Too Big To Fail: 3 Lessons of the “London Whale” Debacle

March 21, 2013 by TIME Business & Money

The London Whale debacle, and the subsequent Senate investigation, gives us a window into the culture and operations of the biggest bank in America…

Of the many scandals that have plagued Wall Street of late, the “London Whale” trades, which cost banking giant JPMorgan Chase more than $6 billion, has captured the attention of the financial media more than any other. The biggest reason for journalists’ obsession with this story is that it tarnished the reputation of JPMorgan CEO Jamie Dimon, who is widely thought to be one of the most competent bank CEOs in the business, and one of the few who ably steered his bank through the subprime-mortgage crisis. And as far as the media is concerned, the bigger they come, the more people like to watch ’em fall.

But there is more to this story than the comeuppance of the biggest banker on the Street today. The London Whale debacle, and the subsequent Senate investigation, gives us a window into the culture and operations of the biggest bank in America as it adjusts to a postcrisis world in which Dodd-Frank is the law of the land. And the picture painted isn’t exactly comforting. The Senate’s report on the losses, coupled with Friday’s public hearing, describes a bank where complex derivatives and other methods were used to hide risk from bank regulators, investors and themselves, all in an effort to boost profits. Luckily, these trades didn’t come close to putting the bank at risk of insolvency. But that doesn’t mean a similar series of events couldn’t play out at a more poorly managed institution without the competence or scruples to contain the situation quickly. Could it be a $36 billion trading loss the next time around? Let’s hope not. With any luck, lawmakers and regulators will use this episode as an impetus for continued regulatory reform. Here are three lessons we should learn from the London Whale fiasco:

1. Derivatives Are Dangerous

Ironically, the $6 billion London Whale loss occurred in an area of the bank — the Chief Investment Office (CIO) — that was in charge of investing excess bank deposits in a low-risk manner. As part of this effort to manage the bank’s risk, the CIO bought synthetic derivatives (referred to as their synthetic-derivatives portfolio or SCP) designed to hedge against big downturns in the economy. These derivatives theoretically functioned much like an insurance contract, whereby JPMorgan was paid large sums in the event that a certain company or companies defaulted on their debt. If those same companies stayed current on their debt, JPMorgan was obliged to continue making regular premium payments.