The latest multibillion-dollar blunder by a supposed Wall Street wizard is like oxygen for regulators – but the body it should breathe life into is Vickers, not Volcker.

The news that JPMorgan Chase & Co. lost at least US$2 billion, and probably more, on a massive failed trade provokes flashbacks to other trading gaffes, such as American International Group Inc.’s near-fatal bad bet on credit-default swaps during the most recent financial crisis.

The fact that, yet again, a high-end shop is suffering from this sort of loss illustrates the inescapable danger that large-scale trading, and undue reliance on risk models, represents. For a bank that is clearly “too big to fail” and that funds its trading with vast quantities of government-insured deposits, these are risks that are effectively being borne by taxpayers, too.

Since the financial crisis, policy-makers have been seeking ways to prevent banks with implicit government backing from taking these sorts of one-sided risks, which allow the traders and top executives to capture the upside but leave taxpayers exposed to the downside.

In the U.S., this had led to the so-called “Volcker rule,” which is designed to limit the market risks that U.S. banks take by forcing them to get out of the proprietary trading, hedge fund and private-equity businesses. However, it would still allow banks to hedge their own risks, which is arguably what JPMorgan was doing in this case – initially, at least.

In any case, the problem with the Volcker rule, as the JPMorgan episode highlights, is that it may be impossible to distinguish between a genuine hedge and dangerous proprietary trading. And, if the bet is big enough – and goes bad enough – it may not matter.

A better approach is the model proposed in last year’s Vickers Report from Britain, which recommends the “ring fencing” of retail banks so that they are kept legally separate from the wholesale side, and hold their own capital, too. That way, the benefits of diversification remain, but the risks and rewards of trading are isolated from the more fundamental, retail operations of a bank. Mainstream banking must be shielded from exotic trading – in both form and substance.

© 2012 Investment Executive. All rights reserved.