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Bernie Madoff Is Jamie Dimon's Latest Headache

Irwin M. Stelzer

Here we go again. JPMorgan Chase will pay $2.6 billion in fines and compensation for its inattention to numerous red flags warning that its important customer, one Bernie Madoff, was running a $65 billion Ponzi scheme. Among other things, JP Morgan Chase failed to notify the authorities that it had turned down one deal with Madoff because, as it had belatedly reported to its UK regulators, Madoff’s investment results were “so consistently and significantly ahead of its peers [that they] appear too good to be true.” This annoying fact, along with countless other red flags cited by the Justice Department-including a warning from another bank that stopped doing business with Madoff-was never reported to regulators, in violation of the Bank Secrecy Act.

Nevertheless, Jamie Dimon and his executive team at JPMorgan Chase have reason to be happy: no criminal indictments against them have been filed, and not one cent of the $20 billion in compensation and fines so far levied against the bank ($7 billion is “compensation” and therefore tax-deductible) will come out of their pockets. The Justice Department is happy: it has been tapping the bank’s treasury for billions in voter-pleasing, headline-making fines. The shareholders are happy: they have bid up the bank’s share by almost 30 percent in the past year.

With the bank’s executives, its shareholders, and the prosecutors all seeming to be happy, why worry? Here’s why. Systemic failure lurks. A spokesman for the bank confessed, “We could have done a better job pulling together various pieces of information and concerns about Madoff from different parts of the bank over time.” That is close to a confession that Paul Miller, a bank analyst at FBR Capital Markets, was right when he told Peter Eavis of the New York Times, “I think JPMorgan is too big to manage and it should be broken up.” So attention must be paid to Kurt Schacht, a director of a firm promoting ethical standards in the financial sector: “With respect to the big banks it is … a complexity problem. We think these firms are so large that they are always going to be plagued by rogue operations.”

This is not a problem for the shareholders alone, although they might be rethinking last year’s decision to allow Jamie Dimon to serve as CEO, reporting to Jamie Dimon, chairman of the board. If the nation’s largest bank is run by a managerial team of serial fine-payers, their next miscue might just threaten the stability of the banking system as a whole. After all, when it comes to size and interconnectedness with other financial institutions, Lehman Brothers is a disconnected pygmy by comparison with JPMorgan Chase, and the collapse of Lehman almost brought down the financial system in 2008.

Even if JPMorgan Chase proves to be manageable, perhaps by a new team, reasons to worry remain. It is true that steps have been taken since the financial crisis to reduce what is called systemic risk, the danger that a bank’s failure will not only wipe out its shareholders, but threaten the system as a whole. Banks must now hold more capital, and take fewer risks with depositors’ money. Legislation has been passed, regulations written and fines levied.

But no enforcement agency dares set fines so high as to threaten the ability of a bank to raise capital, and regulation is a limited instrument given the nature of banking.

Regulators in ever-larger numbers prowl the corridors of these institutions, hoping to sniff out problems before their stench panics investors, and trying to harpoon any new $6 billion “London whale” before it surfaces. Green-shaded government auditors check bookkeeping entries. All to the good, but not entirely sufficient. After all, if the managers of a bank such as JPMorgan Chase cannot connect the dots that would have led to earlier discovery of the Madoff fraud, how can government regulators be expected to do so? We are asking regulators to measure such ill-defined things as “risk,” understand complex financial instruments, decide just how much capital, and of what sort, a too-big-to-fail bank must have-subjects so difficult that in the words of Tevye in Fiddler on the Roof, “they would cross a Rabbi’s eyes.” And probably those of most members of bank boards.

Some hope that adding the Volcker Rule to the post-crisis reforms will do the trick-sharply reduce, if not eliminate, the threat to the system inherent in the presence of huge banking institutions. That rule is aimed at preventing banks from risking taxpayer-insured deposits by “proprietary trading,” buying financial instruments for the bank’s own account, rather than to serve clients. Never mind that no less an expert than incoming Federal Reserve Board chairman Janet Yellen says that there is “an absence of a lot of bright-line distinctions” between these two types of transactions.

The rule will affect some markets, that for municipal bonds among them, but not others. Goldman Sachs will take a 20 percent equity stake in a $2 billion property fund despite the Volcker rule’s prohibition against banks owning more than 3 percent of a hedge fund or private-equity portfolio because property investments are excluded from the rules’ restrictions. Some denizen of K Street has undoubtedly earned a “lobbyist of the year” award.

The 37-word original version of the Volcker Rule, contained in the Dodd-Frank law, has grown into 963 pages containing 2,826 footnotes, to be enforced by five separate regulatory agencies that agreed on a final draft only after pressure from the White House and Treasury to end a three-year squabble over the rule’s details. Now, several of the gang of five are claiming the role of prime regulator of various aspects of the banks’ activities.

Some wags are dubbing the Volcker Rule “The Lawyers’ Relief Act.” The Wall Street Journal asked a senior partner at Davis Polk & Wardwell LLP if the rule had created “a cottage industry” for lawyers, and was treated to the candid reply, “It’s an awfully big cottage.” More like a mansion.

Admittedly unmanageable, too big to damage with fines, too complicated to regulate, the big banks can be made smaller with no so-far proven loss in efficiency. Until that far-off day, we will have to make do with higher capital requirements and tighter regulation. Better than nothing, and far better than the pre-crisis situation.

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