The $2 billion trading loss reported by J.P. Morgan Chase has unleashed a torrent of comments suggesting an even greater need to impose Dodd-Frank, that bank trading operations need to be reined in, that banks managers are badly overpaid and suffer from hubris that gets them into trouble, that our largest banks are too big to fail and too big to manage, and that regulators need to do a better job of keeping banks from taking too much risk with depositor money. Most of these beliefs are misguided at best, irresponsible at worst, and could lead to counterproductive legislation that weakens our economic growth prospects. Rather, regulations need to insure that banks keep enough capital to absorb any losses for any risk they take and these risks must be monitored so the capital requirements cover the risk taking, no more and no less.

(Full disclosure: I am the former chief economist for Chase during which time I worked directly on a daily basis with Ina Drew, the head of the office that lost that $2 billion, Also, Advisors Capital owns J.P Morgan Chase common in client accounts and I do, as well.)

Simplistically, it has been argued that J.P. Morgan took too much risk with its ineffectual hedges that cost the bank about $2 billion in losses, so assorted remedies are necessary. For a bank that makes about $5 billion in profit each quarter, it should be quite obvious that the trading loss was well within the bank’s ability to handle such risks when placed into context. (One analyst on the conference call actually asked why J.P. Morgan bothered to hold a conference call over this matter, since it was well within their normal trading activity. The answer was that it occurred so soon after their previous conference call, the bank did not wish to mislead investors.) So the loss is really more of an embarrassment to J.P. Morgan’s reputation and an opportunity for those who would pick on banks to criticize J.P. Morgan, an institution that mostly avoided losses during the credit crisis and to show that even they can make mistakes. What an unrealistic standard.

Simplistically, how can we prevent any bank from losing money? (There was an excellent editorial on this subject on Tuesday in the Wall Street Journal, which suggests that it isn’t a crime to lose money.) It should not be our objective to prevent a bank from losing money. If that’s our goal, we should prohibit all banks from making any investments or any loans. Then, they’d never suffer the ignominy of a default. Of course, they wouldn’t make any money either, nor would the economy perform well, if firms are unable to borrow or issue debt. Should banks not make any mortgages because of the credit crisis that emerged from the lack of credit standards applied to mortgage borrowers during the housing boom? Such an approach would cause far larger problems. Who would ever be able to afford to buy a home? Moreover, every loan on a bank’s books is the equivalent of a proprietary risk position. Inevitably, some will fail. Imagine disallowing insurance companies from selling hurricane insurance to avoid the spectacular losses that arise from a massive storm. Would that serve the public’s need? It makes more sense to require insurance companies to manage their exposure, to sell off excess exposure (or buy reinsurance), and to retain enough reserves so they can pay out to those unfortunate families who do suffer losses. That’s risk management and it is the critical role played by these companies in our economic system. It is also hard to square the notion that banks should avoid losses alongside the criticism that banks should be lending more aggressively. Thus, the solution is not to prevent banking firms from taking risks but to make sure that they retain sufficient capital to absorb losses from their inevitable mistakes.

Dodd-Frank is an awful piece of legislation partly because it seeks to prevent losses, not to make sure that financial institutions can manage their risks. Moreover, since drawing clear lines is very difficult—the legislation seeks to disallow proprietary trading by banks but can’t even distinguish proprietary trading from other forms of trading—its approach is bound to fail. As the J.P. Morgan episode demonstrates, every losing trade will become redefined as a proprietary trade after the fact. It is not accidental that regulators are still unable to establish rules to implement Dodd-Frank more than a full year after its passage. I’m pessimistic that the Fed or SEC will figure this out over the next two years either, yet some new set of rules will be forthcoming, no matter how arbitrary and illogical they may be. So, why did Dodd-Frank get passed? The credit crisis of 2008 brought to light major faults in our financial system that were ignored by regulators. It was easier to blame the banks, who were certainly not without faults, than to take blame Congress for legislation that promoted irresponsible lending practices and regulators who failed to oversee the problems, as they arose. If Dodd-Frank is implanted as it currently stands, I am highly confident it will be eroded or repealed over time, as legislators come to understand the damage it causes.

Oddly, J.P, Morgan Chase lost $2 billion in a hedging transaction that was “poorly conceived”, although how much this position was a hedge and how much was to make money is as yet unclear. Dodd Frank would permit hedging activity. Would we also preclude banks from hedging? If so, we would increase bank risk. Another risk prevention legislation following on the heels of Dodd Frank would create even greater credit availability issues, which would inhibit all forms of risk taking and economic growth.

Critics of the banking sector are using the J.P. Morgan loss to argue that stronger legislation is needed to prevent such losses from recurring. In fact, this loss is easily absorbed by J.P. Morgan. So, what are the critics really trying to accomplish? Preventing losses should not be the goal of regulation. Banks must be able to lose money. In reaction to the credit crisis of 2008, they are still too reluctant to lend or take risk, which has retarded the recovery. Entrepreneurship, research and development, new business development, start-ups, and other keys to growth all require risk taking and policy should be trying to promote growth, not seeking to establish obstacles to prevent it. The people who criticize J.P. Morgan for its loss may have other motives or some other agenda. Populist politicians simply take joy in being able to blame the banks, even though only shareholders suffered from this loss. Some politicians may be seeking greater control over bank lending decisions, as if they could make such decisions without losses or lending to favored sectors, neither of which constitutes good policy. Regulators always seek to expand their oversight responsibilities, whether they can manage them or not. If this episode doesn’t blow over, another stupid piece of legislation will follow or reinforce Dodd-Frank and we will all be poorer for the result.