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rbw/jp-morgan-shatters-financial-reform-illusions-may-2012

JP Morgan shatters financial reform illusions (May 2012)

Rethinking Bretton Woods | Wed, May 23, 2012

By Aldo Caliari

JP Morgan Chase disclosure of USD 2 billion losses by its trading desk has unleashed renewed scrutiny of the effectiveness that US financial reforms legislation, Aldo Caliari argues in this article.

Last May 10 JP Morgan Chase disclosed USD 2 billion losses by its trading desk, losses that continued to rise due to the continuation of the market trends it had betted against and the impossibility to unload some of the assets without triggering further losses.

The incident unleashed renewed scrutiny of the effectiveness that US financial legislation reforms may be expected to have on the generation of systemic risks by large and complex financial institutions, of which JP Morgan is a paradigmatic example, and the avoidance of losses to the public treasury via forcing bailouts in a crisis situation.

Two relevant initiatives in the “Dodd-Frank Wall Street Reform and Consumer Protection Act” are the prohibition of banks to engage in risky derivative trading activities (embodied principally in the so-called “Volcker rule”) and the regulation of bank capital requirements.

One of the issues that US financial reform tried to address was the potential for banks’ proprietary trading – that is, trading on securities for their own account – to lead to risks that would then ultimately be borne by depositors, taxpayers, or both. What is needed to avoid bailouts is a system that would be for failing financial institutions the analogous of what bankruptcy is for firms in general. This is called a banking resolution, or wind down, framework.

But for any banking resolution or wind down system to work effectively, it is a requisite that vital banking activities are not affected in the process. If the institution cannot be wound down without affecting deposits and public confidence in banks, then public financial support will become unavoidable. When deposit-taking banks engage in proprietary trading, the risks that proprietary bets gone wrong can severely compromise deposits are multiplied.

The Dodd-Frank Act contained the so-called “Volcker rule,” which bans proprietary trading by banks and prohibits them from having hedge funds or private equity funds. But many exceptions were allowed to the rule. Among them, banks were allowed to invest up to three per cent of bank capital in hedge funds or private equity funds, and could engage in proprietary trading to hedge risks, for market-making purposes or on behalf of clients.

The implementation of the Volcker rule has been one of the most objected portions of the Dodd-Frank legislation. In November of last year, after the FDIC and other agencies released a consultation paper preparing for implementation, the financial industry stepped up its efforts to disarm the rule. Even Heads of State and Finance Ministers of other countries were recruited to express concern about it, on the basis that it might undermine liquidity in trading of their governments’ debt.

In the face of the JP Morgan debacle, some politicians and the US Administration are now showing a stronger resolve for enforcement. But enforcement of the Volcker rule would most likely not have prevented JP Morgan’s behavior. This is not an argument in favor of weakening or not enforcing the rule. On the contrary, it points to the problems that the concessions made to the financial industry in “Dodd-Frank” reforms have created.

The main concern is rooted on the differentiation that needs to be made between proprietary trading and trading to hedge risks, on client’s behalf or for market-making needs. A good part of the criticism of the rule relies on the claim that these differentiations are impossible to make.

One controversial point is, for instance, whether the legislation exemption, which allows hedging “in connection with and related to individual or aggregated positions” means that the positions of whole trading desks can be hedged (what is called “portfolio hedging”). If the latter is true, the door opened to hedging strategies is so big that the rule will hardly have any meaning left.

JP Morgan’s CEO, Mr Dimon, has tried to argue that the bets that led to the loss were for legitimate hedging reasons. The fact that this is a tenable argument should, in and of itself, be a reason for deep reflection about the current rule’s capacity to achieve its purpose.

The questioned trading positions taken by JP Morgan were, indeed, taken to hedge the risks of other positions. Had the bets gone well, they would have yielded considerable profit for the bank, and nobody would be talking about them. On the other hand, should the direction of the current trends continue, the losses could be much higher. What sort of bets can get to compromise the capital of the institution to the extent that it requires a public bailout is hard to predict, but one thing is sure: once that point is reached, there is no legally written prohibition that is going to stop the government from doing so.

The US financial reform also contemplated changes to the regime of capital requirements. In this regard, the law largely left implementation to be done by the regulator, thus allowing it some discretion to follow the results of the then-ongoing process of international coordination in review of the Basle Committee on Banking Supervision’s agreement –generally known as the “Basle III” agreement, as they represent the third iteration of such agreement. While the deadlines for domestic implementation of several provisions of Basel III have not, yet, arrived, the JP Morgan loss is also a worrisome sign of the limited effect that their implementation would have in prevention of risk.

Basel III raises capital requirements for banks and also raises the standards for its loss-absorbing capacity.[1] It also calls for an extra layer of capital for global systemically important financial institutions.

Unfortunately, Basel III does all of this in a framework that leaves untouched the reliance of the system on banks’ own risk management models. Let us not forget that in the Basel system the capital requirements are calculated on the basis of “risk-weighted” assets. The importance of this problem tends to receive limited attention in the coverage by media and analysts. That is, although the ratios of capital required are higher than under Basel II, the banks have the opportunity to shape how capital is calculated against different types of exposures. This is not just an opportunity but, as the former FDIC Director has stated not so long ago, an incentive for banks to “game” the models.[2]

As soon as the Basel III reforms were known, reports indicated that banks were getting ready to engage in identifying ways to change the way risk weights are calculated to cut the amount of capital that they will be required to keep. Even a term has been coined for such practice, “risk-weighted asset optimization.”[3]

The relevance of this practice for the JP Morgan incident is not small. Internal risk-management systems rely generally on “Value-at-Risk” (VaR) measures. Value-at-risk indicates the losses in a given period that a company may suffer given a certain level of confidence. JP Morgan changed its model for Value-at-risk earlier this year, for reasons that are still under investigation but that give rise to suspicion. The reported VaR of the trading desk, after that revision, was of USD 67 million, but now JP Morgan has gone back to the original model and reviewed the trading desk’s first-quarter VaR to USD 129 million. The point is not only that even the highest of these two figures is a lot smaller than the actual loss suffered. The major point is that these very wide differences, presumably based on different variables in the calculation, is allowed for a bank in reporting a measure that should be key for its regulator to know the capital situation.

To its credit, the Basel Committee on Banking Supervision, in charge of reviewing the Basel Agreement, has identified the dangers of VaR measures and is seeking substitute measures. In the words of the committee, “A number of weaknesses have been identified with using value-at-risk (VaR) for determining regulatory capital requirements, including its inability to capture “tail risk”. For this reason, the Committee has considered alternative risk metrics, in particular expected shortfall (ES).” “Tail risk” is the name given in financial jargon to a highly improbable, worst case scenario situation. Some analysts have argued, for instance, that the events that configured the recent global financial crisis were overlooked in many models because they were a “tail risk” event. The yardstick that the Committee proposes to consider instead, the expected shortfall, indicates the losses that may be suffered, even above a beyond absent the certain level of confidence assumed by VaR.

It is worth noting that the perverse effects of risk-weighted asset measures can to some extent be corrected with the use of total asset measures, such as the “leverage ratio” that Basel III also introduces. Interestingly, the compromise draft of the Capital Requirements Directive IV approved by the European Council does not contemplate the leverage ratio as obligatory.

It is not clear whether regulations can ever be complex enough to catch up with the evolving complexity of the regulated financial institutions. So it is healthy that incidents like this are prompting reflection on whether and what for are so large and complex financial institutions needed. US Senator Sherrod Brown has reintroduced a bill, the Safe, Accountable, Fair and Efficient Banking Act that, if passed, would have the effect of leading to a break up of at least four of the biggest banks in the US.

 

 



[1] See for a longer analysis Caliari, Aldo 2011. Transatlantic Coooperation in Post-Crisis Reform Efforts: Does It Matter?

[2] Reilly, David 2012. Did J.P. Morgan Fiddle While Risk Burned? In Wall Street Journal, 21 May.

[3] Masters, Brooker, Patrick Jenkins and Miles Johnson 2011. Fears rise over banks’ capital tinkering in Financial Times, November 13.