, a bank and its strategies should be subject to heightened supervision.The best form of heightened supervision is to provide the market with all of its experts ultra transparency into the bank's exposure details. With this information, the market can assess, monitor and exert discipline over the risk of the bank.