What Do Embedded Regulators Do With Their Time?

How many bank regulators does it take to prevent a trading fiasco? More than 110, it seems. After Jamie Dimon's star turn at the Senate Banking Committee hearings, the heat has been turned down on JPMorgan Chase's (NYS: JPM) CEO and raised on the embedded regulators working within the banks' walls.

Too many cooks, but none in the kitchen
A recent New York Times article notes that, despite having 40 Federal Reserve Bank of New York regulators and 70 employees from the Office of the Comptroller of the Currency embedded in the bank, none actually worked in the chief investment office, where the risky trade originated. Though most people working there seemed to have no inkling of the maelstrom to come, one lone bank examiner did sound the alarm, a few weeks before the now-famous hedge, regarding the amounts of money being put into these risky trades. Naturally, these concerns were ignored.

Many question how such a thing could have been missed. After all, it was just about this time last year that the FRBNY and the OCC stepped up the presence each had at the biggest banks. Dubbed "systemically dangerous institutions," because of their ability to destabilize the economy when they teeter on the edge of failure, banks such as Bank of America (NYS: BAC) , Morgan Stanley (NYS: MS) , Citigroup (NYS: C) , and Goldman Sachs (NYS: GS) have been stuffed full of bank examiners over the past year to stave off another financial meltdown. So why did they seem to have no knowledge of this incident?

Regulators can become enthralled by the banks they oversee
Part of the problem may have been that Dimon has attained idol-like status on Wall Street for guiding JPMorgan successfully through the financial crisis -- albeit with plenty of governmental and taxpayer assistance. Because of his reputation and, probably, his position as board member of the FRBNY, it seems that Dimon was able to keep regulators' scrutiny at bay. In addition, there are many who doubt that putting regulators in the thick of things keeps them objective enough to actually do their jobs.

It is not uncommon for regulators to become enamored of the banks they supervise. This phenomenon has been played out many times, and the FRBNY is not the only Federal Reserve bank to act as cheerleader for its charge. For example, each of the Feds pleaded their particular big bank's case when the government was deciding whether each bank was healthy enough to pay dividends last spring.

It isn't surprising that regulation-buster Larry Summers, Treasury Secretary during the Clinton administration, would hold a dour view of bank examiners. However, his comment last year at Bretton Woods that there are scarcely any regulators who have both the chops to carry out their charge and the ability to resist falling under their subject's spell carries a ring of truth. In fact, his summation that "regulators haven't done a terrific job" seems understated.

As the focus shifts to what the regulators knew and when they knew it, it comes to light that Dimon and other executives at the bank had knowledge of problems at the London branch but chose to do nothing. Certainly, the bank did its best to hide relevant information from regulators; however, after the media reported bets being made involving derivatives, OCC personnel started asking questions. Despite their investigation, the examiners didn't suggest changes.

What's the answer?
Changes need to be made, and a plethora of suggestions have been bandied about over the past few weeks. The first step seems to be for the government to realize that embedding examiners just doesn't work. The primary field examiner meets with the CEO every month anyway, and having scores of other regulators milling about on a daily basis doesn't garner the examiners any extra insight. Why, for instance, did OCC personnel have to read about the bank's dodgy trade practices in the newspaper, when the agency had such a heavy presence at JPMorgan? Perhaps keeping government staff at arm's length will be a help, instead of a hindrance, by ensuring more objectivity on their part.

Another good move, I think, would be to actually give the regulators some laws to enforce. Since the gutting of Glass-Steagall in 1999, big banks have had free rein to be creative, with less-than-stellar results. The Volcker Rule, which attempts to curtail some of these activities, simply doesn't go far enough, and the banks have held up its implementation anyway.

For example, the law contains exceptions for the riskiest types of trades and, most importantly, doesn't reinstate the firewall between the commercial- and investment-banking sectors. That last part is especially important, because bankers need clear, unassailable rules to follow, or else things start to fall apart. Dimon himself spoke to this issue when he intoned at the recent congressional hearings that the Volcker Rule's wording is "vague."

Of course, part of the reason for this murky language is the due to lobbying efforts on behalf of big banks like Dimon's, but his comment highlights the fact that such wording gives bankers too much wiggle room. After all, there has as yet been no determination that JPMorgan actually broke any laws by engaging in this trade. The concise language of Glass-Steagall would have prevented the situation, and it did so for many decades.

Reviving clear-cut banking rules will benefit the entire economy and bring stability back to the financial sector, calming jangled investor nerves. The JPMorgan mess has proved that as long as bankers are given imprecise legal language to interpret as they see fit, problems will ensue. Let's hope we won't have to endure another fiscal catastrophe before lawmakers come to the same conclusion.

Will the big banks ever settle back into being the choice investments of savvy financial investors? Until they do, take a minute to check out some banking stocks that our own financial analysts call The Stocks Only the Smartest Investors Are Buying. Find out why even Warren Buffett would have been interested in these opportunities way back when.

The article What Do Embedded Regulators Do With Their Time? originally appeared on Fool.com.

Fool contributorAmanda Alixowns no shares in the companies mentioned above. The Motley Fool owns shares of JPMorgan Chase, Bank of America, and Citigroup.Motley Fool newsletter serviceshave recommended buying shares of Goldman Sachs. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.