The Lessons of J.P. Morgan: Defining Oligopoly
J.P. Morgan’s $2-4 billion trading blunder has reignited the debate of whether our banking industry should remain the oligopoly that it is, or be subject to a broader array of regulatory reforms and restructuring.
The media’s focus on the several billion dollars in bad derivative trades, while replete with shock value, misses the real lessons of the incident. While significant, the losses were hardly catastrophic for the bank. With $2.3 trillion in assets, J.P. Morgan’s loss represents only .1 percent of its total assets and 1 percent of its equity. Clearly, the bad trades represent a failure of risk management, yet the fact remains that J.P. Morgan remains fundamentally well managed. Chances are, the bank will still be profitable in the second quarter.
In the midst of the ongoing media feeding frenzy, J.P. Morgan will do what any well-run organization would do: analyze what went wrong and fix it. Ina Drew, the J.P. Morgan chief investment officer who ran the department behind the massive trading loss, has left the bank with a $32 Million severance package. Other heads will roll in the coming weeks as the forensics behind the bad trades become more apparent.
Jaime Dimon, J.P. Morgan’s chairman and chief executive once praised for adeptly navigating the bank through the 2008 financial crisis shares the blame. His biggest mistake, perhaps, was his lack of humility and his reflexive—if not extreme—resistance to enhanced regulation of the banking industry. On April 13, Dimon downplayed the rumors of the massive losses by referring to it as “a tempest in a teapot.” But after the extent of the losses became clear, and when Dimon was forced to announce the losses on May 10, he explained, “In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored.”
To even a passive observer, the incident highlights that Dimon and other megabank CEOs, supported by a government sanctioned and licensed oligopoly, dominate trading flows and market making, particularly in the “over the counter” (OTC) markets.
What exactly does that mean?
The term, “Oligopoly” comes from the Greek, “Oligos” and “Polein.” “Oligos” translates to “few”; “Polein” means “to sell.” Simply defined, an oligopoly is an economic condition where there are few sellers and many buyers. The few sellers who dominate a market exert control over their competitors’ prices or their ability to freely compete. In an oligopoly, the market is also particularly vulnerable to the mistakes and fates of those few dominant influences.
When Citigroup or Bank of America experience massive losses, the government invariably comes to their rescue with billions in taxpayer dollars quite literally because they are “too big to fail.”
The 2008 financial crisis was largely caused by an overconcentration of derivative instruments in the hands of a few banks. Today, the top six megabanks hold 95 percent of the entire $1.2 quadrillion derivatives market. J.P. Morgan has 44 percent of that market. Those statistics alone constitute an oligopoly in that particular market. Alarming? Now, consider this: today, those same banks have assets that exceed 60 percent of our national GDP.
While the CEOs of the megabank club know the risks of overconcentration well, those whispered conversations normally occur behind closed doors or on the back nine. Their interest, understandably, is in turning massive profits for their shareholders. Each bank, therefore, contributes millions to both political parties, and employs an army of Capitol Hill’s best lobbyists to ensure their advantages are preserved.
Over a century ago, President Theodore Roosevelt confronted the financiers (J.P. Morgan among them) and industrialists head-on with antitrust suits. Despite the accusations of his critics, Roosevelt’s objective was to regulate the giants, not to destroy them. Roosevelt’s direct approach was politically courageous and effective in 1907. Created to safeguard against undo risks by improving accountability and transparency in the financial system, the Dodd-Frank Act was the closest we’ve come to TR’s method yet. But even that “big stick”has, by most accounts, fallen short.
The lessons should be abundantly clear. Mitigating against risk requires sufficient capital. Because J.P. Morgan is a healthy bank, the losses they announced last month, while uncomfortable, were nonetheless manageable. Banks should, therefore be required, by law, to hold ample equity capital to cover any potential losses. That is something regulations can’t do.
Second, the Department of Justice as well as federal regulators should both be empowered and instructed to preemptively break up large financial institutions that pose a threat to the nation’s financial stability. Currently, Dodd-Frank empowers regulators to intervene “only as a last resort.” Dodd-Frank also requires banks to have a “living will” to provide for a managed dissolution in the event of a bankruptcy. This provision remains ill-defined and untested, and offers little reassurance that our economy won’t be driven into the same kind of crisis we experienced in 2008.
Today, the banking system is even more concentrated than pre-2008. Because the largest banks have the implicit backing of U.S. taxpayers, their cost of capital is artificially low. As a result, the megabanks are incentivized to take outsized, irrational risks—and smaller banks are challenged to compete with them.
That is the textbook definition of an oligopoly.