Commercial Banks, the Securities Markets, and the Need for Glass Steagall: The OIG Report on the Supervision of JP Morgan

The OIG at the Fed just issued a report on the Fed's oversight of JP Morgan Chase in connection with the London Whale incident in 2012. A summary of the report is here. 

The report made findings that the Fed's oversight was inadequate. Interestingly, the report noted that the FRB New York was aware of the risks posed by the trading in London but did not share the concerns with the OCC or conduct its own inspections of the London operations. As the report noted: 

• We acknowledge that FRB New York's competing supervisory priorities and limited resources contributed to the Reserve Bank not conducting these examinations. We believe that these practical limitations should have increased FRB New York's urgency to initiate conversations with the OCC concerning the purpose and rationale for the planned or recommended examinations related to the CIO. Even if FRB New York had either initiated conversations with the OCC to discuss the planned or recommended examinations in accordance with SR Letter 08-9 or conducted the planned or recommended activities, we cannot predict whether completing any of those examinations would have resulted in an examination team detecting the specific control weaknesses that contributed to the CIO losses.

The report also found that the Fed and OCC staff "lacked a common understanding of the Federal Reserve's approach for examining Edge Act corporations" and that "FRB New York staff were not clear about the expected deliverables resulting from continuous monitoring activities." Finally, the report concluded that "FRB New York's JPMC supervisory teams appeared to exhibit key-person dependencies."   

So what were the recommendations? There were 10. Some of them went to better coordination among banking agencies. Mostly, though, the recommendations focused on improvements in the inspection process. These included: the issuance of "guidance detailing expectations for documenting and approving the deliverables of continuous monitoring activities, tracking identified issues, and performing follow-up activities," the mitigation of "key-person dependency," and the hiring of "additional supervisory personnel with market risk and modeling expertise."   

The Report will likely result in more intense inspections of commercial banks (the section on the response to recommendations indicated little patience by the FRB New York with the recommendations),  particularly with respect to activities in the securities markets. That in turn will likely result in banks becoming more risk averse. Risk aversion is good for commercial banking but bad for the securities markets.

Prior to the repeal of Glass Steagall, increased risk aversion among commercial banks would have had little impact on the securities markets. The securities markets were dominated by a class of investment banks that could not engage in commercial banking (and visa versa) and were therefore outside the scope of oversight of bank regulators. With the repeal of Glass Steagall, though, the commercial banks have ousted the independent investment banks, a dynamic that was eminently predictable. See The "Great Fall": The Consequences of Repealing the Glass-Steagall. With the demise of Lehman, the acquisition of Merrill and Bear Stearns by commercial banks, and the conversion of Morgan Stanley and Goldman, there are no more large investment banks that fall outside the oversight of bank regulators.

The securities markets are about risk taking. Limitations on risk taking in turn hurts the securities markets. Regulatory oversight of commercial banks seeks to reduce risk taking. This has the potential to impose long term harm on United States capital markets.