When top managers at our largest financial firms claim to have been oblivious of dangerous financial practices carried out under their watch, the most serious implications for regulatory reform don’t actually follow from scenarios in which these managers are lying.  It’s a bigger deal, in terms of how far we need to go in changing the way we regulate the banking system, if they’re telling the truth.

Bad apples, after all, can be replaced.  But what if the ignorance is real; if managers really don’t know what’s going on in the units below them due to the sheer complexity of the financial institutions they’re running?  This might be thought of as a convenient excuse; a universal “get out of jail free” card.  But if true, it has more far-reaching, radical implications than most Bankers Behaving Badly scenarios, because it points to a problem that touches on the very structure of the financial system and its key institutions.

This, says Jan Kregel, is part of the the deeper lesson of JP Morgan Chase’s “London whale” fiasco.  In a new policy brief, Kregel reviews the recent Senate Permanent Subcommittee on Investigations report on JP Morgan Chase’s difficulties and draws out the lessons for financial reform:

The most probable explanation of the misinformation concerning the “London whale” affair is a massive failure of managerial direction and control that was not the result of deliberate deception, but rather the natural response of individuals who were being paid handsomely to take responsibility but simply did not know what was going on because the size and complexity of the organization made that impossible—again, evidence of an institution that was too big to manage effectively and, a fortiori, too big to regulate.

And as Kregel emphasizes, although it’s not size per se that is problem, but rather the complexity of the institution, there’s often an intimate connection between them:  “While complexity is clearly a bigger threat to financial stability than large size, it is usually, but not only, large size that induces complexity.”

Although a lot of the information in the Senate report is not new (and can be found, says Kregel, in JP Morgan Chase’s internal report), it does reveal some of the internal communications between management, the Chief Investment Office (CIO), and its Synthetic Credit Portfolio (SCP) unit where most of the trouble emerged.  According to Kregel, the report confirms that there was some misrepresentation on the part of management, but more importantly, it also reveals the degree to which management had little idea or understanding of what was going on at the SCP.

Kregel digs into the activities of the CIO and its SCP unit, and explains how and when things started to go wrong with what he calls its “macro-hedging” operations (“The activities mandated to the CIO,” Kregel writes, “may be seen as the private sector equivalent of regulators’ recent fascination with ‘macroprudential regulation’.”)  One criticism often levied against the London whale trades is that they were “disguised proprietary trading” of the type that should be prohibited under the proposed Volcker rule.  Kregel has a somewhat different take on this.  “Such hedging activities are by definition proprietary,” Kregel writes, “and the extent of hedging and basis risks will make it impossible to judge when such hedging is adequate to cover perceived risks or is excessive and thus concealed speculative trading.”  And, he continues, “[i]t should be clear that it is not the proprietary trading as such that caused the bank’s difficulties.  The problem is the failure to accept that such activity comes at a cost and therefore cannot be a profit center, nor can it be funded from either customer deposits or an internal shadow bank.”

If this is the case, then Dodd-Frank’s Volcker rule, even if it emerges from the rule-making process in a robust form (which is looking less and less likely), won’t be getting to the heart of the matter.  According to Kregel, the deeper problem is that we have a financial system that creates the necessity for “macro hedging” via derivatives in the first place.  The upshot of the London whale affair is not simply that we need a change in personnel, or even a more robust implementation of Dodd-Frank, but rather a repeal of the Financial Services Modernization Act (otherwise known as Gramm-Leach-Bliley).

Kregel also takes issue with the Senate report’s criticism of the CIO’s remuneration policy.  The problem, says Kregel, is not that the compensation was well above the average for normal traders, but that — for a unit engaged in hedging — the compensation was tied to profitability:

A hedging unit is expected to incur losses most of the time if the bank’s operating strategy and credit assessments are well run; it will only generate profits in periods of crisis. It was thus totally inappropriate to remunerate CIO operations on the basis of profitability.

Kregel’s policy brief can be downloaded here.