Last week, New York-based bank JPMorgan Chase shocked the financial world when it announced that it had lost $2bn trading derivatives called credit default swaps - and that these losses may spiral even higher.
JPMorgan CEO Jamie Dimon has had a reputation for being an excellent risk manager: His bank was one of few that made it unscathed through the 2008 financial meltdown. President Obama recently said that although Dimon is "one of the smartest bankers we got", the bank's losses make a compelling case for reform on Wall Street.
Al Jazeera's Sam Bollier speaks with James Kwak, a law professor at the University of Connecticut and the co-author of economics blog The Baseline Scenario, about what the incident means for the economy, financial regulation, and JPMorgan.
Al Jazeera: There's been a narrative that JPMorgan has historically been better at handling risk than other big banks. Do you think this reputation is deserved?
James Kwak: I've been reading Thinking, Fast and Slow by Daniel Kahneman, one of the founders of behavioural economics. And he said one thing that we're bad at is realising the influence of luck in past performance.
[JP Morgan] has gotten a lot of credit for having been the most responsible bank, the best-managed bank and so on. … In particular, one reason that JPMorgan came through the crisis better than other banks is simply that they had done less mortgage-backed securities during the boom. And it's not clear that was because they were smarter, or if it's because they were just late to that party. We know from the investigation that ProPublica did of [hedge fund] Magnetar that at the peak in 2006-2007, JPMorgan was doing deals that were just as dumb as the deals being done by Citigroup and Merrill Lynch.
So I think that the narrative that you hear about this often comes in the form: isn't this amazing that this happened to Jamie Dimon and JPMorgan, because they're the best. And I think it's quite possible that what's happened is that JPMorgan was luckier than the other banks in the past few years [and now] their luck is running out.
Either way, I think you come to the same conclusion: that we can't simply rely on the competence of the bankers.
It would be interesting to find out just how much Jamie Dimon knew about this specific trade, and obviously down the line that could raise the question of whether his stock compensation in previous years should be clawed back.
I bring up the compensation angle because according to some people - and I have sympathy for this view - the behaviour on Wall Street isn't going to change until you change individual incentives.
Al Jazeera: Will the incident boost the chances of legislation, such as the SAFE Banking Act recently introduced in the Senate, designed to prevent banks from becoming "too big to fail"?
JK: That act in particular I don't think has any chance, although I am a supporter of it. It doesn't have any chance because the politics of financial reform have not changed all that much. Essentially you can count on just about every Republican to be against it, so what that means is that basically at best you'll get what the [Obama] administration wants.
And the administration does not want to break up the largest banks. The administration's position has always been: we need smarter regulators who have more authority to gather more information about banks and who have the ability to clamp down on banking activity.
Now you've always had this stronger, better regulation approach, as opposed to a structural change approach like you'd have in the SAFE Act. That hasn't changed. The JPMorgan fiasco is going to bring financial reform back onto the front pages of the newspapers for a few weeks, but I don't think it'll be enough to really change the political dynamics at work.
Al Jazeera: Do you think that JPMorgan CEO Jamie Dimon is going to be continue to be able to be the banks' standard-bearer against more stringent financial reforms?
JK: I think this episode has really undercut his legitimacy as a critic of reform significantly. And I think and I hope that we will see less of him publicly opposing reform. That said, I don't think that the [banks'] lobbying campaign depended on having an articulate, well-respected figurehead. So I don't think that's going to be a major change.
Despite the $2bn loss, JPMorgan has said that it will still probably turn a profit this quarter. Is this that significant of a loss, given that the bank seems capable of absorbing it?
JK: In the short term, the $2bn in itself is not going to have a huge impact on anything, really. JPMorgan's profits, I believe, were $19bn last year. So they are still going to be profitable and they have a lot of capital. …
I think it's mainly important for two reasons. One is political. It may shift the debate about financial reform a little bit and it may give us a more strict Volcker Rule than it would have otherwise.
The other reason it matters is perhaps a bit more important. … If you really believe that this was a one-time fluke event that will never happen again … it should only affect the stock price by $2bn out of their total market value. What we've seen is the stock price has gone down more than that - I think it was about 9 per cent on the first day.
And that's because when this happens, people wonder, well, could it happen again and could it potentially happen on a bigger scale? If JPMorgan is going to have an accident every five years - this was a $2bn accident. How are we supposed to know it won't be a $10bn dollar accident next time, or a $20bn accident?
I think people's confidence in JPMorgan, and by extension in the other banks, has slipped a little bit. Now that's not going to be fatal, certainly, but the banks rely on the image that they are highly competent and especially good when it comes to risk management. Every time they do a stupid thing, that reputation suffers. That, I think, is what's weighing on the valuation of banks. In the long run, that's also what could make more significant financial reform possible.
I think the big lesson about this episode is that we can't trust the bankers to be as smart as they think they are.
Al Jazeera: Under the Volcker Rule, a regulation that will go into effect this July, banks will be prohibited from "proprietary trading" - buying and selling securities for their own gain. But banks will still be allowed to make trades to "hedge", or reduce, risk. Will banks be able to get around the ban on proprietary trading by characterising trades like this as hedges?
JK: I think, unfortunately, that it will be possible for them to do so … As some news reports have indicated, the behaviour of this specific Chief Investment Office [that incurred the $2bn loss] was something that Dimon was particularly concerned about with regard to the Volcker Rule.
So one of his priorities in lobbying the regulators was making sure that exactly what this group did, the bank would continue to be allowed to do. Conceptually, the problem with the hedging exception is that hedging can mean many things. … It's going to be very difficult for regulators to determine what's a hedge and what isn't a hedge. So that's why … it's hard to see how this isn't going to become a major loophole in the Volcker Rule.
Hopefully this example is going to lead to a stricter, rather than a less strict, Volcker Rule. But that's no assurance of safety in the long term.
James Kwak is a professor at the University of Connecticut School of Law and the co-author of economics blog The Baseline Scenario.
The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera's editorial policy.