Dimon’s Testimony Makes it Clear: Finance is Broken

by Trefis Team
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Last week, Jamie Dimon, CEO of JPMorgan Chase (NYSE: JPM), testified before Congress to discuss JP Morgan’s extraordinary trading loss of at least $2 billion (with the potential of up to $7 billion).

The loss is significant, because – as we’ve all heard – JP Morgan is “Too Big to Fail.” If the bank were to collapse, it would cause extreme financial pressures and the government would provide a bailout.

That means JP Morgan’s risk-taking is underwritten by taxpayers, so we have a right to regulate and monitor those risks.

But how can such regulation actually be put into place? What rules should JP Morgan and others be made to follow?

Far from resolving the complications those issues raise, only one thing came out of yesterday’s testimony: a feeling of overall futility.

The trading loss stems from a complex derivatives trade in the credit markets by Bruno Iksil, also known as “The London Whale.” (I explain JP Morgan’s trading loss in more detail here.)

According to many, the loss sustained by Iksil’s trade should have never occurred. So, unsurprisingly, much of the testimony was focused on reviewing JP Morgain’s risk controls. By most measures, those controls – meant to protect against losses – are very good. Remember, Dimon and JP Morgan’s risk managers piloted JP Morgan through financial crisis pretty successfully.

JP Morgan has multiple levels of risk committees monitoring the bank’s activities. Dimon doesn’t blame them or the committee for missing Iksil’s trade. Dimon says, “I think it’s a little unrealistic to expect the risk committee to capture something like this.”

In other words, the banks are too big and the trades too complex for the banks to monitor themselves. So can we have regulators step in to do it?

In a word? No.

According to Senator Shelby, “Regrettably, the Comptroller of the Currency, the Federal Reserve, the FDIC were unable to tell us what happened [with this trade] despite having more than 100 on-site examiners at JP Morgan.”

Also remember, this wasn’t a rogue trader.  According to Dimon, no one in the CIO office had pay structures that would incentivize outsized risk taking. On top of that, JP Morgan has clawback provisions in place that allows it to take back past earnings if a trader’s positions lose money.

Translation? All the traditional ways to limit risks were in place… And the trade still blew up.

Too Big to Fail and Too Complex to Understand

The problem isn’t management structure or rules.

The problem is that financial markets are extremely complex. And complex financial systems are destined to occasionally have big losses. No amount of regulation or rules will prevent such losses entirely.

So if the risk on the trades banks make can’t be managed, let’s limit the type of trades they can make in the first place…

This means some sort of “Volcker Rule” that prevents Too-Big-to-Fail banks from trading for a profit.

But thanks (again) to complexity, this is easier said than done.

You see, banks argue that if you take away trading for profit, a need to allow trades to hedge other positions still exists. The point has merit. Banks’ main industry is to make loans that help businesses expand and, in turn, lead to an growing economy. If banks were unable to hedge their positions, they would lend less and our economy would suffer as a result.

But where exactly does a hedge end and a proprietary trade start?

Let’s look at the London Whale trade…

When asked if this trade truly counted as a hedge, Dimon responded: ”I would call this hedging at that point in time.”

The obvious implication is the hedge became a trade shortly after.

How does that happen?

JP Morgan bought securities that would profit if the credit markets started to go bad. This makes sense as a hedge. If credit markets got bad, the bulk of JP Morgan’s assets would suffer, but these securities would rise in value and offset the loss.

However, the hedge started to go against JP Morgan and began losing money. At that point, there were two ways to reduce JP Morgan’s exposure. One, sell the positions and reduce the hedge. Or two, take opposing positions to offset the original ones. The latter makes a bigger position overall, but it should have reduced JP Morgan’s exposure.

JP Morgan took the second route and it didn’t work. Both positions started losing money.

But again, this highlights the problem. A simple hedge can quickly turn into a disaster. It’s simply not possible for a regulator to micromanage trades at that level, especially in the fast-paced and quickly evolving world of finance.

In other words, this was a mistake, made by humans, in a complex system where mistakes are downright impossible to avoid.

Senator Johnson, who convened the meeting, admits as much, saying, “No financial institution is immune from bad judgment.”

Don’t forget, $2 billion may seem like a lot, but it’s not much to JP Morgan. The company has a $700-billion portfolio of loans it’s trying to hedge.  And it still has $160 billion of cash and liquid Treasuries on hand.

The point is this: If you let JP Morgan hedge, it’s going to incur a $2 billion loss from time to time.

That’s why “Too Big to Fail” has become untenable. As Senator Shelby says, “Banks take risks because that’s what they do.” Sometimes risks turn into losses. And the complexity of the systems means you can’t regulate or manage them away.

That being said, there’s one thing that could work…

Requiring a Positive Skew

If you decide that banks can only hedge, you can allow them only to take positions with “positive skew.”

Positive skew means a trade has a small, well-defined potential loss and an unlimited potential gain. It’s not a judgment call and it doesn’t take a complex model to determine. If you can’t lose more than your upfront investment, it’s allowed.

JP Morgan’s initial hedge was a positive skew trade in which the bank would lose a small amount if credit markets stayed strong, but would make a lot of money if credit markets collapsed. So far so good.

But when they wanted to alter the trade, JP Morgan entered into contracts with a negative skew. This meant that if things went against them, the amount of money they could lose would be uncapped.

That’s where the trade went wrong.

By limiting government-backed banks to positive skew positions, the risk of any trade is immediately known and limited.

Alas, there’s one small problem. Positive skew positions need a counterparty – someone to take the other side of the trade and pay up if JP Morgan wins. There aren’t many institutions – and they need to be non-governmental – big enough to take that side.

To develop such capabilities, it would take a brand-new and equally complex financial market… putting us back right where we started.

Bottom line: The entire system needs to be overhauled. This hearing, if anything, was just a very, very slow start to that process.

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