Jonathan Macey, a former professor of mine at Yale Law School,* recently wrote an op-ed for the Wall Street Journal (paywall; excerpts here) arguing that we shouldn’t worry about JPMorgan’s recent trading loss because market forces will ensure that the bank does a better job next time. Here’s a key paragraph:
“Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan’s losses should be treated as further proof that markets work. J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.”Macey’s central point is that companies don’t like losing money, so losing $2 billion means that they will do a better job of figuring out how not to lose money in the future. That’s obvious. But it’s also beside the point.
Bankers don’t ask, “Do I want to gain or lose money today?” That’s not the relevant point at which incentives apply. Instead, they ask: “Do I want to engage in this specific class of activities that has a certain expected payout structure?” In the JPMorgan case, the question is: “Do I want to engage in trades that are, roughly, portfolio hedges but that also take significant long or short positions on the credit market as a whole, with the conscious intention of making money?” And what we care about is whether the bankers’ decisions are producing the socially optimal level of risk.
We know that Jamie Dimon pushed the Chief Investment Office to take more risk in pursuit of profits. We also know that the trade in question was not really a true hedge; if it were, there would be no news, because the