Jamie Dimon’s letter to JPMorgan Chase’s shareholders included a whole section on the crisis and his solutions. Because Tim Geithner and Barack Obama listen to every word Jamie utters, I think it's worth reproducing the whole section here to see whether, in a year or so, his recommendations are implemented:
“Banks are not fighting regulation
“We at JPMorgan Chase and at other banks have consistently acknowledged the need for proper regulatory reform, and I also spoke about this topic in great detail in last year’s letter.
“Looking back, one of the surprising aspects about the recent crisis is that most of the specific problems associated with it (global trade imbalances, the housing bubble, excessive leverage, money market funds, etc.) were individually well-known and discussed. But no one, as far as I know, put together all of the factors and predicted the toxic combination it would become – and the crisis it would cause.
“So what can we do to help fix the situation going forward? We must focus on the problem: bad risk management. This not only caused financial institutions to fail, but it also revealed fundamental flaws in the system itself. These flaws existed at both a macro level, where the interplay of the numerous critical factors was missed, and a micro level: for example, the failure to prevent AIG from taking excessive, one-sided positions in trading derivatives and the failure to limit mortgages to families who could afford them and to keep loan-to-value ratios to a more reasonable 80%-90%.
“Over the last 50 years, we have allowed our regulatory system to become dangerously outdated. The structure is archaic and leaves huge gaps in the system. Today, in America, banks account for only one-third of the credit outstanding, with all kinds of non-banks taking and trading risks and providing credit to the system. So the idea that banking is confined to deposit-holding entities is inaccurate and deceptive. The failure of so many firms in a range of sizes and categories – from Bear Stearns and Lehman Brothers to IndyMac and WaMu to Fannie Mae, Freddie Mac and AIG, as well as local community banks – proves that regulation needs to be administered by product and economic substance, not by legal entity. We have a chance to simplify and strengthen our regulatory system, and, if we do it right, it will not only be able to handle the complex challenges we face today but will be able to do so in a way that will be flexible enough to continuously adapt to our changing world.
“We support a systemic regulator
“Going forward, we will need a systemic regulator charged with effectively monitoring the spread and level of risk across the financial system in its entirety. Think of it as a “super risk” regulator. Such a regulator would not eliminate all future problems, but it would be able to mitigate them. If we had eliminated just some of the problems, it might have stopped the crisis from getting this bad. Congress appears to be well on its way to creating just such a regulator, and we hope it succeeds.
“Some issues the systemic risk regulator should keep in mind are the following:
- Focusing the process on managing risk. This should not be a political process. It should function like a strong risk management committee.
- Eliminating gaps and overlaps in the system. For example, mortgages were regulated by multiple entities, some of which did a terrible job, causing a “race to the bottom” as even good companies started to do bad things to maintain market share.
- Analyzing areas like the mortgage market and other elements of the consumer-finance system to ensure that when new rules are written, they create a sound, safe, effective and consumer-friendly mortgage market.
- Carefully tracking new products, as they often are the source of many problems.
- Reviewing credit across the whole system – including “hidden” extensions of credit, such as enhanced money market funds and SIVs.
- Aggressively monitoring financial markets and potential excesses, or bubbles. It may be hard to detect bubbles, and it may be inadvisable, once detected, to exert a direct influence on them with macro economic policy. However, it is appropriate to try to minimize the collateral damage bubbles can cause. It also would be appropriate to try to manage bubbles, not by using monetary policy but by restricting credit on specific markets (i.e., it would have been appropriate to ask lenders to reduce loan-to-value ratios in mortgages or to minimize speculation in the financial markets by reducing the leverage used in the repo markets).
- Recognizing distortions as they develop in the broader economy (fiscal deficits, trade imbalances, structural state budget deficits) and forcing policy bodies to anticipate the problems that may result.
- Encouraging international coordination as much as possible – not only so companies compete on a level playing field but also because crises don’t stop at national borders.
“These are just some of the ways a systemic regulator could help fix the flaws in our regulatory framework and create a system that continually adapts and improves itself.
“We support an enhanced resolution authority — and the elimination of too big to fail
“Even if we achieve the primary goal of regulating financial firms to prevent them from failing, we still have to get government out of the business of rescuing poorly managed firms. All firms should be allowed to fail no matter how big or interconnected they are to other firms. That’s why we at JPMorgan Chase have argued for an enhanced resolution authority that would let regulators wind down failing firms in a controlled way that minimizes damage to the economy and will never cost the taxpayer anything. Fixing the “too big to fail” problem alone would go a long way toward solving many of the issues at the heart of the crisis. Just giving regulators this authority, in and of itself, would reduce the likelihood of failure as managements and boards would recognize there is no safety net. Think of this enhanced resolution as “specialized bankruptcy” for financial companies. The principles of such a system would be as follows:
- A failure should be based on a company’s inability to finance itself.
- The regulator (or specialized bankruptcy court) should be able to terminate managements and boards.
- Shareholders should be wiped out when a bank fails – just like in a bankruptcy.
- The regulator could operate the company both to minimize damage to the company and to protect the resolution fund.
- The regulator could liquidate assets or sell parts of the company as it sees fit.
- Unsecured creditors should recover money only after everyone else is paid – like in a bankruptcy. (In fact, the resolution authority should keep a significant amount of the recovery to pay for its efforts and to fund future resolutions.) • In essence, secured creditors should be treated like they are treated in a bankruptcy. • The resolution fund should be paid for by the financial industry (like the FDIC is today).
- All institutions under this regime should live with the exact same rules.
- Regulators should make sure that companies have enough equity and unsecured debt to prevent the resolution fund from ever running out of money. To give an example, while Lehman had $26 billion in equity, it also had $128 billion in unsecured debt. A resolution regulator, in my opinion, would clearly have been able to let Lehman meet its obligations, wind it down and/or sell it off and still have plenty of money left over to return some money to the unsecured creditors. Had this been done wisely, the economy would have been better off.
- If a firm fails, there should be enough clarity about the financial, legal and tax structures of that firm to allow regulators, cooperating across international boundaries, to wind it down in a controlled manner – what some refer to as living wills.
- While there is no argument about who should pay for the resolution (i.e., banks), there are some technical issues about how it should be funded. The resolution regulator does need to be able to fund these companies while they are being wound down, and there are plenty of appropriate ways to accomplish this.
“Once it is established that any firm can fail, firms of all sizes and shapes should be allowed to thrive. It is wrong to assume that big firms inherently are risky. Banks shouldn’t be big for the sake of being big, but scale can create value for shareholders and for consumers who are beneficiaries of better products that are delivered more quickly and less expensively. These benefits extend beyond individuals to include businesses that are bank clients, particularly those that are global in scale and reach, and the economy as a whole.
“Many banks’ capabilities, size and diversity enabled them to withstand the crisis and emerge from it as stronger firms. This strength, in turn, made it possible for many firms to acquire weaker firms at the government’s request and help to alleviate potential damage to the economy.
“Closing comments on regulation
“While we support the general principles behind enhanced regulation of derivatives, securitizations and enhanced consumer protections, we do not support each and every part of what is being recommended. The devil is in the details, and it is critical that the reforms actually provide the important safeguards without unnecessarily disrupting the health of the overall financial system.
“We also believe there are some serious ideas that need attention if the system is to be made more fail-safe:
- Repo markets could be better structured, monitored and controlled.
- Loan reserving could be made far less pro-cyclical.
- Securitization markets could be fixed so that both originators and distributors have skin in the game.
- A system could be put into place to prevent a “run” on money market funds.
- The ability to buy shareholder or creditor voting rights without owning and being exposed to the risks of owning the underlying securities should be extremely limited. Investors should not have the ability to vote the capital securities actually owned if the investors are voting for the failure of the company and stand to gain more on their short positions than on their long positions.
- Finally, we support strong controls on so-called naked short selling.
“During the past year’s discussion among regulators and legislators, many other ideas have been proposed or recommended – from the Volcker Rule to new bank taxes to changes in Basel capital. These ideas are all in varying stages of development and are too undefined to comment on here. What we would urge our regulators and legislators to do is proceed with clarity and purpose and avoid broadly penalizing all firms alike – regardless of whether they were reckless or prudent.”