Although Jamie Dimon has not defended the disastrous London Whale deal – who could – he has offered as a rationale the hundreds of billions that flowed into the bank as it acquired Bear Stearns and WaMU. Bloomberg has highlighted these deposits and the billions more that followed as a spark for new regulatory inquiries not just at JPM, but also across the spectrum of large banks. Here, we assess the risks these deposits pose, whether they drove JPM to do this deal and, going forward, what needs to be done at banks awash in liquidity without a profitable pot in which to put it. In our view, the basic JPM incentive – a need to park its cash for profit – points to a grave emerging risk in global finance that the Volcker Rule will do little to fix.

In broad terms, holding lots of deposits is not just good for banks, it’s what they are supposed to do for a living. As the new liquidity rules rightly note, deposits – especially core ones – are the most stable funding source around, avoiding the risks posed by secured and wholesale funding that runs like a bunny at the first sight of trouble, exacerbating risk. Of course, banks only get deposits because of deposit insurance in the U.S. and here, as elsewhere, the regulatory construct underpinning banks that provides all of us the comfort we need to give banks our money. Capital is the cornerstone of this regulation – at least it is now – but here’s where the deposit story gets interesting.

Banks aren’t just depositories. Their mission is also to be financial intermediaries – turning deposits into assets so the bank’s balance sheet matches up and provides a bit on the side for shareholders. The more deposits, the greater the need for assets and, with the assets, the more capital the bank must hold. Even if all the bank does is store its deposits in U.S. Government sovereign obligations, it still has to hold capital against them because the U.S. leverage rules mandate a five-percent capital requirement despite the zero risk weighting accorded these assets. Ideally, the deposits would go into loans or other economically-productive assets which yield more than enough to provide a reasonable risk-adjusted return on capital to absorb the cost of holding the offsetting liability, but even USG holdings can do the trick. But, now, they don’t. This is the heart of JPM’s dilemma and that of all of the other very large banks once known as “money-center” institutions because of the vital importance deposits play in their business model. Interest rates are at record lows – negative in real terms. So, deposits don’t cost banks much, but neither are the USG obligations in which they are housed. Take the capital for even the USG obligations into account and the liability/asset equation turns into a major money-loser. The solution to this problem would be to put the money where the FRB wants it to go – into the economy – but the ongoing recession, market jitters and a host of other macrofactors have parked billions back at the banks.

So, what to do? Turn down the deposits? At least one bank (BNY-Mellon) tried to do that last year by charging a fee for taking on new funds. That didn’t catch on across the industry for several reasons, but one was that some banks thought they had a nifty solution to the deposit pile-up: other investments that turned a tidier profit than simple USG holdings. These investments aren’t loans or even inter-bank liquidity. Instead, they are complex structured-finance transactions, repos included, that put core deposits into the maelstrom of financial markets for what the banks hope prove to be considerable profit despite the macroeconomic morass.

This might be fine if the banks could hedge these riskier bets – but the “if” here is of course what brings us back to JPM. Even though the question of whether the London Whale did bets or hedges is to be resolved, the underlying incentive behind it – JPM’s need to do something with all its cash – is a critical policy problem. Many analysts have rightly concluded that the search for yield drove investors – many banks included – into high-yield junk bonds and MBS in the run-up to the financial crisis. This is harder to do now because AAAs are in scant supply and other hard lessons have choked off asset supply. But investors must still search for yield if they sit on piles of dough.

If JPM and other big banks are doing this with complex structured instruments that cannot be effectively hedged, the financial system has a far bigger problem than Paul Volcker tried to fix with a ban on proprietary trading. The risk has nothing to do with trading; instead, it has everything to do with concentrated positions in complex instruments acquired in hopes of outsized yield – not exactly the sound footing needed for stable global finance.

.