Big Banks Just Can’t Make Money Banking.

“Traditional banking just isn’t that profitable,” said Frank Partnoy, a professor of law and finance at the University of San Diego. “Bankers like to make lots of money, and they are finding other ways to do it.”

Traditional checking accounts, ATM networks, and loans to home buyers and main street merchants just don’t cut it anymore. Banks lose more money on an average Joe with $1,500 in his checking account, a credit card with a $2,500 balance and an $80,000 home mortgage at 5% than they earn on a wealthy customer with 4 banking products and $100,000 in their savings account.

Where can the poor banks turn in their hour of grief?

How about the part of the banking business that tries to stay out of the spotlight? The high-pressure trading rooms where a company’s best and brightest bet hundreds of millions of dollars on arcane financial instruments such as over-the-counter synthetic derivatives and credit default swaps. That’s where the money is.

These activities aren’t showcased in ads and news releases, but they are as central to modern banking as certificates of deposit and debit cards. The risks are considerable, however, a fact underscored by JPMorgan Chase & Co.’s recent loss of at least $2 billion on such trades.

Coming just four years after the financial collapse of 2008, JPMorgan’s humbling admission has spurred lawmakers, regulators and even many seasoned Wall Street hands to question whether banks — shepherds of trillions in consumer deposits — should be allowed to make such investments at all.

Speculative trading can turbocharge profit in a way a revolving credit card loan portfolio cannot, but it comes at the risk of losses that, at the extreme, could threaten the bank itself or force yet another taxpayer bailout.

“We have to understand that these losses are not rare,” said Christopher Whalen, senior managing director of Tangent Capital Partners in New York. “These are recurring events that have to do with the fact that banks don’t want to lend money. They want to trade opaque, illiquid securities that are not well understood, and I’m not sure banks should be doing that.”

As we have pointed out before, banks were historically prohibited from such trading by the Glass-Steagall Act, a Depression-era law separating retail and commercial banking from investment banking and trading. But both the spirit and the letter of that law were progressively weakened over time and abolished altogether by the Clinton administration in 1999, clearing the way for a huge expansion of activities that had little relationship to conventional lending and borrowing.

Now an increasingly large share of bank profit comes from closely guarded trading operations with limited outside oversight, run by people chasing seven-figure bonuses who treat FDIC-insured deposits like so many chips at the Wall Street casino.

And because bigger bets can spell richer rewards, the most aggressive speculation is concentrated at the top. Just four banks — JPMorgan, Citibank, Bank of America and Goldman Sachs — control almost 95 percent of the marketplace for derivatives.

Derivatives are specialized investments usually tied to the value of an underlying asset. A simple example is a future contract for oil, in which investors bet on what they think the price of oil will be in months ahead.

Jamie Dimon, chairman and chief executive of JPMorgan, has contended that the chief investment office’s trades were intended to be hedges, essentially performing as insurance against the potential for losses in its overall loan portfolio. But what may have started out as a legitimate hedge, has by the bank’s own admission, turned into trade positions that were no longer a hedge at all.

That’s an important distinction to make as Washington finalizes the so-called Volcker rule, which bars banks from speculating with federally insured deposits, but has a loophole: Investments designed specifically as hedges would be permitted. So, guess what will happen next?

Opponents, and there are many and they are well funded, will fight any such regulation furiously and will point to the fact that despite the loss, analysts still expect JPMorgan to book a $4 billion profit for the quarter. Dimon himself has said he would embrace rules that prevent such bad trades from happening, but does not endorse a full-scale retrenching of the banking business.

“This loss was bad, but there was no threat to the financial system,” said Matt Levine, a former Goldman Sachs derivatives trader who now writes about finance. “If a plane crashes, it doesn’t mean we should go back to horses.” Well, that may depend on how many planes and who was on them. I’m sure there is a derivative that can be traded on that too.

When the European banking system collapses over the next couple of months and the big four US banks are discovered to be co-party to $39 billion in worthless positions, we will see how popular the notion of letting the banks do what they like turns out to be, without the current reality distortion aura.

Unfortunately, the cost to reinstate the Glass-Steagall Act will be much, much higher than it needs to be, and the burden will once again fall on the taxpayers. We must love this, because we keep setting it up to repeat itself.

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About Steve King

iPeopleFINANCE™ Chief Operating Officer. Former CEO of Endymion Systems, Inc. a $36m Information Systems Services company. Co-founder of the Cambridge Systems Group, the creator of ACF2, the leading IBM Mainframe Data Center Security product; acquired by Computer Associates. IBM, seeCommerce, marchFIRST, Connectandsell alumni. UC Berkeley alumni. View all posts by Steve King

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