Big Banks Bend, Don’t Break
JPMorgan’s trading loss jolts the sell side amid the Volcker Rule debate, though many market players are unfazed
JPMorgan’s recent $2 billion-plus trading loss has made for popular headline fodder, but market participants and those who follow Wall Street closely say the episode is not especially significant as far as institutional trading goes.
“Banks are in the business of taking on risk,” said Tim Walsh, chief investment officer of the New Jersey Division of Investment, which manages $85 billion. “The amount of money I’ve seen that JPMorgan lost so far, relative to what they make, seems trivial.”
“A bank loses money at times,” Walsh told Markets Media. “They set aside a certain amount of capital every year for loan losses, whether it’s your local bank, or JPMorgan, or Deutsche Bank. If banks wanted no losses, they should just buy Treasuries.”
JPMorgan Chief Executive Jamie Dimon disclosed in May that a series of derivatives trades and hedges made by traders in the firm’s London office had soured, resulting in a loss of more than $2 billion. In June 13 testimony before the Senate Banking Committee, Dimon said a strategy meant as a risk reducer had instead increased risk, though some questions about specifics of the trades remained unanswered.
At a time when the memory of the 2008-2009 financial crisis is still somewhat fresh and financial-market participants are under the spotlight amid unfolding financial-regulation initiatives in the U.S. and Europe, some political figures and supporters of tight regulation have seized on the JPMorgan stumble as more evidence of Wall Street run amok. But big banks deal in risk every day, and not every trade, deal or loan works out.
“Banks have a diversified portfolio of loans, including a certain amount of loans that they lose money on, which they factor in. If you look at net losses of a bank, as a general rule banks lose 1% on their loans every year,” Walsh said. “From what I’ve seen so far, I think the JPMorgan story is overrated.”
To be sure, a pattern of sizable trading losses at a financial institution would indicate that something is amiss, and despite the best efforts of risk managers, there is always at least a theoretical risk of a much-bigger loss. However, while no Wall Street bank wants their trading losses to be in the headlines, many see the JPMorgan incident as a normal cost of doing business, that does not provide any broad lessons for traders. In other words, the fallout is not at all like that of the 2008-2009 financial crisis, which pushed banks to retrench and take risk off the table.
“All the major, systemically important banks that engage in active trading activities – which are most of them – to the extent that they engage in trading with $2 trillion balance sheets, they will have $2 billion trading losses from time to time,” said Roy Smith, a former Goldman Sachs partner and now an economic historian at New York University Stern School of Business. “That’s only one-thousandth of their balance sheet,” or not remotely representative of the systemic risk that regulators are targeting, he said.
“You can’t completely cut out all risk in a failsafe way, otherwise you’d never make any money,” added Smith.
In his June testimony, Dimon said JPMorgan had taken steps to prevent a recurrence of the trading loss, such as replacing some managers who were involved; analyzing, managing, and reducing risk; and extensively reviewing the incident. “While this does not reduce the losses already incurred and does not preclude future losses, it does reduce the probability and magnitude of future losses,” Dimon said.
Given that JPMorgan’s risk management had been considered by many as best-in-class, it’s safe to say other big Wall Street banks are reassessing their own risk management.
“One of the main aspects of proper risk control is diversification, regardless of the type of investment thesis,” said Tim Ghriskey, co-founder and chief investment officer of Solaris Asset Management. That is, “not putting a huge amount of capital into any one investment idea, but diversifying across multiple ideas. JPMorgan and other big banks have the issue in that they are so big, it really takes a fairly significant trade to move the needle. But you can still have multiple investment ideas and not have an excess amount of capital in any one idea.”
The U.S. Office of the Comptroller of the Currency, which regulates and supervises banks, determined that “inadequate risk management” was to blame for JPMorgan’s trading loss. Much of the blame of JPMorgan’s trading loss fell on the bank’s risk committee and chief risk officer, and some say that was miscast. In the grand scheme, such individuals or entities don’t have the ultimate say on the decisions being made, but rather they provide guidance to the chief executive.
“The bigger the bank, the more the CEO has to be a manager of the whole shebang,” said Smith. “The CEO is the allocator of resources, (who) appoints managers, and handles external affairs and press conferences.”
“Whether other Wall Street CEOs do anything differently because of the JPMorgan matter is doubtful,” Smith continued. “They all already have a system in place. At most it may be polished a bit. But it’s not possible to be in this business and not take losses from time to time. The difficult part is making sure the trading losses don’t exceed a certain percentage of the bank’s capital or create systemic risk.”
Some Wall Street leaders downplayed the possibility of a trading loss similar to JPMorgan’s happening at their firm. Bank of America Merrill Lynch chief executive Brian Moynihan told investors in late May that he was “very comfortable” with the bank’s investment portfolio, which is invested mostly in government-guaranteed mortgage bonds and U.S. Treasury bonds.
He added that BoAML buys insurance-like protection on some loans to large companies, but doesn’t make broader, macro hedges, which were apparently behind JPMorgan’s stumble. One specific lesson of the JPMorgan loss may be that when trading positions make news for their size, as did those of the so-called ‘London Whale’, it’s time to unwind.
“It’s important for any trader to shield their idea from being leaked out and becoming so visible that other traders can come in and work against it,” said Ghriskey. “The big issue was the fact that the trade leaked out and became visible, so that hedge funds took advantage of it and basically attacked the trades and size of the position, and it was too big for JPMorgan to work out of it on a timely basis. You need to…not have any one person or investment thesis control an inordinate amount of capital.”
One perceived shortcoming of JPMorgan’s risk management is its risk committee, which has lacked financial and market expertise compared with its five largest competitors.
“It seems hard to believe that this is good enough,” said Anat Admati, a professor of finance at Stanford University who studies corporate governance. “It’s a massive task to watch the risk of JPMorgan.”
Risk management is a critical function at a bank, one that is dynamic and goes beyond just following rules, standards and guidelines.
Risk management is ingrained in a bank’s culture, for better or for worse. Paul Moore, the former head of regulatory risk at HBOS, a failed U.K. bank that was scooped up by Lloyds Banking Group during the height of the financial crisis in 2009, wrote that HBOS had “a cultural indisposition to challenge” and that the task of “being a risk and compliance manager…felt a bit like being a man in a rowing boat trying to slow down an oil tanker.”
“The key for banks is in knowing how to put proper risk management into place,” said Richard Clayton, research director of CtW Investment Group, which advises labor pension funds that own JPMorgan shares.
The board of directors has a vital role in managing risk and should not just monitor reports from the chief risk officer, Clayton said. As the board ultimately represents the interest of shareholders, it should be actively involved in issues including the firm’s overall risk appetite, as well as specific risk appetites for individual business segments. “These aspects should really be set by the board of directors,” said Clayton.
To be sure, there are situations where a particular business unit may want to take on more risk because it sees an opportunity. In this type of situation, which is what may have occurred at JPMorgan’s chief investment office unit, an executive needs to have the ultimate veto as far as trades going beyond the established risk tolerance. It’s not clear if that type of check was in place at JPMorgan, or if Dimon or another head was entirely aware of the size of bets that the CIO was making on bond derivative indexes that led to their losses until it was too late.
JPMorgan’s trading loss is jarring to some not because of its size, but rather due to which institution was tagged. JP Morgan emerged strongly from the 2008-2009 global financial crisis, which saw rivals fail or struggle mightily. Dimon was widely acknowledged as the ultimate chief risk officer, and the nominal head risk manager reported directly to Dimon and was part of the executive team with open access to the company’s board of directors.
In addition to independent risk managers, JPMorgan’s private banking unit at the time also deployed a group of local risk managers who were considered well-versed, savvy, informed and empowered about the complexity of risks being taken.
This time around, although Dimon was aware of risk being taken from the CIO office, he missed the details and the enormity of the situation. Board and risk-committee members didn’t step in either.
“Most of the other big banks have on their relevant risk management committees individuals with clear banking or regulatory backgrounds,” said Clayton. “They each seem to have professional trading experience at some level, which would indicate that they are in position to understand how the risk-management process works.”
At least for now, it seems JPMorgan isn’t blaming the trading loss on faulty risk management. Chief investment officer Ina Drew and other investment executives left the bank recently, but none was a high-profile risk officer. Dimon attributed the loss to “bad execution, bad strategy and the environment.”
One way a bank can reduce the chance of a big trading loss is banning compensation structures based on trading profit. This has been mentioned by regulators including Bart Chilton of the U.S. Commodity Futures Trading Commission.
Regulators are reviewing the JPMorgan trading loss to see if stricter rules would have averted the situation. While it’s been said that the Volcker Rule, which restricts banks from engaging in proprietary trading, would not have prevented the loss because it stemmed from a hedging move, perhaps new rules can better define a hedge and how it differs from market making.
“The rules should be set up so that banks can put a hedge in place but not where they are hedging hedges and they end up with something like JPMorgan where they were essentially doubling down,” said Clayton.
“The argument is that although financial institutions should be able to engage in hedging procedures, there is a fine line between really trying to hedge and trying to add in additional exposure based on views of the market, which would then be considered a proprietary trade or principal position,” said Michael Wong, investment banking analyst with Morningstar. “As long as it is a legitimate hedge where the bank is trying to reduce exposure to certain factors then they should be able to do it.”
One fairly drastic remedy to preclude bank trading losses from harming loan capacity is to separate commercial and investment banking, as was required by the Glass Steagall Act of 1933 that was repealed in 1999. But market observers say this is a longshot.
“It would be very difficult to go back to Glass-Steagall now, because of how integrated the bank loan market is with the bond market,” said Smith of NYU. “If you’re engaged in the mortgage loan business you’re also in investment banking because you trade on the bond market. And mortgage loans were permitted under Glass-Steagall.”