I was prepared to take notes and tweet (no pun intended), having carefully reviewed the subcommittee’s 301-page report released the night before.  That report provided many new details regarding the  JP Morgan Chase 2012 tempest-in-a-teapot-turned-$6.2 billion trading loss. A regulator from the Office of the Comptroller of the Currency (OCC) who testified in the afternoon admitted finding new information in its pages that he thought they still needed to “digest.”

In the spirit of the Stevens’ poem, there are at least thirteen things I learned from the report and hearing:

1. They Saw it Coming: A potential $6.3 billion loss within the synthetic credit portfolio (SCP) at the Chief Investment Office (CIO) was predicted through the banks own comprehensive risk measure. However, market risk executive Peter Weiland dismissed the prediction as “garbage.”
2. Building up Risk: The portfolio did not reduce risk, but added risk: The SCP trades violated internal risk limits, yet more risk was added. The OCC saw the risk breach reports but did not act.
3. Not a Rogue Trader or Rogue Desk– CEO Jamie Dimon Knew: According to Ina Drew, the head of the CIO, who “resigned” last year, Dimon was aware of the CIO trading. In addition the report also details he was informed of the risk limit breaches.
4. The Cover Up:  The bank CIO unit changed its pricing practices to make losses on portfolio positions look smaller. This phantom pricing continued even after the story of the whale broke and even after it was clear another part of the bank priced the same positions like the CIO had in the past — at the midpoint between the bid/ask spread.
5. The Potential Fraud: Levin said that the bank agreed that “books were cooked.” The bank arguably made false statements to the public, policymakers and regulators about many things. Levin focused on the statements made by CFO Braunstein in April of 2012.
6. Gambling with Federally-Insured Deposits, Not Hedging Positions: The bank could not point to specific assets it was hedging, and appeared to be engaging in proprietary trading, using insured deposits to do so.
7. Positions Not Transparent: The bank claimed to investors in April of 2012, that it had disclosed trading positions to regulators when it had not.Levin called this and other statements made by CFO Braunstein an attempt to “calm the seas.”
8. Minimized Losses to Regulators: The bank may have told regulators losses were just $580 billion at a time when they had grown to $1.2 billion.
9. Regulator in the Dark: Scott Waterhouse, the lead OCC examiner for the bank said he did not find out about the London Whale risky trades until the Wall Street Journal broke the story in April of 2012. He said the whale “did not surface to our attention” until that time.
10. Yet Bright Red Flags: The OCC failed to investigate the trading activity even after learning of the multiple risk limit breaches. In addition when the bank applied a new value at risk (VaR) model and the VaR dropped by 50% using that model, the OCC did not inquire as to why. Did not look at the portfolio. Levin called this a “pretty bright red flag.”
11.  The Bully: CEO Jamie Dimon apparently yelled at bank examiners and called them “stupid” if he did not like their recommendations. Dimon apparently also instructed the bank to withhold daily profit & loss reports from the OCC regarding the whale trades. When Doug Braunstein the former CEO revealed that he had resumed providing reports to the OCC, Dimon raised his voice and said it was up to him whether reports resumed. Dimon previously had told OCC “you don’t need that level of information.”
12. Penny wise, pound foolish: The bank did not want to pay to automate the new VaR model, so an employee regularly worked late into the night manually entering data into a spreadsheet (and making errors) for the $350 billion portfolio. OCC did not know about this manual process.
13. The Volcker Rule: Comptroller Curry did not provide a date by which he though the Volcker Rule would be implemented, however, he did indicate that the London Whale experience with the CIO would affect the rulemaking. Curry who was sworn-in last April just days before the news broke seemed to imply that this so-called “portfolio” hedging that JP Morgan Chase claimed to have engaged in would be banned under the rule, as many argue the Dodd-Frank statute already prohibits.

When the hearing adjourned after six hours, a mental escape was welcome. I turned to Stevens’ poem, in particular the third stanza:

The blackbird whirled in the autumn winds./It was a small part of the pantomime.

The blackbird connection? Bruno Iksil, the former JP Morgan Chase trader dubbed “The London Whale” never appeared at the hearing. Residing in France, outside the reach of the Senate’s subpoena authority, Iksil himself was not in the building. Indeed, if one took a close look, even his trading was a really small part of the investigation, the hearing, and its broader implications.

This is a point made by Josh Rosner, co-author with Gretchen Morgenson of Reckless Endangerment.  On Barry Ritholtz’s Big Picture blog, Rosner contends that internal control problems at the bank “appear to be pervasive.” The whale problem may just be the tip of the iceberg, so to speak. He also notes that the whale loss itself is less than related litigation expenses — the bank has already paid out more than $8.5 billion in settlements since 2009 related to matters covered in the Levin report.

The hearing also raises again the question of whether banks are still “too big to fail.” Ina Drew did not help the camp that argues the status quo is fine. She headed up the CIO, earning $14 million in 2011 alone, but claimed that she was unaware they were 1,000% over their risk limit. And, when Levin asked her how big the hedge was and she said she not know the answer, she defended this by pointing out, that the bank had a $2.2 trillion balance sheet, implying it was either too trivial or perhaps impossible to track.

Senator Levin also attempted to create a larger frame for the hearing. In his opening remarks, he asserted that:

The Whale trades exposed problems that reach far beyond one London trading desk or one Wall Street office tower. The American people have already suffered one devastating economic assault, rooted largely in Wall Street excess. They cannot afford another. When Wall Street plays with fire, American families get burned. The task of federal regulators and this Congress is to take away the matches. The Whale trades demonstrated that this task is far from complete.

And, also incomplete is accountability. One can hope that the next time a banker is cross-examined about  arguably materially misleading statements, it is in a court of law, not a Senate hearing room, and one can hope that the prosecutor has carefully reviewed at least thirteen ways of looking at a white collar crime. But I won’t hold my breath. The statute of limitations will probably run before that happens. “The river is moving/The blackbird must be flying.”

Admati and Hellwig are leading figures in the financial reform debate, both in the United States and Europe.  Anat Admati has blazed the trail in exposing the muddled nonsense so many bankers talk when they debate whether higher capital levels would make our financial systems safer.  We see examples of this confusion every day:  for example as recently as yesterday Bloomberg News ran a report in which a senior consultant was quoted as blaming lower loan-to-deposit ratios in part on “new regulations” that “include holding more capital to cushion losses.”  Ironically, on the same day the Wall Street Journal ran a report on the “flood” of business loans “roaring back” into the market.  Obviously something other than capital is making the difference between lower lending rates in some areas and higher lending in others (low borrower demand in certain sectors?; some loans being more risky than others?; no more NINJA and liar loans allowed?; and so on).  The Bankers’ New Clothes explains the fundamentals of bank finance once again to illustrate why the Modigliani-Miller theorem (which says that absent other costs it would make no market difference whether a firm uses capital or debt to fund its operations) remains relevant, though insufficient, for understanding the dynamics of finance in banking.

There are of course some countervailing considerations, for example whether there are tax advantages to using debt rather than capital, and whether the public subsidies that support banking are among the reasons why banks choose to use “other people’s money” rather than their shareholders’ capital.  These are complex and difficult issues, but they are rigorously anticipated and investigated by Admati and Hellwig.  By contrast, the counterarguments, which raise important points, remain surprisingly (after all this time and debate) tentative, seldom directly addressing studies published both in the United States and Europe, by Andy Haldane (and his research staff at the Bank of England), Reserve Bank research staff in the United States, Simon Johnson and James Kwak and many more experts and commentators.

The sweep of The Banker’s New Clothes is much broader than just the debate about whether banks should be required to hold more capital.  The reality of bank lending and bank politics is explored in detail and woven into the analysis at many points in the book.  The authors develop much more fully their previously published talks and research papers.

This is the kind of serious analysis and discussion we badly need in order to achieve effective reforms.  It will be well worth investing the time to read The Bankers New Clothes.

It is a splendid application of complexity science to the field of financial regulation.  It is a succinct analysis of why “more begets more,” why big finance is leading us into a mess and big regulation into an even bigger one, and why simpler approaches would be more effective.  Mr Haldane’s speech demonstrates in a nutshell why our efforts to reform financial regulation, be it Dodd-Frank, Basel III or Vickers, have become a convoluted mess.

Suffice it to quote his conclusion:

Haldane’s speech is essential reading.  He says it better than anyone else so far.

Prominent figures and firms have avoided prosecution and, at most, settled cases with relatively light penalties and without acknowledgement of guilt.  It seems as though the Justice Department has given up on further investigations, notwithstanding even a direct, in depth criminal referral from the Senate’s Permanent Subcommittee on Investigations—a referral developed after extensive investigations, hearings and analysis and detailed in a massive, joint majority and minority report published in April 2011 (Wall Street and the Financial Crisis: Anatomy of a Financial Collapse).

Executives were imprisoned two decades ago.  Few, if any, have been now, even though the laws are in fact stricter.  It therefore seems strange that so few prosecutions have been launched.  One explanation could be that we are really only dealing with the sometimes distasteful ethical standards in modern “financial capitalism,” concerns about which are widely shared.  Another might be that we are indeed avoiding the prosecution of real criminality.

Many do believe that we are dealing with actual criminality.  Some commentators are concerned, even enraged by the fact that no one has gone to jail for “causing” the Financial Crisis.  The Attorney General is accused of having no spine.  It is asserted that executives are protected simply because they either happen to be supposedly privileged white collar criminals or they give so much money to political campaigns that they are actually protected.  Serious and hard working committees have concluded that criminality seems to have occurred.

On the other hand, others believe that the activities in question are not really crimes at all, that there is a public rush to criminalize perfectly legitimate albeit irresponsible activity, and that it is silly to blame the Crisis itself on the specific activities that have been singled out as “crimes.”

One thing seems clear:  the situation is very different from that of twenty years ago.  In my view, three big factors have been at work.

• Political “normalization” of financial abuse

First, financial abuses have become “normalized” through the political process.  Activities that would not have been tolerated two decades ago have attained a degree of “respectability” because their advocates have mastered the ways of Washington, developed theories to justify their actions, and promoted a reverence for economic growth at all costs.  Activism on the part of the various components of the financial sector, among others, has succeeded in changing profoundly  the terms of the debate:  regulation of any kind has become suspect and advocates of measures to restrain financial activities in any way have been placed on the defensive.

When I first joined a (fairly large) bank in 1995, its lobbying activities were crude, to put it mildly.  We had a couple of people schmoozing in Washington and the three state capitals where our main subsidiaries were based.  Industry associations were active but nowhere near as aggressive as they are now.  Some of the “sophisticated” banks (JP Morgan, Citi, Banker Trust, Nationsbank) operated a little more aggressively, using large DC law firms to handle technical matters in Washington.  Yet the overall picture was rather bucolic and rather loosely organized as compared to the lobbying of today, and the big finance industry was much more fragmented.  Banks enjoyed their “special” status and, in turn, accepted that they had to operate within certain safety constraints.

How this has all changed.  Banks, insurance companies and securities firms learned the importance of lobbying and became vastly more sophisticated at it.  Now the financial industry spends well over a million dollars per day trying to shape the outcome of legislation and what it looks like when the rubber hits the road as regulatory agencies translate that legislation into real action.  The ideology of unbridled competition, even as they continue to enjoy massive subsidies and government protection, has become the mantra for most financial companies.

But the change goes much deeper.  In his new book entitled The Payoff:  Why Wall Street Always Wins, Jeff Connaughton describes the near-futility of trying to get the White House, Treasury Department and Justice Department to take financial criminality seriously.  Connaughton was chief of staff for Senator Ted Kaufman, a tireless campaigner for holding the financial industry accountable in the aftermath of the Crisis.  With surprising personal honesty, and having himself been one of the “Permanent Class” in Washington, he describes his growing awareness of the level of cronyism that has evolved in Washington between politicians, politically appointed agency executives, and the financial industry.  As Connaughton pungently puts it, “Money is the basis of almost all relationships in DC.”

In this sordid tale, Connaughton’s views run entirely consistent with those of another disillusioned former campaigner for financial integrity, former special inspector general for the Troubled Asset Relief Program (TARP) Neil Barofsky, author of the recent book Bailout:  An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street.  Such sense of disillusionment seems equally to seep from the reflections of Anton Valukas, the investigator into the Lehman failure who, among other things, exposed Lehman’s fraudulent use of Repo 105s to conceal its financial condition.

The result of this financialization of public policy is that the relentless defense of industry practice, coupled with the far reaching financial influence of the industry on the overall political process, has produced a situation in which formerly unacceptable activities can be defended with a straight face and expressions of public outrage can be dismissed as a reflection of the general naiveté of the public about the ways of finance.  Timid journalists compound this situation by failing to ask simple questions about complicated financial devices out of a fear that they will appear unsophisticated themselves.  And, as Katya Grishakova has aptly put it, there seems to be an “enchantment” on the part of even our highest officials as they have become seduced by the siren song of Wall Street.

• Complex modern finance

Second, the scale and complexity of modern finance has made it extremely difficult to pinpoint criminal liability in ways that make successful prosecutions likely.

Perhaps “banksters” don’t go to prison anymore because this new environment has rendered prosecutors pusillanimous and legislators and regulators corrupt.  I am not sure this is the case.  Even if financial crimes were prosecuted more vigorously, we might not see many convictions because there is another major obstacle:  the nature of the modern financial enterprise.  The scale and complexity of modern financial operations is vastly different than it was in 1990.

Many of today’s financial companies have become massive and their services highly complex. This has in turn diluted the responsibility and therefore the accountability of individual executives and dispersed the overall actions across the enterprise as a whole. In the S&L Scandal, the financial institutions involved were tiny: Lincoln Savings and Loan, which was the principal financial company within the infamous Charles Keating’s American Continental Corp., had no more than $6 billion in assets. Every executive in a company of that size, including the CEO, knows–or at least should and easily could know—exactly what the other executives are doing.

Now we are talking about trillion dollar, diversified organizations. When a bank gets larger than about $100 billion and starts to combine all kinds of financial instruments and services, the assumption that executives in the company know what is going on starts becoming a fantasy.  Roles become highly specialized and the combination of services becomes increasingly synthetic.  In such situations individuals cease to be fully responsible for the final product.  Think of workers in an auto production line who never see the final vehicles they make until they reach the showroom.

This makes it extremely hard to put together a case against individual executives that would meet the high standards of criminal liability, even if the overall actions of the corporation itself resulted in a crime.  If prosecutions are brought it is likely that well-funded lawyers will defend well-heeled clients.  The definitions of the crimes themselves will be tested against demanding constitutional standards, and the actual knowledge of all the elements of criminal activity will be very hard to prove against specific individuals.  So, as Jeff Connaughton has described in his book, when the Justice Department itself chooses not to treat financial crimes as a priority it is no surprise that prosecutors tend to shy away from committing massive resources only to hope that they might get lucky with a jury, and then only to face a realistic prospect of being overturned on appeal.

• Perceived social benefit

Third, while even this dispersion of responsibility need not be an absolute bar to criminal liability, we have not as a society clarified what should be the acceptable limits of risk-taking.

Bill Black, perhaps the person most responsible for sending S&L executives to prison in the late 1980s, developed a theory of “control fraud” in which he attempts to show that the standards of criminal liability for high-level executives, particularly CEOs, should take into account the fact that they are able to control the overall actions of various actors within the organization.  The control fraud doctrine has not, to my knowledge, gained much traction in the courts as an independent basis for prosecuting financial executives.

Nevertheless, we could more directly address the problem with legislation in ways that are not even very novel.  For many decades, even centuries, we have solved the problem of fragmented culpability by making it a crime to be part of an organization that commits crimes, and we measure criminal intention by much broader concepts than the precise intention to commit the underlying crime itself.

The most famous example of such a “crimes of crimes” is perhaps the Racketeer Influenced and Corrupt Organizations Act (RICO), enacted to help prosecutors break up the Mob and other criminal enterprises. We could take a few instances of actual bank criminality committed by a specific bank–and recent scandals have shown that there are enough to go around–and then make it a crime for the executives to be organizing with the knowledge that such underlying or “predicate” crimes will inevitably be committed somewhere within the organization. We could even go further to define culpability in strict liability terms, not requiring a specific intention or expectation that a criminal outcome will be committed.

But we have not taken this action because to do so would force us to confront our cultural and social values.  This effort becomes really uncomfortable.

Whereas we believe that it is a rather criminal thing to shoot people or sell them drugs and that no earthly good could ultimately come of this activity, we don’t really think it is criminal to take risk, even great risk, in order to make profit. We might believe that financial risk taking should be restricted if it threatens to cause harm to others. We might believe that we should even stop participants where they repeatedly make high-risk mistakes without concern for the consequences. But we don’t think organizing to take risk in an inherently risky marketplace is criminal. We know that all kinds of motivations lead to risky behavior, particularly during the widespread exuberance or madness of crowds that creates bubbles and leads to crises. We find the excesses of some quite distasteful and we want them to pay back their recklessly gotten gains. Sometimes we remove them from their positions. We usually object to bailing them out even if they convince us that we must do in order to save ourselves from their wreckage.

But as a society that understands the risk-reward correlation and bases our entire prosperity on this correlation, we just don’t really think it is actually criminal for the individual participants to undertake these risks– even when the outcome itself becomes a crime.  However dubious our belief might be—and it surely is in part a self-delusion—we just think too much good comes of the overall activity to get serious about curbing it.

Putting a few executives in jail would not only satisfy our lust for vengeance; it would very likely change behavior on Wall Street. Nevertheless we worry that the chilling effect of doing so might be excessive, that we would be turning into criminals the individuals who might be like the rest of us in different circumstances.

This is perhaps another, more basic reason why I don’t think we will see serious effort being devoted to the detailed investigation and forceful prosecution necessary to make examples of some  financial executives.

Todays financial institutions are totally dependent on their technology systems, and if rigorous, darn well near perfect, discipline is not observed then  things can go wrong, sometimes horribly so and in unpredictable ways. And things often do go wrong.

Now we have Knight Capital, a key element of the trading infrastructure, creating havoc on the stock exchange–not for the first time either–as a result, predictably, of yet another premature installation of a new software system.  The company suffered a $440 million loss on Wednesday.  Even more importantly, it has caused chaos on the stock markets.

So here’s the point:  such “unexpected” events are not “Black Swans” (the usual financier’s excuse for avoiding responsibility).  They are inherent in the complexity of modern finance.  And they can become catastrophic, as RBS will now surely attest.

I don’t care what a CIO or even a CEO might say:  if they claim that they can eliminate the real risk of such missteps, they just don’t know what they are talking about no matter how good they are.  And if such missteps are inevitable, then we simply cannot avoid the question whether the dangers posed by large, complex financial institutions and systems could outweigh their benefits.

This question demands careful, detailed and informed answers and credible risk management and recovery strategies.  The issue cannot be dismissed by the predictable  huffing and puffing of the captains of the financial industry.

Libor, the London Interbank Offered Rate, is updated daily at 11 a.m. in London  (6 a.m. e.t ). It is actually a schedule of rates, calculated based upon the average interest rates banks report that they are charged to borrow from each other. The schedule includes rates for 10 different currencies and 15 different maturities (from overnight to 12 months), thus 150 total. Though an unfamiliar concept to most American consumers, Libor is quite significant, as it is a worldwide benchmark for about $10 trillion in loans, including many mortgages, student loans, car loans and credit cards, and more than $350 trillion in derivatives.

How does this affect American consumers? For example, according to the Cleveland Fed, more than 50 percent of prime adjustable rate mortgages and nearly all subprime mortgages  in the US in 2008 were tied to Libor. Though Barclays (and presumably others) were underreporting at one time, to appear more healthy, there is also a belief  that the rates were kept artificially too high at other times.

As early as December of 2007, the Federal Reserve Bank of New York learned that some banks might be falsely reporting what it cost them to borrow, thus manipulating Libor. According to phone call transcripts, a Barclay’s employee told  a New York Fed official in April of 2008:

We know that we’re not posting um, an honest LIBOR. And yet and yet we are doing it, because, um, if we didn’t do it it draws, um, unwanted attention on ourselves.

In response, Geithner wrote a memo to Mervyn King, the Governor of the Bank of England in June. In the memo he made suggestions for improving the Libor process. Those ideas were never adopted, and the rigging continued through at least 2009. The HuffingtonPost reported today that Geithner’s suggestions were not his own or even from his staff, but instead were formulated by the banks themselves.

What was Geithner thinking? As President of the New York Fed wasn’t there more he could have and should have done upon learning about the fraud? We  can be troubled by his inadequate response, but we should not be surprised. Remember, during his confirmation hearings to become Secretary of the Treasury, Geithner insisted, “I’ve never been a regulator.”  This was a jarring comment given that the job of the New York Fed includes supervision and regulation. Just take a look at the “what we do” page of the website which states:

In addition to responsibilities the New York Fed shares in common with the other Reserve Banks, the New York Fed has several unique responsibilities, including conducting open market operations, intervening in foreign exchange markets, and storing monetary gold for foreign central banks, governments and international agencies. Foremost among its functions is the implementation of monetary policy, one of the three missions of the New York Fed. The other two are supervision and regulation, and international operations. (bold type in the original).

So, to understand Geithner, if he was not a regulator, then was he admitting that he deliberately neglected one of the three missions?

Barclays recently paid a total of $453 million in civil settlements with the Justice Department, the CFTC and the British Financial Services Authority. Though there have been no criminal charges to date, reportedly, the criminal division of the Justice Department “is building cases against several financial institutions and their employees.” There are many more banks under investigation, including Bank of America, Citibank and JP Morgan Chase. This trio comprises the three US banks on the panel that submit interest rate information for inclusion in the Libor.

All eyes should now be on Attorney General Eric Holder. Even if Geithner forgot he was a regulator, perhaps Holder will remember that he is a prosecutor. Just to be sure, you can review the mission of the criminal division of Justice, as posted on the website:

The mission of the Criminal Division is to serve the public interest through the enforcement of criminal statutes in a vigorous, fair, and effective manner; and to exercise general supervision over the enforcement of all federal criminal laws, with the exception of those statutes specifically assigned to the Antitrust, Civil Rights, Environment and Natural Resources, or Tax Divisions.

Prosecuting Libor-rate-rigging seems to fit that mission.  Journalist James Stewart in the New York Times on Friday deemed the LIBOR fiasco a “textbook case of white collar financial crime — including a conspiracy that was flourishing at the height of the financial crisis.”  Hopefully, Holder will make an effort to bring criminal charges against the top personnel and firms who participated in this as well as other crimes associated with the financial meltdown of 2008 and beyond.

It would be a fine time to do so. As noted here, more than a year ago, “after the Savings and Loan Crisis of late 1980s, more than 1,000 bank officials were prosecuted and around 800 went to jail,” whereas so far not a single high-profile participant in the 2008 financial crisis has been prosecuted. The continued failure of this Administration to enforce the law vigorously, fairly and effectively is a great disappointment. Maybe that will change.  And while change is in the air, it’s time for Mr. Geithner to write another memo, this one to the President, tendering his resignation.

Ulster Bank is controlled by the Royal Bank of Scotland (RBS). As readers will recall, RBS had to be nationalized by the British Government during the Financial Crisis. The British Government still holds an 84% stake. RBS is the seventh largest banking conglomerate in the world (over $2 trillion in assets)–larger than Bank of America and JP Morgan Chase. In an indication of its weakened state, it is only 48th largest in the world by market capitalization ($25 billion). Yet RBS remains as large as the entire economy of the United Kingdom.

Presumably, Ulster Bank’s processing center is in Edinburgh as part of the “efficiencies” available to the RBS conglomerate by reason of its scale.

Apparently an outside contractor (no doubt another “efficiency” in operations) attempted to fix a slow running systems scheduler with a patch. This in turn caused the system to run two separate days’ processes in parallel, thereby crashing the system. Now there are frantic attempts to find out what happened: inadequate testing, improper or nonexistent contingency planning, reckless outsourcing, incompetent customer communication, and so on. All issues familiar to those of us familiar with the engine rooms of large financial institutions. Under political pressure, the CEO of Ulster Bank has agreed not to take his annual bonus for 2012 (the CEO of RBS, Stephen Hester, had earlier and rather more promptly also agreed not to take his bonus). It is not yet known whether anyone will be fired. Chris Sullivan, head of UK corporate banking at RBS, somewhat hopefully declares that the whole world will learn from this “unprecedented” disaster. Yeah right!

The important lesson from this episode is not that large banks should ensure that nothing goes wrong. It undoubtedly will. Instead, the lesson is that these kinds of catastrophes can and often do take place. They are not always as visible as the one with which Ulster Bank and RBS are contending. But they happen with varying degrees of severity all the time, whether in the form of customer data breaches, online banking outages, or risk modeling updates. This is but part of the human condition.

By creating the impression that such “glitches” can be fixed and avoided in the future we are lulled into a false sense of security. Even the “too big to manage” rhetoric can be misleading because it suggests that smaller scale operations can indeed be managed flawlessly. While it is true that ultra large companies emerging from merger and acquisition sprees are likely to intensify the odds of things going wrong, the finest and most disciplined companies of any size can and do run into unexpected difficulties. As the Comptroller of the Currency has just pointed out in its Semiannual Risk Perspective, current economic conditions are actually intensifying operational risks:

Increased operational risk is a key concern as banks try to economize on systems and processes to enhance income and operating economies. This risk may be amplified by the use of third-party products or distribution systems.

On this occasion it looks as though RBS has contained the situation. Any similar operational failure could, however, also trigger counterpart defaults, which can evolve quickly into a cascading problem as a contagious problem spreads through the financial network.

The problem is not whether we have eliminated the chance of things going wrong–an enduring political fantasy–but whether we can manage the damage once it is triggered.

And this, to my mind, is one of the most powerful reasons why we must be extremely concerned about the continued existence and growth of ultra large financial institutions.

Mr. Diamond and Mr. Dimon have long been strident and enormously influential critics of the efforts to reform financial regulation, both in the US and UK. So with JP Morgan currently embroiled in its London Whale trading debacle and a major investigation into alleged manipulation of power markets in the US, and with Bob Diamond’s sudden and dramatic resignation as CEO of Barclays (along with the resignation of Barclays’ Chairman, Marcus Agius) in the midst of Liborgate, the opponents of large universal banks might be forgiven for invoking the caution in Proverbs 16:18, that pride comes before a fall. The attention has moved from Citibank, Bank of America and UBS to two of the best of the best: Barclays, which survived the Financial Crisis without being nationalized (like Royal Bank of Scotland and LLoyds) and brilliantly acquired the pieces of Lehman after that firm’s collapse, and JP Morgan Chase, which until recently had maintained a stellar record despite the Crisis setback.

Beyond mere schadenfreude, the travails of Barclays and JP Morgan Chase have emboldened those who believe that such behemoths are simply too big to manage and, because they are also too big to fail, should be broken up. A persistent problem with this attack, however, continues to be the fact that the large universal banks are united in their opposition to such a move, and their enormous political power, not to mention their codependent relationship with governments, makes such breakups highly unlikely without another crisis.

Nevertheless, current events might be symptomatic of larger forces at work.

Could it be that the banking conglomerates have grown so large that they are no longer sustainable in the financial ecosystem? Like other unsustainable species could they be showing early signs of a gigantic, slow die off?

A healthy market sustains itself through creative destruction. So far the TBTF banks have been protected from the genuine threat of bankruptcy by government and political support, justified by the fact that they can pull everything else down with them.

But if CEOs are no longer able to control corporate actions and performance, the situation might be approaching in which not only regulators but the market itself will find it more efficient to break their conglomerates up into more efficient and profitable entities. Credit downgrades lead commentators to wonder whether we have reached the end of the era of global banking. The production by the big conglomerates of detailed resolution plans (“living wills”) that identify potentially free-standing components capable of operating on their own might also translate into roadmaps for break-up artists, possibly acting in collusion with concerned regulators. The investor community is already starting to mumble.

More London Whales and Liborgates might well have the effect of turning the murmuring into something more like market discipline.

A number of commitments in the spring, not least the production of articles and presentations and a good deal of teaching, supervision and foreign travel, crowded out much of my free time. More important, however, I have also been spending a good deal of time reading, listening, learning and reflecting on the state and many challenges of financial regulatory reform.

Its many good elements notwithstanding, the debate around Dodd-Frank has become atrophied. Battle lines have been drawn between two untenable approaches to the incredibly complex challenges of large scale finance regulation. On the one hand, attempts to defeat the new structures and processes initiated by Dodd-Frank in 2010 have amounted to unconstructive, knee-jerk defenses of industry by politicians who benefit from massive financial support by the industries they protect. On the other, some–though by no means all–of the Byzantine regimes being created by regulators as they try to implement the Act feel more like efforts to erect CYA shields using weapons designed for fighting old wars and ones that will be ineffective in dealing with current reality. So much of the public debate around financial reform has lately become stultifying and the Presidential election guarantees that this won’t change soon.

At the same time, we are still learning about the causes of, or at least the conditions for, financial instability. We are still seeing the predictable dysfunctions created by excessively sized financial institutions, unrealistic public policies–in the United States, Europe and elsewhere–and soundbite policies. The challenges posed by the global financial system that is our reality will require much more imaginative thinking in order to create a system that is effective and resilient over time.

In future posts I will try to focus on new ideas generated by research, interdisciplinary sciences and thoughtful commentary. My posts will generally be shorter than they have been in the past and, I hope, more thought provoking. I will also provide brief summaries of my own research. If I can find a suitable new template, I might even change the theme and layout for this blog.

As always, I will welcome comments and controversy, provided it is not the tired old vituperations we see repeated still all over the media.

In an analysis of the Financial Crisis Inquiry Commission Report, I challenged the blame-Fannie-and-Freddie for the crisis myth, here. As I wrote early in 2011:

Myth 4: The big government-sponsored companies (GSEs), Fannie Mae and Freddie Mac caused the Financial Crisis because the government pushed them to guarantee mortgage loans to poor homeowners as part of their public housing mission. Variations on this are that public housing mission drove bad underwriting by lenders who had to create risky mortgages to fulfill the demand of the GSEs who needed to buy them, as they were desperate to meet housing goals.

Reality 4:  Not exactly. Both the Report and the primary dissenting statement agree that on their own Fannie and Freddie did not cause the financial crisis. They focus blame largely on the so-called “private label” mortgage market. These are bank and non-bank,  brokers, lenders, and securitizers.  Fannie and Freddie did not originate loans; the “exotic” and dangerous loans were designed by and extended to borrowers through the private label channel. While the Report and the Thomas Dissent support the notion that Fannie and Freddie’s business model was flawed, they also agree that affordable housing goals did not either drive Fannie and Freddie to ruin or cause them create the overwhelming demand for predatory, high-risk, mortgages.

So, why is it that the distortions repeated by folks like Peter Wallison have traction with the public?

This phenomenon reminds me of an early scene in F. Scott Fitzgerald’s The Great Gatsby. At the start of the novel, upon reacquainting with her cousin Nick Carraway, Daisy Buchanan inquires whether the rumors of his engagement to a woman out West are true. Even Daisy’s husband Tom chimes in. Nick quickly denies any designs to be wed. However, Daisy brushes off his response and insists that she knows better: “We heard it from three people, so it must be true.”

The statement is funny on its face because Nick is the primary source. Surely, Daisy should recognize that he is more capable, than three gossips, of knowing whether he is or was engaged to be married.  Yet, what is also amusing is that beneath the surface, there is a kind of familiar truth to Daisy’s rejoinder. It resonates, echoing various biases to which many of us succumb. Through exposure to repetition, particularly by a seeming variety of sources, we accept a certain version of reality. Even when faced with credible contradictory evidence, we have a hard time shaking free of the various “truths” we have collected.

So what does this have to do with the financial crisis? The story of the crisis deals with very real people offering fictions, steeped in ideology.  Yet, there is a connection. There is much the falsehoods about the financial crisis, fed on ideology, politics and economic-self-interest have in common with Daisy’s triple-sourced “truth.”  The myths about the causes and responses to financial crisis are repeated by many people. Yet, notwithstanding clear evidence refuting them, even from a number of sources with better information, many of us continue to hold on to them.