Here's Why JP Morgan Needs to Pay Hundreds of Millions in Fines

Moneybox
A blog about business and economics.
July 30 2013 12:20 PM

How JP Morgan Stumbled Into a Tough Regulator and Got Slapped With Hundreds of Millions in Fines  

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Photo by Donald Bowers/Getty Images for FORTUNE

The Federal Electricity Regulatory Commission is not normally the place you look for big banks to get policed, but they've slapped JP Morgan with $410 million in fines today, and, if you read the complaint (PDF), you'll see why even this fine may not be enough.

The basic issue here goes back to when a number of states adopted a system for electricity pricing that, though confusing known as "deregulation," actually involves quite a lot of regulation. The way a deregulated system works is that ownership of power plants and utility grids is separated, and then electricity is bought and sold on a regulated marketplace. The idea of this is that electricity should be priced in a way that's responsible to demand fluctuations rather than set arbitrarily. Different electricity sellers submit different bids at different times of day, with the idea being roughly that you use your cheapest sources for your always-on baseload needs and then surge on your more expensive planets at peak demand times. But turning power plants on and off isn't as simple as throwing a switch, so in some markets—including the ones where JP Morgan was engaged in the manipulation—you have "day ahead" markets as well as "real time" ones. There's also a system of what's called "make whole" prices to compensate power plant operators for situations in which their facilities were geared up and then the power was unexpectedly not sold.

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What JP Morgan did, essentially, was notice that the regulators had done a poor job of designing the system. They created moral hazard. The make-whole payments are supposed to help cover the fixed costs of operators who accidentally wind up producing electricity that isn't needed. But making the payments available created an incentive to structure bids designed to trigger make-whole payment. Thus high cost highly inefficient electricity plants could be transformed into revenue sources through the magic of clever bidding.

JP Morgan saw the loophole, and instead of phoning up the regulators to inform them of the situation and suggest a rewrite of the rules decided to walk through the loophole.

The bank's view, in other words, was that this was the kind of situation where "the real scandal is what's legal." FERC says that on the contrary, even though the loopholes are right there in the rules there's a larger Anti-Manipulation Rule that generically bans "any device, scheme or artifice (i.e. intentional or reckless conduct)" intended to defraud energy users. So FERC's thought is that they need to pay a really really big fine to act as a deterrent against future malfeasance. The admirable goal here is that next time someone sees a loophole in an electricity pricing scheme they won't exploit it. They'll say "yes the rules allow this strategy, but if we do it we're going to end up paying gigantic fines." This turns out to be a great example of the kind of principles-based regulation that banks have largely been able to avoid in their mainstream banking activities. There wasn't just a set of rules and then if companies hire really smart people to find loopholes we decide it's all in the game. Subverting the purporse of the rules is itself actionable activity. It's an idea that should be more broadly applied.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.