It’s never polite to say I told you so, but JPMorgan Chase & Co.’s $2 billion trading loss has proponents of a tougher proprietary trading ban saying . . . well, you know what.

JPMorgan’s admission is a shocker. The bank said the losses resulted from errors, sloppiness and bad judgment, which top bank executives didn’t know about or understand until it was too late. On Wall Street and around the globe, JPMorgan was a standard-setter for risk management. If regulators can’t trust JPMorgan to get it right, whom can they trust?

The Volcker rule, part of the Dodd-Frank financial reform law, was inspired by former Federal Reserve Chairman Paul Volcker. It’s supposed to stop federally insured banks from making speculative bets for their own profit ― leaving taxpayers to bail them out when things go wrong.

As we have said, banks have both explicit and implicit federal guarantees, so the market doesn’t impose the same discipline on them as, say, hedge funds. For this reason, the Volcker rule should be as airtight as possible.

The huge trading positions taken by the London branch of JPMorgan’s chief investment office certainly drive home the point. As first reported by Bloomberg News, the investment office, operating much like a hedge fund, built a position that may have totaled $100 billion in a credit-derivative index known as the CDX, which tracks the default risk of a basket of companies. Those are the positions that blew up. They could ultimately cost the bank much more than $2 billion now that the market knows they are being unwound.

Although their precise size and purpose aren’t known, the trades ― bets that companies in the index wouldn’t default on loans ― caused distortions in a $10 trillion market. For a while, the price of the index actually diverged from the price of default insurance on the individual companies underlying it. The skewed values adversely affected investors and others who relied on the instrument to hedge hundreds of billions of dollars of bond holdings.

The blowup is stirring debate among U.S. policy makers wrangling over the Volcker rule, complicating the job of JPMorgan Chief Executive Officer Jamie Dimon, who is leading the industry charge against the rule. Dimon at first sought to downplay all the fuss as a “complete tempest in a teapot.” It was Dimon who transformed the investment office in recent years to make bigger and riskier speculative trades with the bank’s money, Bloomberg reported. One sign that the unit may have been doing more than hedging could be seen in its daily trading risk ― it was about the same as JPMorgan’s entire investment bank, which includes Wall Street’s biggest stock-trading and bond- trading units.

In truth, the London trades fall into a gray zone in the Dodd-Frank law. The act gives regulators discretion to exempt “risk-mitigating hedging activities” for “individual or aggregated positions” from the proprietary trading ban. JPMorgan still argues that it was following the letter of the law because its trades were meant to hedge the bank’s overall portfolio risk. If the Federal Reserve and other bank regulators agree, and write a Volcker rule that allows such broad-based hedging to continue, they risk a systemic failure.

Bank executives have an incentive to mask proprietary trading as hedging or as market-making ― another activity the Volcker rule permits. After all, taking large speculative positions in derivatives markets is a tempting shortcut to profits and bonuses. Almost any trade by a large bank could be made to look like a hedge ― and regulators would be hard- pressed to prove otherwise. As JPMorgan has now shown, giant trading positions can backfire as easily as they can pay off.

We urge regulators not to view such portfolio-hedging trades as benign. The final Volcker rule, which could come as early as this summer but won’t be enforced for two more years, should require banks to put stricter boundaries around trading activity with a risk profile that includes estimates of losses under various worst-case scenarios. Regulators should approve these profiles and have the ability to monitor compliance.

Regulators also must not let banks continue to do prop trading under the guise of market making. One solution is to look at how long a trading desk has been holding its inventory of securities. The average for a big market-making operation should be a matter of days. And regulators could look at the percentage of trades a desk makes with clients, versus with other securities dealers. If most trades are with customers, the bank is probably doing true market making.

Overseas regulators are considering alternative approaches that could work just as well, so long as the end-goal is to limit proprietary trading. The U.K. allows banks to conduct prop trading as long as they split their banking and securities activities into independent, separately capitalized entities, an approach known as ring-fencing. The European Union is also considering requiring risk profiles as well as higher capital requirements for securities that aren’t easily sold.

Banks say these rules will impair their ability to act as market makers in service to clients, harm liquidity in bond markets, and impose costs that will reduce lending and slow the economy. What banks don’t mention is that depositors’ money will be safer, taxpayers won’t have to bail out big banks that suffer large trading losses, and financial crises and recessions may occur less often. That’s a lot of upside.

(Bloomberg)