Lesson of JPM Debacle: Keep the Board's Eye on the Ball

The facts in the JPMorgan Chase (JPM) "London Whale" case are still being sorted out, but that hasn't stopped analysts — myself included — from pondering its policy impact. Much of what the bank's CEO, Jamie Dimon, calls punditry has focused on whether the $2 billion-plus loss proves points on the Volcker Rule, TBTF, CEO compensation and, perhaps, nicknames.

Key to all but the last of these disputes is whether JPM's trades were risks the board and senior management should have seen coming and, now, be held accountable for failing to prevent. At issue here is whether the transactions were trades — blocked by the Volcker Rule — or hedges — rightly permitted by it. A recent op-ed in the American Banker by Peter Wallison argues that knowing which is which is so complex that neither law nor rule should attempt it. I don't think it's all that hard if boards and senior management cut to the heart of what hedges are to do: mitigate risk, not make money.

So, what does the JPM unpleasantness really tell us about public policy, including the Volcker rule? It isn't that the Volcker Rule is wrong or even, as some have argued, that it should join the rest of the Dodd-Frank Act on the scrap heap. Rather, the case reinforces the hard lessons of the financial crisis, which are that a sound financial system depends on three bulwarks: 

• Regulation targeted tightly at protecting the innocent and punishing the guilty, not randomly aimed at every aspect of financial-institution activity. For the Volcker Rule, this means a limited set of defined proprietary trades banned by rule and meaningfully enforced  by supervisors.
• "Fortress" balance sheets. To its credit, JPM has one and, so, its shareholders are rightly the ones at risk for the Whale's losses, not the FDIC either as deposit insurer or systemic-institution liquidator.
• Rigorous, responsible and accountable governance to ensure that the board of directors knows that a financial institution complies with the rules and can withstand the crises, misdeeds and unforeseen circumstances sure to befall it. Here, we're not so sure about JPM. We'll find out what its board knew when, but the CEO's description of the numerous internal-control lapses that led to the debacle tells us that, even if the board knew about the size of the bets, it didn't appropriately test their bottom-line risk, let alone the reputational one now gripping the bank.

Big financial services firms are complex and the transactions in which they engage even more so. This has led many to argue that the solution to complexity is mandatory simplicity – breaking up big banks into bite-size pieces or simply banning certain transactions. However, enforced simplicity doesn't ensure that these three bulwarks are in place and may even undermine long-term financial-market stability as "simple" firms take on concentrated risk without ample reserves or effective governance. Complexity isn't the problem per se. Rather, it's the willingness to date of regulators and directors to kow-tow to complexity on grounds that someone somewhere must understand it.  Real governance , just like effective regulation, means sifting through structured finance — a necessary part of modern markets — to describe its safeguards in terms clear enough for directors to assess, ascertain, and ensure that, when risks are taken, results are well within thresholds set up in advance to protect the bank's balance sheet and its regulatory integrity.
These safeguards drive what regulators have come to call the "risk appetite" directors must set for each financial institution. That's right, but then regulators take this sound concept and turn it into yet another over complex set of rules to which no one, themselves included, can be held accountable. By our count, there are 184 new to-dos for directors in the FRB's proposed set of systemic regulations. The more questions directors must answer, the easier it is for them to miss the big one where the answer tells them that someone has bet the bank. And, then, the more quickly directors will descend from trying to set meaningful risk appetites again to rubber-stamping plans presented to them by financial engineers toting impressive resumes and fancy power points.

As a ground-breaking report by the Group of Thirty on corporate governance has rightly observed, the financial crisis shows a profound failure across the industry in this critical regard. I would go the G-30 one further and argue that, in fact, the financial crisis was at bottom caused by flawed corporate governance. Had boards understood the risks being taken, none that were any good at their fiduciary duties would have stood by. Regulators failed, the tools to handle huge troubled firms were not at hand, rating agencies got a lot wrong and much else needs a post-crisis redo.

But, had banks and other financial-services firms gotten a grip on their own risk exposures, the critical missing element — meaningful market discipline — would have applied and the trillions lost in the crisis would have been minimized if not altogether saved.

Karen Shaw Petrou is a managing partner at Federal Financial Analytics.