J.P. Morgan’s big loss: Why banks still haven’t learnt their lesson

When J.P. Morgan Chase announced its $2 billion trading loss on May 10, some analysts asked, “What’s the big deal?” Even though the loss now appears to have grown to $3 billion, and could, by some accounts, soar to $5 billion or more, that’s pocket change to this enormous bank, which is healthy and making money.

Even the trading operation that booked the loss is in the black overall. Aren’t losses part of the game? Why does one loss matter if it is more than offset by other trades’ gains? The problem, says Scott E. Harrington, professor of insurance and risk management at Wharton, is that J.P. Morgan’s loss struck at a particularly sensitive time.

“My first reaction was that $2 billion is a tempest in a teapot,” he says. But on closer inspection, the bank’s loss raises serious questions about the kinds of risks banks are shouldering. “The incentives really encourage risk-taking,” he notes, arguing that excessive risk is still possible four years after the financial crisis struck.

“The particular loss that J.P. Morgan faced in this instance is clearly easy for them to absorb, but the timing of it is very consequential because it comes while regulators are implementing the Volcker rule,” says Wharton finance professor Krista Schwarz, referring to a regulation, still being finalised, that would restrict bank’s right to speculate with their own money.

Lawmakers continue to wrangle over the best way to moderate the systemic risk caused by financial institutions that are “too big to fail,” and the top banks have only grown larger since the financial crisis. Regulators are still writing rules required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. And, of course, it’s a presidential election year, with the two candidates and their parties dueling over the best way to spur growth and avert undue risk. “The political backdrop, I think, has heightened the newsworthiness of this particular [incident] beyond what it really means in substance,” Harrington notes.

The J.P. Morgan case is seen by many as a warning shot — notice that incentives and practices at big financial institutions can still, despite the lessons of the financial crisis, produce a toxic mix. If a bank can lose $2 billion, can it lose $20 billion? $200 billion? What if several banks had big troubles at the same time? Could the ripple effects swamp the innocent, as they did a few years ago?

“I think the main lesson [from J.P. Morgan] is how difficult it is to control risk,” says Wharton finance professor Franklin Allen. “What’s more, although this loss can be absorbed by J.P. Morgan, one wonders how big a loss is possible. For example, could a major institution be brought down by this kind of loss?”

Whither Volcker?

Huge, risky speculations played a major role in the financial crisis, and reforms like the Dodd-Frank bill aimed to curb those practices. J.P. Morgan contends that the trades in question were part of a hedging strategy designed to reduce risk rather than to speculate, but the case shows how even hedging can go wrong. The bank has not disclosed details of its strategy.

Hedges are designed to reduce risk rather than make money. In the simplest form, an investor with 100 shares of stock could buy a “put” option giving its owner the right to sell those shares at a set price for a given period, insuring against loss if the share price went down.

In another case, a bank making a loan to a company could buy put options on the company’s stock, or a credit default swap that is a kind of insurance against default on a specific debt. If the company went under and defaulted on the loan, the put or CDS would produce an offsetting profit. “That’s a simple hedge to understand,” says Wharton finance professor Itay Goldstein.

The Volcker rule was intended to permit hedging of this type, and to steer most of it to options and other types of derivatives traded on exchanges, making it easy to track values. In the financial crisis, many financial players had used individually tailored derivatives that were difficult to understand and price.

But the Volcker rule is not yet in effect, with key provisions expected to be unveiled in June. Large financial institutions — especially JPMorgan and its chairman and CEO Jamie Dimon – have been lobbying hard for looser hedging rules, saying tight restrictions will increase costs, reduce American banks’ international competitiveness and prevent them from offering needed products and services. “Jamie Dimon was at the forefront of efforts to weaken the Volcker rule, because it lowers the return on equity of JP Morgan,” Schwarz notes.

The bank’s big loss involves the kind of hedging Dimon wants permitted – hedging against an entire portfolio of assets rather than against each holding individually. “Hedging on an asset-by-asset basis could be more costly, more complicated,” Goldstein points out. “Sometimes, if you have many assets that can go in one direction [up or down], it’s easier to hedge with some complex security or an index, or something like that, which is what [J.P. Morgan] did.”

Defenders say a portfolio hedge also keeps the bank focused on what really matters – the behaviour of the portfolio as a whole, which involves a variety of risks as market conditions affect different holdings in different ways. There might, for instance, be no need to have individual hedges on two different assets if, under certain conditions, one asset were likely to gain value while the other lost. In that case, the two assets would hedge one another.

But when a portfolio contains a large number of different stocks, bonds, commodities and derivatives, it is very difficult to predict how the whole will behave. J.P. Morgan’s traders, according to Dimon, built “sloppy” hedging positions that failed to align with the actual risks.

The more complex the portfolio hedge, the more difficult it is to be sure the hedging instruments will move properly in correlation with the assets, says Harrington. “It’s more difficult to get an effective hedge.”

“I think the real problem is not this loss but what it tells us about risk management even at the best-run banks like J.P. Morgan,” adds Allen. “They simply don’t seem to be able to put systems in place that control risks well. Although we don’t have full information, it seems as though this was more of a speculative trade than a hedge. It should have been stopped before it got to the size it did, but it was not.”

Because a portfolio hedge is so difficult to understand, it can be used to disguise trading that is really intended as speculation, Schwarz notes. “The idea of portfolio hedging would represent a loophole in the Volcker rule that would effectively allow commercial banks to continue speculative trading,” she explains. “For many positions that they might wish to take, it is possible to find some other position such that it can be characterized as a portfolio hedge. But it is not really a hedge.”

The more things change…

If the traders themselves can’t fully predict how the hedge will behave, how could regulators? “The problem is we still don’t know exactly what happened here,” Allen says. “Certainly, hedging portfolios is difficult.”

Another issue: the human factor. A New York Times story detailed harsh battles between J.P. Morgan traders in New York and London as the head of the group was out sick. Even the best risk-management system can be derailed by human error.

The J.P. Morgan case also draws new attention to the issue of institutions that are so big and influential that the government can be forced to provide taxpayer-funded bailouts to avert wider damage if things go wrong. This was an issue in the financial crisis, and now, because of consolidation after the crisis, the biggest institutions are even bigger. “In one sense, [J.P. Morgan] shows that maybe things did not change so much following the financial crisis,” notes Goldstein.

Companies that can count on bailouts are more inclined to take risks, he says, referring to the process termed “moral hazard.” The Dodd-Frank act, while an attempt to reduce risk in the system, actually enshrines the bailout process by describing the steps the government would take, adds Harrington. It even extends that process to other types of institutions deemed “systemically significant,” a reaction to the role played in the crisis by American International Group, basically an enormous insurance firm.

“It is naive to think that in any way, shape or form Dodd-Frank has solved the too-big-to-fail problem,” Harrington says. “In fact, I think Dodd-Frank, as written, is going to expand the too-big-to-fail problem.”

“This does seem to be a reminder of the need for regulation,” notes Schwarz. “JP Morgan is explicitly backstopped by the [Federal Reserve] and everyone is aware that they would never be allowed to fail.

“This gives them an incentive to take on tail risk, as they can profit from the upside and face limited risk on the downside,” she adds, referring to bets on unlikely events. “On this occasion, the loss was manageable, but another time it might not be…. Models that institutions design to measure their risk are never good in the tails, because these events are rare and no one crisis looks exactly like another one. JP Morgan has indeed been at the forefront of risk management, and the episode is another reminder that these models fail when they are needed the most.”

While it is impossible to guarantee no financial crisis will ever occur, it is possible to make them less severe and less frequent, Schwarz adds. “A strict implementation of the Volcker rule would help,” she says. “This would crimp the profitability of large commercial banks, but other financial institutions would pick up some of the slack, and it would make for a more stable financial system. The timing of J.P. Morgan’s loss may be rather fortunate as it could lead regulators to lock in a stricter version of the Volcker rule.”

An industry built on risk

During the financial crisis, there were numerous examples of incentives that drove traders, loan officers and risk managers to take excessive risks, such as pay tied to short-term results. The J.P. Morgan case suggests incentives may still be a problem, Goldstein says. “The question is whether the market did teach them a lesson or not,” he notes. “That, I’m not so sure of.”

Few of the people who took the excessive risks that triggered the crisis suffered severe consequences, Goldstein points out. No top executives went to prison, and many risk-embracing players, though hurt financially, remained wealthy. “At the end of the day, many of them are in good shape… And many of them did not learn the lesson that we thought they should learn. That could be part of the problem.”

Requiring that firms have more equity capital would insure that shareholders suffer the consequences when firms are burned by big risks, giving shareholders and incentive to rein in overly risky behavior, Allen notes.

“Make shareholders have more of their own money at risk,” adds Harrington, arguing that capital requirements need to be “significantly higher” than those specified under the current international Basel III proposals.

In addition, says Goldstein, firms could be required to use tough claw-back provisions in compensation contracts, so that key individuals would have to give up pay if their decisions turn out badly later.

Another option, according to Harrington, is a return to something like the Glass-Steagall Act, which from 1933 to 1999 kept a strict separation between investment banks that were meant to take risks and commercial banks that were meant to be relatively safe and therefore had government backing like FDIC insurance on deposits.

With many of the Dodd-Frank rules still to be written and implemented, there is sure to be considerable debate over the significance of the J.P. Morgan loss, especially as more details of the firm’s trades come to light. But the big banks have many supporters who worry that too much regulation will dampen growth and competiveness.

According to Allen, the financial industry has attempted to redesign incentives to discourage excessive risk. But this is a tough balancing act, since taking risk is a necessary part of the business, or else there would be no loans. “It has tried,” he says of the industry. “I don’t think it has fully succeeded yet, and I am not sure it ever will. You would think an institution should be able to design systems to prevent this kind of event, but it seems they can’t,” Allen adds. “This is one of the reasons we need big capital buffers.”

This article first appeared on Knowledge@Australian School of Business.