What Should Be Done About JPMorganChase?

http://www.forbes.com/sites/stevedenning/2012/05/17/what-should-be-done-about-jpmorganchase/

What Should Be Done About JPMorganChase?

5/17/2012

Steve Denning

Among the many responses to my article yesterday, JPMorganChase [JPM]: Ten Defenses Against The Indefensible, were some requests to be more specific about what should be done.? ?CloseReader? for instance wrote ?Steve Denning makes ten powerful arguments that take dead aim and then doesn?t pull the trigger.?The news that a JPMorgan official has told The New York Times that losses from the trades, which were initially estimated to be $2 billion, have already ballooned to at least $3 billion adds urgency to the issue. (Last week, CEO Dimon indicated that the losses could double within the next few quarters. But that process has been compressed into four trading days as hedge funds and other investors take advantage of JPMorgan?s distress.)

So let me be even more explicit about the necessary agenda that must be followed in dealing with financial institutions like JPMorgan if the economy is to be put on a steady and sustainable growth path.

1.????? A Volcker Rule that bans portfolio hedging

The Glass-Steagall Act served us well for half a century. Steady economic growth and no financial crises. While it is tempting to say: ?Let?s go back to Glass-Steagall and separate commercial from investment banking!? the problem with that is that the world has gotten more complicated. The banking business has changed. Things like derivatives didn?t exist back in the time of Glass-Steagall.

In effect, the modern equivalent of the Glass-Steagall Act is the Volcker Rule, which is still being drafted. Banks like JPMorgan have lobbied hard to have the Volcker rule allow this type of portfolio ?hedging?. That contrasts with any normal definition of hedging, which matches an individual security or trading position with an inversely related investment ? so when one goes up, the other goes down.

According to The New York Times, there has been a debate going on within the Administration, with Treasury and the Federal reserve siding with the banking lobby and allowing ?portfolio hedging? (aka gambling) and the the Securities and Exchange Commission and the Commodity Futures Trading Commission opposing it.

Although opinions differ, I believe that Senator Levin had it right when he said: ?Portfolio hedging is a license to do pretty much anything. There is no statutory basis to support the proposed portfolio hedging language, nor is there anything in the legislative history to suggest that it should be allowed.?

If the Volcker Rule allows portfolio hedging, it will hardly be worth even issuing. It is time for officials at the Treasury and the Federal Reserve to rediscover their vertebral columns and issue a Volcker Rule with teeth.

2.????? Viable living wills for banks that are ?too big to fail?

The Dodd-Frank Law put in place a provision for banks that pose a systemic risk to the economy, because of their size, to operate with ?living wills? that provide a viable plan for dealing with them in the event that they become insolvent.

The schedule for submitting living wills is staggered based on the size of the bank. Bank holding companies with more than $250 billion in nonbank assets will have to file initial plans by July 1, 2012. Firms with between $100 billion and $250 billion in nonbank assets will have until July 1, 2013, to file plans. All other companies covered by the rule will have until Dec. 31, 2013.

Some experts have questioned whether the living wills will actually be implementable in a crisis. We won?t know for sure until we see what the living wills look like. JPMorgan?s plan is due July 1, 2012. When it becomes available, public and expert scrutiny should be focused on assessing its viability. If the conclusion is that the living will is unimplementable and the flaws cannot be remedied, then further action will be needed, including breaking up the relevant banks and removal of the implicit incentives that were accorded to big banks during the 2008 crisis.

3.????? Resolving ?too complex to manage?

Given the widespread hand-wringing over banks that are?too big to fail?, it is well to remember that the last two major financial crises were caused, not by banks that were ?too big to fail?, but rather by smaller outfits that were involved in complex transactions in which the large banks were entangled: i.e. Long Term Capital Management in 1998 and Lehman Brothers in 2008.

Derivatives, which Warren Buffett has called ?instruments of mass destruction?, need special attention. The particular problem in 2008 was that none of the financial institutions knew who was holding the other side of these exotic securities, and so the markets froze. The root cause was lack of transparency, which should be addressed by, you guessed it, transparency. Trading in such instruments should be carried in the light of day in public exchanges so that everyone can see what is going on and regulators can step in if things are getting out of hand.

4.????? Tobin taxes on high-frequency trading

Buying and selling shares for periods as short as a fraction of a second need to be discouraged. As Charlie Munger, Vice Chairman of the Berkshire Hathaway Corporation [BRK A, BRK B], said on CNBC?s Squawkbox recently:

?Take the rapid trading by the computer geniuses with their algorithms: those people have all the social utility of a bunch of rats admitted to a granary. I never would have allowed the rats to get in the granary. I don?t want the brilliant young men of America dawdling away their lives in someone else?s granary. ..What good is it doing civilization to have people ?clipping? money through computer algorithms that work a lot like legalized front-running of orders? I wouldn?t allow people to make money out of short term trading. I might have Tobin taxes. If we changed the incentives, a lot of this regrettable behavior would go away.?

5.????? Removal of tax breaks for hedge funds

It?s bad enough to think of a windfall of some $4 billion flowing from JPMorgan to a bunch of hedge funds for taking advantage of JPMorgan?s bad gambles, with no benefit to the economy. It adds insult to injury to realize that these ?earnings? are taxed at the lower capital gains rate.

Allowing the managers of hedge funds to treat their earned income as long-term capital gains makes no sense and creates a serious economic distortion. The earned income of hedge funds should be taxed at the same rate as everyone else?s earned income.

6.????? Abandonment of shareholder value as the goal

?In future,? Dimon says, ?We?re going to manage [the bank] to maximize the economic value for shareholders.?

Unfortunately this pervasive, and seemingly plausible, idea that a firm like JPMorgan should be focused on maximizing shareholder value is misguided. It ignores Peter Drucker?s foundational insight of 1973 that the only valid purpose of a firm is to create a customer. Paradoxically, focusing on maximizing shareholder value ends up making less money for shareholders, because it leads firms to do things, like the recent JPMorgan gambles that actually destroy shareholder value.

Even the heroic exemplar of maximizing shareholder, Jack Welch at GE from 1981 to 2001, has come to be one of its strongest critics. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, ?On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy? your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. ? Short-term profits should be allied with an increase in the long-term value of a company.?

?We must shift the focus of companies back to the customer and away from shareholder value,? writes Roger Martin, Dean of the Rotman School of Management at the University of Toronto, in his important new book, Fixing the Game, ?The shift necessitates a fundamental change in our prevailing theory of the firm? The current theory holds that the singular goal of the corporation should be shareholder value maximization. Instead, companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders.?

If you take care of customers, writes Martin, shareholders will be drawn along for a very nice ride. The opposite is simply not true: if you try to take care of shareholders, customers don?t benefit and, ironically, shareholders don?t get very far either. In the real market, there is opportunity to build for the long run rather than to exploit short-term opportunities, so the real market has a chance to produce sustainability. The real market produces meaning and motivation for organizations. The organization can create bonds with customers, imagine great plans, and bring them to fruition.

7.????? A radical shift in management

The shift from making money to delivering value and delighting customers requires fundamental changes in management. The command-and-control management of hierarchical bureaucracy is inherently unable to delight anyone?it was never intended to. To delight customers, a radically different kind of management needs to be in place, with a different role for the managers, a different way of coordinating work, a different set of values and a different way of communicating. This is not rocket science. It?s called radical management.

The shift from maximizing shareholder value to delighting the customer involves a major power shift within the organization. Instead of the company being dominated by traders and salesmen who can pump up the numbers and the accountants who can come up with cuts needed to make the quarterly targets, those who add genuine value to the customer have to re-occupy their rightful place.

The shift from maximizing shareholder value to delighting the customer doesn?t involve sacrifices for the shareholders, the organizations or the economy. That?s because delighting the customer is not just profitable: it?s hugely profitable.

8.????? Shareholder activism on C-Suite compensation

Underlying all the other problems is of course the issue of C-suite compensation, which is driving much of the asocial behavior. Professor Mihir Desai, the Mizuho Financial Group Professor of Finance at Harvard Business School wrote in the March 2012 issue of Harvard Business Review that the C-Suite is so grossly overcompensated that US competitiveness is being systematically undermined.

Shareholders need to realize what?s driving behavior here is neither value for customers nor value for shareholders, but bonuses for the executives and traders.

Fortunately, as the Wall Street Journal reports, shareholders are beginning to wake up as to what is really going on. As noted in yesterday?s article, in the last two months shareholders have shown signs of revolt at Citigroup?s [C], AstraZeneca, Barclay?s [BCS], Credit Suisse [CS] Aviva?s [AV] Trinity Mirror and two shareholder lawsuits have even filed a lawsuit against JPMorgan and its top executives.

As Desai?s article makes clear, despite the constraints to change, the overcompensation of the C-suite and the financial sector is not sustainable. It causes serious mis-allocation of capital and talent, repeated governance crises, rising income inequality and an overall decline of the US economy. It obviously cannot continue, if only because, as Margaret Thatcher once said, ?sooner or later you run out of other people?s money.?

demarcus cousins savannah brinson mount rainier ohio state football capital one bowl winter classic 2012 georgia bulldogs football