May 16 (Bloomberg) -- Don’t worry your pretty little heads, JPMorgan Chase & Co. Chief Financial Officer Douglas Braunstein seemed to assure listeners on the bank’s quarterly earnings conference call last month. Regulators knew everything JPMorgan’s chief investment office was doing, he said.

“We are very comfortable with our positions as they are held today, and I would add that all of those positions are fully transparent to the regulators,” Braunstein said April 13. “They review them, have access to them at any point in time,” and “get the information on those positions on a regular and recurring basis as part of our normalized reporting.”

In other words: Clearly there wasn’t a problem, because if there was, the regulators would have seen it. And of course, by all indications, they didn’t see it, even though they were embedded in JPMorgan’s offices. On May 10, JPMorgan divulged $2 billion of intra-quarter trading losses and said they might get worse.

Once again, regulators seem to have been oblivious to huge risks at a bank they were supposed to be overseeing. To JPMorgan, however, they also have served a valuable purpose.

Having regulators around the clock at JPMorgan reinforces market expectations that the government has an obligation to stand behind the bank should it run into more serious trouble. Also, lest anyone forget, JPMorgan’s chief executive officer, Jamie Dimon, sits on the board of the Federal Reserve Bank of New York, even as the Fed is one of the agencies now investigating JPMorgan’s trading debacle.

Personal Benefit

The regulators’ very presence also may be of personal benefit to anyone at JPMorgan who might face scrutiny later from federal investigators. Let’s say the Securities and Exchange Commission were to consider accusing JPMorgan executives of possible rule violations. If what Braunstein said is true, there’s a chance these people might defend themselves by saying that everything they did was right under the regulators’ noses.

This might be one reason the government hasn’t brought a case, criminal or civil, against former executives of Lehman Brothers Holdings Inc. For several months before it collapsed, regulators were inside Lehman’s offices full-time, as the company’s bankruptcy-court examiner, Anton Valukas, noted in his 2010 report on Lehman’s failure.

If Lehman was lying to investors, the bank’s regulators should have been able to spot this. As Valukas has said, however, Lehman’s on-site regulators from the SEC may have lacked the expertise to understand the information they were receiving from the company. It didn’t occur to them, for example, that Lehman was manipulating its leverage ratios through accounting tricks that weren’t disclosed to investors.

We have come to expect similar ineptitude from the Fed, the Office of the Comptroller of the Currency and other agencies charged with keeping large banks safe. They failed to prevent the last banking crisis; their policies even helped cause it.

Nonetheless, the U.S. Congress responded by doubling down on regulators’ abilities to stop the next crisis when it passed the Dodd-Frank Act in 2010. That law expanded the regulators’ oversight responsibilities. The biggest banks have gotten bigger since then, and now enjoy the official distinction of being “systemically important.”

There must be a better system for protecting the public. We shouldn’t need federal minders permanently camped out at giant banks’ offices, and we wouldn’t need them there at all if we didn’t have too-big-to-fail banks such as JPMorgan. Breaking them up is the simplest solution. The trouble is it might take another spectacular blowup by one of them to break the industry’s stranglehold on Washington’s political machinery.

Basic Principles

Let’s start with some basic principles that should be obvious but seem long forgotten. A bank’s employees and regulators should operate at arm’s length. They shouldn’t be so tight with each other and in such close physical proximity that a regulator’s failure to object can be held up by management as a government seal of approval.

No financial institution should be so large that its collapse could topple the economy. Failed banks should be allowed to fail, which isn’t a problem as long as they are too small to cause a worldwide crisis. And if a bank’s executives break the law, prosecutors should be able to pursue claims or charges against them without worrying that they can assert “the regulators knew everything” as a defense in court.

It’s no surprise that Federal Reserve Chairman Ben Bernanke has rejected calls to break up the big banks. As the largest ones grow bigger and more important, so do the bureaucracies overseeing them. No government agency wants to give up power or influence, any more than a CEO like Dimon wants to take a cut in pay. (Dimon’s compensation last year was $23 million.)

The only way we will end too-big-to-fail is to break them all up. Forget the Volcker rule, which has been defanged by industry lobbying and whining. Bring back the Glass-Steagall Act, which Congress repealed in 1999, to separate commercial lending from investment banking. Then maximize transparency: The investments that banks make with federally insured deposits shouldn’t be a secret. Detailed disclosure of these holdings -- at least monthly, maybe even daily -- should be mandatory, so that markets can catch whatever the regulators miss.

JPMorgan just gave the country a $2 billion warning. There’s no sense waiting for a bigger one.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)

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To contact the writer of this article: Jonathan Weil in New York at jweil6@bloomberg.net

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net