One thing to understand about the Fail Whale debacle at JPMorgan Chase is that there were lots of warning signs. The trades were public knowledge for over a month; in fact, that’s part of the reason they failed so spectacularly, as hedge funds got wind of the trades and started taking the other side of the bet. Jamie Dimon simply ignored the red flags:

In the years leading up to JPMorgan Chase’s $2 billion trading loss, risk managers and some senior investment bankers raised concerns that the bank was making increasingly large investments involving complex trades that were hard to understand. But even as the size of the bets climbed steadily, these former employees say, their concerns about the dangers were ignored or dismissed.

An increased appetite for such trades had the approval of the upper echelons of the bank, including Jamie Dimon, the chief executive, current and former employees said.

Initially, this led to sharply higher investing profits, but they said it also contributed to the bank’s lowering its guard.

Apparently, regulators plan to scrutinize risk management at JPM and other banks. However, the investigation will be led by the Office of Comptroller of the Currency, which if past experience is any guide makes it approximately worthless. There’s a new leader at OCC, Thomas Curry, and in one of the first acts under his leadership, they let go Allonhill, the company that both created and was hired to audit foreclosure operations at Aurora Loan Services as part of the ongoing OCC foreclosure reviews. So that was a step in the right direction for OCC.

Still, I put little faith in the hands of the regulators at this point. The renewed focus on financial reform, and in particular principle-based rules that go beyond the Swiss cheese that has become prudential regulation, offers the best hope that the risks at JPM and other banks will not get borne by the everyday taxpayer. That’s the concern here. JPMorgan Chase has enough profits and reserves to cover this bet. But what if another bank engaged in the same practices didn’t? What if they didn’t have the reserves? What if they lowered their capital and increased their leverage? Then the gambling with taxpayer-insured money, as Dick Durbin puts it, would have a real cost.

Even Republican Bob Corker of the Senate Banking Committee believes that the Fail Whale trades could be a signifying event in creating stronger rules for Wall Street. The Banking Committee will hold hearings in the coming weeks on the issue.

But the more important work is being done outside the political system, to create the best menu of policies to ensure that bank investors rather than taxpayers and ordinary Americans pay the price for recklessness at Wall Street banks. I think Mike Konczal had the best explanation of the importance of this effort:

There is something to a conservative like Kevin Williamson’s remark that “The odd thing about this is that it is now considered somehow scandalous when a business loses money. It’s a scandal when banks make profits, and it’s a scandal when they make losses.” On a long enough timeline, the survival rate for everyone drops to zero. Though it was clear quickly at 5 p.m. Thursday that JP Morgan wasn’t in danger of collapsing, if things had been different it could have failed.

This illustrates the need for a mechanism to allow firms to fail in a way that fairly allocates losses to the right parties. The way corporations fail in this country is a series of legal choices we’ve made, and we found in the fall of 2008 that the mechanism we have for a shadow-bank financial firm failing — Chapter 11 bankruptcy — dragged down the entire system with it. Hence the move to bring in the FDIC to make sure a financial firm fails in a way compatible with fairness [...]

Shareholders are wiped out, the bank is recapitalized through previous debt holders, and the old board is fired. Stability and accountability are both emphasized. This is not simple, and this is where Dodd-Frank hangs together or it falls apart. It is a system of deterrence and detection alongside FDIC resolution. The Volcker Rule is meant to prevent having hedge fund-like gigantic losses out of nowhere, which would allow the FDIC to have some lead time to try to steer a firm back to solvency through prompt corrective action before resolution. Well-capitalized and transparent derivative markets will help with issues of contagion and panic that come with a major financial firm approaching collapse.

In a subsequent post, Konczal looks at how breaking up megabanks can aid the resolution authority process, by giving it the opportunity to work more smoothly and more credibly. Similarly (and this is the key point in my view), reducing size would reduce market power at these firms, which includes political power and influence. It’s one of the only ways to get back to an equilibrium where the “free market” actually means something, instead of the current situation of socialism for the rich, where the risk is socialized and the profit privatized. Capitalization plays a role in this to ensure we put off the point where a financial firm fails to the extent possible. I discussed this yesterday.

I’m glad the Fail Whale trade has opened up space to talk about these issues, even as I don’t believe it will lead to immediate adoption of anyone’s reform wish list. The first step is to get these ideas into the conversation.