August 19, 2013

FORTUNE — Does it pass the smell test? Every senior executive at a large multinational company in China is likely asking this question amid reports that the U.S. Securities and Exchange Commission is investigating J.P. Morgan Chase’s (JPM) hiring of children of senior Chinese officials in connection with some of its China-related investment deals.

The answer is no. Even if the SEC clears J.P. Morgan of any wrongdoing, the damage to the reputation of the American banking giant will be irreparable. Of course, should the outcome of the investigation go against J.P. Morgan, the legal costs and penalties could be substantial.

Sadly, J.P. Morgan is not alone in hiring princelings — children of senior Chinese officials — in the cutthroat investment banking market in China. Other Western investment banks have used the same tactic in trying to win business in China. To be fair, these firms are stuck between a rock and a hard place in China. The country is run by a one-party regime that has created a hereditary political aristocracy well-versed in the art of turning power into personal profits. The Chinese ruling elite also knows how to capitalize on the fierce competition among Western firms. Because investment banking is now largely a commodity business (quality differentiation is minimal), Chinese officials who make decisions on lucrative underwriting mandates take into account other factors.

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Since demanding an outright bribe from Western banks is most likely to be rebuffed, thanks to the Foreign Corrupt Practices Act, Chinese officials weigh whether the banks can do something for their children. Over the last decade, when the Chinese economy was booming and many giant state-owned enterprises floated their shares in Hong Kong, a decisive factor in determining which Western bank got the underwriting mandate was its political connection.

As a result, Western banks rushed to hire well-connected Chinese individuals who could help them win these lucrative deals. The hottest prospects were invariably the princelings. They were thought to be the most effective tool to influence Chinese decision-makers.

Although some of the princelings managed to deliver coveted deals, it is doubtful that hiring them worked like a charm each time. Nearly all the investment banks competing for Chinese deals have resorted to this tactic, so they unwittingly abetted an unpredictable contest among China’s ruling elite. The children of senior Chinese officials working for these banks were merely proxies of their fathers, whose positions on the Chinese political food chain determined their ability to close deals.

Even if the lucky princeling should, through his father’s political clout, secure a deal from his competitors, his employer — the Western investment bank — could suffer nasty consequences. The losers would be motivated to exact retaliation. They could also reveal dirty secrets and create public relations disasters or huge legal headaches for the winner. If a princeling’s father falls from grace because of corruption, as is often the case with senior Chinese officials, the risks for a bank could be incalculable.

Given the enormous legal and reputational risks involved, one has to wonder why Western investment banks, J.P. Morgan included, have allowed this questionable practice to continue for so long. For one, Western regulatory and law enforcement agencies have been too lax. Such negligence may have reassured those who have hired princelings that their practice was safe. Another explanation is that hiring princelings was not really expensive. They function much like stock options. Their compensation may be high in nominal terms, but such sums come out to a pittance for a bank if it wins a multi-billion dollar deal. If the princelings fail to deliver, the bank can always cut them off.

Today, with J.P. Morgan under a harsh regulatory spotlight, Western investment banks and all multinationals doing business in China must rethink their exposure to China’s corruption risk. In the case of hiring princelings, these firms will need to institute new safeguards to protect their reputation and bottom lines.

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One small step the banks can take is to institute a strict system of recusal. Princelings on their payrolls should not be allowed to work on deals in sectors overseen by their parents. This measure may not completely prevent these princelings from lobbying their parents on their employers’ behalf, but it can help reduce potential reputational and legal risks.

Western multinationals should also develop a code of conduct to reduce the incentive to hire princelings in the first place. If most Western firms pledge not to engage in a political arms race, everyone will be better off.

Minxin Pei is the Tom and Margot Pritzker ’72 Professor of Government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Foundation

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