JP morgan

Turning Off the Alarm System: JP Morgan Chase’s Regulatory Dodge

The following post is from Wallace Turbeville at Policy Shop, the weblog of Demos

Last night, the Senate Permanent Subcommittee on Investigations released a searing 300-page report on JP Morgan Chase’s London Whale episode. The bank lost at least $6.2 billion through trading credit derivatives in a business unit tasked with reducing firm-wide risk, the Chief Investment Office. (The trading activity is called the “Synthetic Credit Portfolio” or “SCP.”) There is much to digest in the report. Hearings are to commence today. But, even at this early date, the veil has been lifted on the complex and cavalier approach that banks take when they put the American public at risk every day in the quest for profits and personal gain.

The bank’s CEO, Jamie Dimon, famously claimed that JP Morgan Chase featured the very best risk control systems in the industry. But the report makes it abundantly clear that these systems were manipulated to reduce the calculated risk of the CIO’s massive credit default swap positions.

The SCP had grown from $4 billion to $51 billion in 2011, and the CIO had made handsome profits from the position. But things started going bad in early 2012. Like a gambler with a problem, the CIO could not walk away from the table. By March, when the traders were finally ordered to “put their phones down,” the SCP was $157 billion in notional value and hemorrhaging losses. The deep irony is that the bank had used its vaunted risk management system to allow this to happen.

The manipulation came in several forms. But perhaps the most troubling involved the Value at Risk model, as anticipated in the space months ago. VaR is a methodology that looks to historic data to calculate how much a portfolio might lose under conditions that have occurred in the past. One weakness of this statistical model is that this approach ignores the possibility of an historically unprecedented set of circumstances. Another is that changes to the basic assumptions can yield very different results.

This is terribly important. Under the Basel accords, as implemented by U.S. regulators, VaR is used to value the assets held by banks to determine how much capital they are required to hold against the risks of their business. It is used to calculate the value of “Risk Weighted Assets” held in positions like the SCP. To the extent that it provides an inaccurate picture, the soundness of a bank is misstated.

As the losses became apparent in January 2012, JP Morgan Chase decided to change its VaR model to avoid the consequences. It rushed into place a new VaR model that reduced the calculated risk of the SCP so that the flashing red lights set off under the existing model would be turned off. The best practice is to run a new model side-by-side with the old one for several months to test for anomalies. Not so with the new VaR model. The need to reduce the calculated risk associated with the SCP appears to have been too urgent.

An even greater outrage then ensued. Instead of using the breathing room manufactured by changing the math to reduce the SCP, the London Whale and his colleagues doubled down on the bet, laying on more risk to try and retrieve their position. Remember that the SCP went from $51 billion to $157 billion in the first three months of 2012.

This is just the start of what will be a long process of unraveling how this happened. We need to understand how the management of JP Morgan Chase allowed the SCP to continue even after alarms were sounded. And the role of the Office of the Comptroller of the Currency, which is responsible for oversight of the safety and soundness of banks, must be clearly analyzed. The OCC has a well-earned reputation for regulatory capture, a problem that the relatively new Comptroller has vowed to address.

The losses were not high enough to threaten the existence of JP Morgan Chase. But the implications are immense. The debate over the implementation of financial reform will soon move into questions of bank risk management and the nuances of risk hedging and models designed to ferret out proprietary trading from the apparently benign activities of risk hedging, like the CIO was supposed to engage in. The long process of sorting through the exhaustive work done by the staff of the Permanent Subcommittee on Investigations will have a huge impact on the outcome of these important next steps.


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