That second set of trades -- when JPMorgan was using the derivatives market to sell insurance -- was clearly a speculation. And if I were writing the regulations to implement the Volcker rule, which prohibits proprietary trading by banks, I would bar any bank from ever selling a credit-default swap. If you want to gamble, go to a casino. If you want to sell insurance, get a license from the state commissioner (who, by the way, will regulate your capital).
Here’s the problem. In the era of Old Jamie, if someone in Europe wanted to borrow money, and if Jamie was a conscientious banker, he had to think long and hard about whether the customer was a good risk. In all likelihood, those customers would be with him for a long time. The new Jamie, and the people working for him, don’t have to worry quite so much. They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market. I have heard this offered as a defense of credit-default swaps from executives of JPMorgan. Were it not for the ability to hedge, they wouldn’t make all the loans they do. Hedging becomes an excuse for relaxing credit standards.
Jamie had an escape hatch, but hedging doesn’t offer an escape for markets as a whole. To sum up, thanks to these instruments, banks take more risks than they otherwise would and thus more risky bets are collectively owned by society. Only now the traders who set the market price are removed from the credit itself. In the past, Jamie and his team knew the borrower and evaluated the credit (the original J.P. Morgan Sr. famously testified that an individual’s “character” was the basis of credit)... The plasticity of modern finance -- the ease with which institutions can transfer risk -- is a major cause of the heightened frequency of meltdowns and increased volatility. As with a saloon in which each gunslinger comes armed (and with the safety catch released), markets resemble a shooting gallery in which risk takers, each in the name of self-defense, put the group in peril.
Regulators should remember this the next time a bank starts boasting about its sophisticated, state-of-the-art risk management systems. Most of the time, those systems involve complex bets in a zero-sum-game derivatives market, where the bank’s counterparties charge a premium for the fact that they’re on the wrong side of an information asymmetry. At best, in such cases, the bank is merely abdicating responsibility for its risks, rather than properly managing them. And at worst, it thinks that it has gotten the credit risk off its books, when in fact it’s just pushed that risk into the tails, where it’s bigger than ever.