JP Morgan (JPM) one of the most prestigious investment banks in the world, informed financial markets recently that it had lost $2 billion in risky trading. The news put markets on high alert. Financial markets have barely recovered from the meltdown of the financial system in 2008. There has been a lack of confidence in the ability of banks to do the ‘right’ thing.

Democrats have been calling for regulation of banks. 'Volcker rule' as the banking regulations are called, recommends breaking up big banks so that no one bank is too big to bring down the entire system. The rules also propose increasing capital to make banks stronger and restricting them from making large risky trades. Many bankers and those in the Republican party oppose these regulations and the fiercest opponent among them has been Jamie Dimon, the CEO and President of JPM. 

Let us spend a moment to understand the roles of banks and what regulation means.

What do banks do?

Banks perform many tasks. Very broadly, they take deposits from you and me, and help us with our financial transactions - transfer money to other accounts, pay checks etc. With the excess money we leave behind in our deposit accounts, banks lend to people and businesses and earn interest. Besides lending, banks sometimes invest on their own in financial markets, where they earn even more profits.

Banks and financial institutions are the life-blood of every economy and need to function properly to ensure a smooth flow of money through the whole system. Even a small problem in the banking system can bring an economy to its knees.

What is the 2008 financial crisis?

In the period leading up to 2008, banks lent money without proper oversight. Easy money and greed for profits led bankers to aggressively lend and trade in new less understood financial instruments. When lenders defaulted -- that is, did not pay back their loans and lost money on poor investments, banks were unable to keep the financial system working smoothly. Big investment banks such as Lehman Brothers and Bear Stearns collapsed, leading to a near freeze up of the banking system. The Government had to intervene and put money into the system with the stimulus package. This was ultimately paid for by the US taxpayers.

Why banking regulation? 

Since banks are vital to the economy to ensure things runs smoothly and protect the small depositor, it is necessary that banks follow rules. When rules are light, bankers jump on the opportunity to make profits. Too much regulation is not good either as it can stifle creativity. However, when financial institutions are protected with tax-payer money and backed by the Government, many agree that the price for this security is regulation to ensure banks are transparent about how funds are used.

Why is the JP Morgan’s loss a big deal?

Jamie Dimon

When markets collapsed in 2008, JPM was the only institution that was safe and had followed safe risk practices. JPM’s management and risk processes had been highly acclaimed. That confidence has been shaken with the recent losses. It shows that even JPM is not infallible.

Though the loss is large, the impact on the bank is not very substantial. Last year, JPM had turned in a profit of $19 billion. However, an analysis of the loss suggests that the vastness of the banking empire made it difficult to have complete oversight over all its parts leading to the huge losses. This incident may just be the trigger for tighter control and regulation of the US banking system in the future.

Critical Thinking: Do you thinks banks need to be regulated to prevent losses that can derail the economy? Since banks are businesses like others, do you think regulation can strangle the ability of the industry to innovate and grow?