Washington, DC, May 15, 2012 --  

The best way to stop big banks' risky behavior isn't to regulate them, it's to eliminate them.

The announcement of a $2.3 billion trading loss at JP Morgan Chase has left-leaning Americans on yet another tear about tighter regulation of the financial industry.¹ The company's bad bets on complex derivatives led to an unprecedented loss, giving fodder to those who say large banks should not be allowed to make risky trades, lest their potential failures put the nation's economy at risk.

Advocates of tough regulation will probably get their way. The Securities and Exchange Commission, the Treasury Department and the Federal Reserve are due in July to implement the Volcker rule of the Dodd-Frank financial reform package, which would prohibit banks from speculative trading. Whether or not the trades at JP Morgan Chase will soon be illegal under this rule, depends on the final wording, which has been under review after public comment on a 298-page draft from last fall.²

The coup de grace that may push this regulation to the toughest extreme is the fact that JP Morgan Chase CEO Jamie Dimon, the very man who oversaw the $2.3 billion loss, was one of the main opponents.³ You can't make this stuff up.

Big banks have been on the losing end of their tug-of-war with regulators since the financial crisis forced them to accept $431 billion⁴ in federal bailout funds (most of which have since been recovered by the government), in exchange for minor federal controls, notably limits executive compensation.

Yet to anybody with any foresight, it was clear that these minor controls were just the beginning. Once the big banks accepted bailout funds, they could no longer claim they could operate independently from the government. This opened up the door to unlimited meddling in the banking industry.

Who do you trust more to make decisions affecting America's financial stability? Greedy and corrupt big corporate bank executives? Or greedy, corrupt politicians and the lobbyists who write their regulations?

Your answer to the above question probably depends on where you stand on the ideological spectrum. Leftists will believe that regulators are principled and therefore to be trusted to police the excesses of capitalists. Conservatives will say that private executives are best suited to run the economy without government interference.

But this is a false dichotomy. Politicians and big banking executives been in bed with each other since the New Deal reforms. There is a well-documented "revolving door" between the federal government and Wall Street firms. The regulatory struggle between Wall Street and Washington is but a gentleman's game.

Rather than more tightly regulate these big banks, some more radical policymakers, like Vermont Senator Bernie Sanders, and Dallas Federal Reserve President Richard Fisher, have advocated breaking up the larger banks to mitigate the risk of a single failure to the overall economy.^5,6

Such radical intervention is anathema to free-marketers. But consider that after 80 years of federal intervention, and regular role-shifting between Washington and corporate boardrooms, these large banks have ceased by be true free-market entities. Also consider that smaller banks tend to be less in bed with politicians, provide better customer service, and therefore much better align with the free market ideal. And cutting big banks down to size doesn't have to be a Bell System-style dictate, it can be accomplished through easier rules that enhance smaller banks' competitiveness, thereby gradually cutting the big boys down to size.

If given a choice between a tighter symbiotic relationship between corrupt bankers and corrupt politicians, or a breakup of this relationship -- it's an easy choice to go for the break up. Given the propensity of federal officials to look out for their friends on Wall Street, however, don't hold your breath that this will happen any time soon.

Notes:

1. New York Times, Why We Regulate, May 13, 2012

2. Bloomberg, Muni Bond Issuers Say Volcker Rule Will Drive Up Costs, May 9, 2012

3. Value Walk, Jamie Dimon Tells FBN Paul Volcker Doesn't Undertand "Capital Markets", February 13, 2012

4. Congressional Budget Office, Report on the Troubled Asset Relief Program--March 2012, March 28, 2012

5. USA Today, JP Morgan's $2B Mistake Aids Those Seeking Stronger Rules, May 14, 2012

6. Reuters, JP Morgan's Dimon Loses Clout as Reform Critic, May 11, 2012