Should Banks Just Buy Treasuries?

By May 15, 2012, 3:40 PM Author's Blog  

There’s a widespread impression that the $2 billion-plus trading loss JP Morgan Chase (JPM) announced a few days ago strengthens the case for more regulation of banks.  Below  Jerry O’ Driscoll makes this argument more thoughtfully than I’ve seen any where else.

Two basic facts are worth remembering.

Fact number one is that in 2010 Congress passed the gigantic Dodd-Frank financial regulation law, which is being translated to thousands of specific rules by coteries of government bureaucrats. The Volcker rule against bank proprietary trading is the least of it. There are numerous new rules. None of these could have prevented the JP Morgan loss or even moderated it, as best I can tell. The trading was meant to protect the bank from market shocks emanating from the European debt crisis. Evidently it went awry.

Fact number two is that all investment, indeed economic activity in general, carries with it risk of loss. The risk varies with the type of activity but never disappears. A hotdog seller can lose money. The only way not to take the risk is not to engage in the activity. This is like saying getting out of bed is risky – well it is, you might be hit by a truck! – and therefore you should stay in bed all day. If we took that advice, we would not have much of a life.

Banks could minimize risk by investing only in Treasury bonds. Over time this won’t be safe because rates will rise and bonds will lose value but for now it is a relatively low-risk investment. It is also a very low-return investment, that being the other side of the same coin. Low risk typically means low return.

Banks could not make money by keeping their assets in Treasuries. If that’s what they had to do, then they would cease to exist. This goes for commercial banks as well as investment banks. Hundreds of commercial banks failed in the past several years in large part because of loans made for real estate development that went under.

As long as there are banks, they will continue to make loans. Every now and then they will lose money. They will try to hedge their bets and on occasion get it wrong. This will happen regardless of how extensive and stringent regulation is.

Certainly, the reasons for a loss should be investigated and measures instituted to avoid mistakes. But we need to take it as a given that sometimes human beings will make errors and sometimes businesses will lose money.

In view of that reality, it is absurd to call for further regulation every time a bank makes a loss. By such logic every regulatory failure to prevent loss will lead to further regulation, with the result of explosive regulatory expansion. The logical end point would be to forbid the taking of any risk, at which stage most of the financial industry would have to shut down.

But why stop there? There are risks everywhere. One could argue for more regulation in all areas. That picture is not far fetched. Between Dodd-Frank and the similarly gigantic healthcare law, the amount of new red tape generated is so immense as to act as a drag on the American economy.

The truly systemic danger we face is paralysis by regulatory overreach.

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