I think that folks are missing the implications of the JPMorgan Chase (JPMC) London losses, including FDIC board member Thomas Hoenig in this Monday’s Wall Street Journal. The JPMC situation illustrates the problems that derive from the shift in “banking” from a limited form of credit intermediation, namely, commercial banking, into the general form of credit intermediation, including methods that used to be the province of investment banks. Meaning: Banks now provide credit by holding market-traded instruments that are marked to market (unlike commercial loans), and thus want (need?) to hedge exposure to minimize earnings volatility and solvency threats. This is what “London” was mostly about for JPMC.

What counts as “banking” (credit intermediation) these days can take many forms: banks can extend credit by originating and holding, by originating and distributing (bond issuances and structured finance), and by purchasing and holding debt securities originated by others. What are the implications? First, this understanding illustrates the conceptual gap in the Volcker Rule. The Rule, in its focus on market making and hedging, imagines that the bank is taking a long position for customer accommodation and needs to hedge it. That’s what a broker-dealer does, but it’s not what a bank does. A bank takes a long credit position for its own account, which it wants to (partly) hedge. Banks are always adjusting their credit position in light of their views about credit risk, in deciding who to extend credit to and their mix of assets. We want banks to do this to assure their solvency. The Volcker Rule’s focus on proprietary trading simply misses this underlying reality: extending credit and holding credit risk is a proprietary business and it’s hard to limit hedging such activity in a mechanical way. Because the hedged position is the bank’s, this hedging activity will be, at its core, “proprietary.”

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