Smith Faculty Opinion Article
May 11, 2012
J.P. Morgan Mess: Bust up the Big Banks
J.P. Morgan’s $2 billion loss from betting on corporate bonds will embolden
advocates of the Volcker Rule—a provision of the 2010 Dodd-Frank law that will
prohibit banks from trading on their own account. Unfortunately for federal
regulators, trading in securities is essential to modern banking, and busting up
the big Wall Street financial houses may be the only way to better ensure
The Glass Steagall Act of 1933 separated commercial banking—taking deposits
and making loans to finance businesses, homes and the like—from investment
banking—selling stocks, bonds and other securities, and making markets for
investors to buy and sell those assets quickly. That separation was repealed
during the final years of the Clinton Administration, and Wall Street
institutions like J.P. Morgan now perform both roles.
Modern commercial banking simply won’t tolerate such an absolute separation,
because banks cannot finance all the demand for loans from deposits. In recent
decades, too many savers have found they can earn higher returns than at the
bank by investing in money market funds, bond funds and directly buying bonds.
Consequently, banks make loans, issue credit cards and the like, and bundle
borrowers’ promises to pay into securities and sell those to bond investors.
Fannie Mae and other government backed housing banks don’t take deposits at all,
and get virtually all their financing selling mortgage-backed securities.
Also, regional banks can buy securities backed by the loans of banks in other
regions to mitigate the risks inherent in serving a local economy. Kansas banks
are just too dependent on the price of corn, and do well to hold some debt whose
repayment depends on the vitality of other regions and industries.
Of the many activities performed by large investment banks—essentially, the
big financial houses on Wall Street like J.P. Morgan—making markets for
securities, so that investors can buy and sell when they like, is most essential
for making the U.S. and broader global economies work.
Without assurance bonds can be sold when liquidity is needed, many investors
simply would not buy mortgage-backed securities or would demand much higher
interest rates, making the cost to ordinary folks pay on home mortgages
prohibitively high. The same reasoning applies to the availability and cost of
business, auto loans and credit card debt that create jobs.
Investment banks must buy and sell securities with their own capital—“on
their own account”—to ensure liquidity and hedge—to insure their positions
against losses. The Volcker Rule would permit these activities but ban simple
gambling—the latter is what cost J.P. Morgan at least $2 billion in recent
The basic problem is that regulators have been working for the last two years
to define the difference between hedging and gambling, and can’t. Either the
rules would be too severe and shut down banking, or would permit reckless risk
taking that could take down a huge bank, and potentially put the taxpayer on the
hook to pay off depositors through the FDIC.
Commercial banks are essential to the smooth function of a market
economy—capitalism runs on credit much as air conditioning runs on
electricity—and without stable commercial banks the economy can’t grow.
The simplest solution is to once again separate commercial and investment
banking, as was required by the Glass Steagall Act, with some modest exceptions.
Let banks take deposits and make loans, and sell those to investors through
investment banks who would do the bundling of loans into securities. Even let
commercial banks own securities backed by loans in other regions to balance
default risk, but leave the business of making markets and trading to separate
Commercial banks would continue to be regulated and government insured by the
FDIC, and investment banks would be free to trade and take risks with their
stockholders capital. If the latter failed from foolish trades their investors
would lose their capital, but the taxpayer would not be on the hook.
Peter Morici is a professor at the University
of Maryland School of Business and former Chief Economist at the U.S. International