Volcker Rule would not have prevented trading loss at JP Morgan

As reported by the Wall Street Journal, the Fed Governor in charge of bank supervision is operating under the delusion that the Volcker Rule would have prevented the trading loss at JP Morgan.

Still, under the draft rule, J.P. Morgan would have had to provide regulators with documentation showing it was a permitted hedge, not a banned proprietary bet designed to make money for the bank. 

"If a firm said, 'We're doing this because it's a hedge,' they would be required to explain to themselves, importantly, as well as to the primary supervisor, what the hedging strategy was, how it was reasonably correlated with the positions that they were hedging and how they would make sure that they didn't give rise to new kinds of exposures,"...

J.P. Morgan would have to provide regulators with documentation showing this, he added.

Before debunking this argument, let me be clear that all the information I have on the trade is either from the mainstream media (Bloomberg, WSJ, Telegraph,...) or from blogs (Zerohedge,...).

Regular readers know that the purpose of bank supervision is not to approve or disapprove of individual positions.  Doing so would substitute the regulators for the financial system in the allocation of capital throughout the economy.

Rather, bank supervision assumes that there will be losses on individual positions and attempts to estimate these losses so as to be sure the bank is holding enough capital to absorb the losses.

With that background, at the inception of the trade, JP Morgan would have handed the regulators a sheet of paper which showed their current outstanding corporate loan balance and the credit default swaps they were going to buy to hedge this portfolio against losses.  It would show the efficacy of the trade and how JP Morgan's exposures were changing and becoming less risky.

The regulators would have said thank you very much and put the piece of paper in a file.  Challenging the trade would violate rule number one of not approving or disapproving individual positions.  After all, if the regulator challenges the hedge and then says go ahead, there is no doubt that constitutes approval.

Now we move on to the second part of the trade where rather than close out the position by selling the credit default swaps, the credit default swaps themselves were hedged.

It would replicate what happened when the trade was initially put on: the trade would have been put down on a sheet of paper and handed to the regulators and the regulators would put the piece of paper into a file.

Hopefully, I have made the point that the entire activity between JP Morgan and the primary bank regulator would not have prevented the trade or protected the regulators from the theatrical kicking they received from members of Congress in an election year.

Regular readers know that if you want to stop JP Morgan from engaging in these types of trades in the future you simply require that JP Morgan provide ultra transparency and disclose on an on-going basis its current asset, liability and off balance sheet exposure details.

Fear of market discipline would eliminate the trading behavior.