JP Morgan Chase: beaching the London whale
By Ingrid Goodspeed
Governor of the Institute of Financial Markets
n 10 May 2012 JP Morgan Chase (JP Morgan) announced a USD 2 billion (ZAR 16.5 billion) trading loss.The sharpest criticism of the loss came from the bank's chief executive, Jamie Dimon who said the loss was the result of “sloppiness”, “poor judgment” and “stupidity” on the part of the bank.
JP Morgan is the US’s largest banking group by assets (USD 2 trillion) and is renowned for the quality of its risk management. The bank is credited with being the first bank to use value-at-risk (VaR) as a risk measure. The bank’s use of VaR is said to have originated when Dennis Weatherstone, at the time the Chairman of JP Morgan, asked the question that is the basis for VaR namely: How much can we lose on our trading portfolio by tomorrow’s close? The result was the so-called 4.15 report, a daily one-page report that showed the potential losses over the next 24 hours across all the bank’s trading portfolios by aggregating different trading positions on the basis of a single consistent risk measure namely VaR.
Although there has been limited detailed disclosure about its loss from JP Morgan, probably to protect its ability to unwind its positions, it would appear the event occurred as follows:
- JP Morgan bought credit default swaps on high-yield bonds (“credit-portfolio hedge”) to partially hedge the bank’s existing credit portfolio. The bank would profit if the credit worthiness of high-yield bonds worsened. It is likely that the basis risk of this hedge was high because JP Morgan’s commercial loan book was not comprised mainly of high-yield bonds.
- The hedge went against the bank as the economy appeared to improve.
- The bank then sold enormous amounts of CDX.NA.IG.0, an index comprising a basket of credit default swaps on investment bonds from 121 issuers. The bank’s trades were so large that a substantial gap was created between the price of the index and the composite price of its components.
- These index trades may have been a hedge on the credit-portfolio hedge or proprietary trades. If seen as a hedge, it would have compounded the basis risk. In addition a better strategy would have been to simply unwind the credit-portfolio hedge. Therefore the index trades should rather be seen as proprietary trades attempting to take advantage of the improving economy.
- Hedge funds began to bet against the bank and its losses deteriorated rapidly.
The trader responsible for the trades is Bruno Iksil dubbed the London whale due to the size of his trades. He worked in JP Morgan’s Chief Investment Office (CIO). The CIO’s primary responsibility is to manage an approximately USD350 billion portfolio in a conservative manner by investing excess liabilities and managing long-term interest rate and currency exposure. It also maintains a synthetic credit portfolio to hedge the bank against a systemic event, like the financial crisis or Eurozone sovereign defaults. The synthetic credit portfolio was designed to generate modest returns in a benign credit environment and more substantial returns in a stressed environment.
The July 2012 internal investigation into the activities of the CIO by JP Morgan found that:
- The CIO’s judgment, execution and escalation in the first quarter of 2012 were poor
- The executed strategy of the CIO resulted in increased position size, complexity and risk without a concomitant intensification in the level of scrutiny
- CIO Risk Management was ineffective in dealing with Synthetic Credit Portfolio in that (i) the inadequacy of risk limits were not addressed timely manner, (ii) the front office was not forcefully challenged and (iii) there was insufficient escalation to management
- Risk limits for the CIO were not sufficiently granular. At least limits by size, asset type and risk factor are required
- The approval and implementation of CIO Synthetic Credit VaR model were inadequate
The losses at JP Morgan have intensified debate around certain issues that are uppermost in the minds of regulators and policy makers:
- Too-big-too-fail institutions(1) like JP Morgan may be too complex to manage even for good management. If too complex to manage, such institutions are certainly too complex to supervise. The risks faced by such institutions are difficult to understand and if insiders cannot get a handle on the risks how can outsiders like supervisors and regulators. Supervision can never be a substitute for management. The CEO of JP Morgan was asked whether the bank’s supervisor – the Office of the Comptroller of the Currency (OCC) – was informed of the bank’s trades. He stated “in this particular case, since we were a little misinformed, we probably had them misinformed. We passed that mistake onto them.”
- Many regulators and supervisors believe that retail and investment banking should be separate. The reason for this is that the culture of cynical greed at the investment banking unit may negatively impact the service-orientated culture of the retail banking division of a composite bank. The implications of separation are that separated the retail and investment banks will probably have to hold more capital and will not have the same level of income diversification.
- Should trade information repositories, such as those envisaged in the Financial Markets Bill, have identified that JP Morgan had apparently cornered a market? The OCC was aware of JP Morgan’s positions. It was “talking” to the bank about the trading position in April 2012 and “evaluating” the trades when the value of the position deteriorating rapidly at the end of April and early May. Sheila Bair, former chair of the Federal Deposit Insurance Corporation, stated that “"I think the regulators missed this, I think it would be refreshing if they would admit they'd made a mistake."
- Would expected shortfall(2) have alerted the management of JP Morgan to the risk? It is doubtful whether either VaR or expected shortfall is a sufficient measure when a position is as large as that of JP Morgan. Other indicators such as a concentration or market-share measure would be required.
- Would the JP Morgan trading strategy have been permissible were the Volcker rule (section 619 of the Dodd-Frank Act) in place? The rule prohibits a bank from engaging in proprietary trading. The problem is that it may be difficult to distinguish between a bank that is (i) risk-mitigating hedging, (ii) speculating for itself or (iii) acting on behalf of customers.
It is likely that the scale and unforeseen nature of JP Morgan’s USD 2 billion loss may accelerate plans by global policymakers to (i) strengthen capital standards for market risk and ensure that regulatory capital is sufficient in periods of significant market stress and (ii) require banks to improve their trading risk management and models. The ultimate purpose is a more resilient banking sector. However can this be achieved without a move away from a culture characterised by greed, obfuscation and exploitation to one of service, integrity and long-term commitment to consumers and other stakeholders?
(1) Owing to the size, interconnectedness, or complexity of systemically important financial institutions negative externalities emanating from their financial distress makes them a source of systemic risk and lead to them being perceived to be too-important-to-fail.
(2) In its fundamental review of the trading book consultative document of the Basel Committee on Bank Supervision proposed the replacement of VaR by expected shortfall
Basel Committee on Banking Supervision. May 2012. Fundamental review of the trading book. www.bis.org
Carver, L. 14 May 2012. JP Morgan’s London whale losses spark VaR debate. www.risk.net
Pollack, L. 19 June 2012. JPM whale-watching tour. www.ft.com
Rimkus, R. 17 May 2012. JP Morgan and the London Whale: understanding the hedge that wasn’t. http://blogs.cfainstitute.org/investor/2012/05/17/jpmorgan-chase-and-the-london-whale
Short, G. Murphy, EV and Miller, RS. 16 August 2012. JP Morgan trading losses: implications for the Volcker rule and other regulation. Congressional Research Service
Testimony of Jamie Dimon Chairman & CEO, JP Morgan Chase & Co. before the U.S. Senate Committee on Banking, Housing and Urban Affairs Washington, D.C. June 13, 2012
Wutkowski, K. 14 June 2012. Bair decries hyperventilation over JP Morgan loss. www.reuters.com