JP Morgan Chase's $2 Billion Trading Loss

This editorial uses the JP Morgan loss to argue that banks are still subject to risk from the unregulated derivatives market.  It shows that even the best banks are unable to control risky betting on derivatives.  Therefore, Congress should enact the Dodd-Frank bill that the banks have successfully lobbied against.  The point is well made, but I would like to turn it into an argument about incentives.

Most people will not understand the nature of the trade that produced the $2 billion loss.  It is easier to understand why the banks are making these kinds of trades, and why politicians are anxious to let them continue. In the first place, the trade that produced the $2 billion loss could have gone the other way.  It would have earned a huge bonus for the trader in London.  It would also have boosted the bank's profits and increased the bonuses for senior executives.  The downside risk for those involved is small relative to the potential gain.  The bank's CEO fell on his sword, but it will be quickly forgotten by the public, and also by the bank's directors when it is time to dole out executive bonus's.  What would most CEO's do under this kind of risk-reward system?

It is also easy to see why Wall Street banks continue to be the largest source of campaign contributions to politicians.  The banks would lose a major source of profits if derivatives were regulated.  They get large return on their contributions relative to the potential profits on derivative trading.  Politicians take few risks when they respond to the contributions that they receive.  They are eager to please the bankers.  Mitt Romney, for example, has campaigned on a promise not to regulate derivatives.  Unfortunately, many Democrats are willing to reward bankers for campaign contributions. They are subject to same incentive system that motivates the GOP to champion the deregulation of almost everything.  While the GOP is eager to deregulate business, it is also eager to regulate personal behavior in ways that please their base which pays attention things, like "family values" that it can understand.