Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

In the ordinary course of political events, months or even years pass between a definitive investigation and sensible policy remedies being proposed. There was a lag, for example, between the Pecora hearings in the 1933 and some of the modern securities legislation that followed. (Consider reading Michael Perino’s book, “The Hellhound of Wall Street,” or watch his 2009 conversation with Bill Moyers, in which I took part.)

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We finally had a modern Pecora moment last Friday, when Senators Carl Levin of Michigan and John McCain of Arizona laid bare how JPMorgan Chase has been run since the financial crisis and since the passage of the Dodd-Frank Act, which supposedly “reformed” banks.

Within 24 hours, we had the clearest possible statement of how to think about the modern financial system – and make it less risky – in the form of a speech by Richard Fisher, president of the Federal Reserve Bank of Dallas. The timing was presumably coincidental, yet it also reflects the speed with which smart people are reassessing the risks posed by the mismanagement of financial institutions. With Mr. Fisher as a thought leader, some of the best new ideas are being developed within the Federal Reserve System.

The question now is how fast attitudes will change within the Board of Governors, the seven presidential appointees who sit atop the Federal Reserve System. Unfortunately, at least two powerful governors seem to resist sensible further reform.

At its heart, the Levin-McCain report reveals executives with a profound misunderstanding of risk in the world’s largest bank (I use the calculations of comparative bank size offered by Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation). Even worse, the report shows us in some detail that banks – even after Dodd-Frank – can and do readily manipulate complicated measures of risk in order to make their positions look safer than they really are.

As Jeremy Stein, a Fed governor, pointed out recently, there are strong incentives to do this repeatedly in banking organizations (read the opening few paragraphs of his speech carefully).

The banking regulators – in this case, the Office of the Comptroller of the Currency – are clearly unable to keep up with this form of “financial innovation” (which is really just clever ways to misreport risk).

Did JPMorgan Chase’s top management do this intentionally? Did they mislead investors, particularly in the fateful conference call on April 13, 2012? This is a fascinating question on which the courts will no doubt rule. (You should also review this report by Josh Rosner of Graham Fisher, with the link kindly provided by Better Markets.)

Jamie Dimon will survive because JPMorgan Chase remains profitable. But it is profitable precisely because it receives implicit subsidies from being too big to fail. JPMorgan Chase disputes the precise scale of these subsidies – as Idiscussed here last week. Let’s just call them humongous.

This is not about individuals, this is about policy. And Richard Fisher has exactly the right approach:

At the Dallas Fed, we believe that whatever the precise subsidy number is, it exists, it is significant, and it allows the biggest banking organizations, along with their many nonbank subsidiaries (investment firms, securities lenders, finance companies), to grow larger and riskier.

This is patently unfair. It makes for an uneven playing field, tilted to the advantage of Wall Street against Main Street, placing the financial system and the economy in constant jeopardy.

It also undermines citizens’ faith in the rule of law and representative democracy.

Mr. Fisher’s speech is entitled “Ending ‘Too Big To Fail,’” the same title as a recent speech by Jerome Powell, a governor of the Fed board (which I wrote about here recently).

The difference between Mr. Fisher’s approach and what Mr. Powell proposes is significant, particularly regarding the timing for needed action.

Mr. Fisher wants to make the largest banks smaller – and particularly force investors to confront the reality that they will face losses when high-risk investment banking arms fail. In Mr. Fisher’s words:

The downsized, formerly too-big-to-fail banks would then be just like the other 99.8 percent, failing with finality when necessary – closed on Friday and reopened on Monday under new ownership and management in the customary process administered by the F.D.I.C.

Mr. Powell, by contrast, is not willing to take any additional actions at this time. As far as we can see, the Fed’s chairman, Ben Bernanke, is on the same side as Mr. Powell in this argument. But the Bernanke-Powell team is losing ground almost every day, at least on the merits of the argument. On Wednesday, Mr. Bernanke seemed to move a little closer to Mr. Fisher’s position but did not go as far as he should.

As Jesse Eisinger sums up the JPMorgan Chase mess with its multibillion-dollar trading loss last year, “Regulators remain their duped and docile selves.” The view that “smart regulation” can rein in excessive risk-taking is completely implausible.

Cyprus now demonstrates that the case for limiting the size of individual banks relative to the size of the economy is beyond debate. The awful financial debacle in that country, including the fumbled bailout unfolding this week, is a further reminder of the dangerous ledge on which we live.

If you let a few banks become very large relative to the economy, then their missteps can cause enormous damage – and big costs that will fall on someone. The losses incurred by Cypriot banks – around 6 billion euros (almost $8 billion) – are roughly on the same scale as the losses suffered by JPMorgan Chase as a result of its failed “London Whale” trades.

As the Nobel laureate Christopher Pissarides points out, nothing about this situation is fair or good for economic prosperity. A few Cypriot banks bet big on Greek bonds, very big, and their losses are about one-third of Cypriot G.D.P. Why would anyone want bank executives and traders to be in a position to do this much damage to a country?

The question is only what the size cap should be – surely in the United States we should seek to be below the risk levels that built up in Cyprus (or Iceland or Switzerland or Britain). In fact, why should any single financial institution be big enough to damage the United States with its miscalculations or misrepresentations? Yet the existence of too-big-to-fail subsidies means that a financial company like JPMorgan Chase has motive and opportunity to become even larger.

The British have figured out that finance needs to become safer; the authorities there are pushing for higher capital levels (above what seems likely to happen in the United States). And Martin Wolf, an influential senior columnist at The Financial Times, has a ringing endorsement of Anat Admati and Martin Hellwig’s new book, “The Bankers’ New Clothes,” on what is wrong with banking. Expect more British thinking to follow in this direction.

Why, in the United States, are we standing by?

As with so much in our economy today, much depends on the Federal Reserve. The Fed could do a great deal by itself to make the largest banks smaller and safer; the F.D.I.C. is ready to move in this direction.

The Fed likes to look to Congress for action. But Congress will not act unless so advised by the Fed.

It’s time for Mr. Bernanke and Mr. Powell to listen more carefully to Mr. Fisher – as they watch the awful events in Cyprus.

Article source: http://economix.blogs.nytimes.com/2013/03/21/the-london-whale-richard-fisher-and-cyprus/?partner=rss&emc=rss