With the mighty JPMorgan humbled by an embarrassing and very expensive trading loss, critics are arguing that this case proves the point Congress made so emphatically in the Volcker Rule. But, does it? JPMorgan’s CEO, Jamie Dimon, describes the situation as a case of “morphed” hedging. In my view, it’s the morphing that’s the problem, not the hedging and it’s the poor risk-management that permitted the morphing that needs ready redress not just by JPM, but also by regulators.
In a U.K. TV interview earlier today, I was asked if this case not only validates Volcker, but also proves “Vickers,” which separates commercial from investment banking into ring-fenced units. The argument went that the JPM losses are trading, trading is investment banking and, thus, it’s too risky to be allowed in close proximity with traditional commercial banking. But, the facts as we know them are that the synthetic CDS trades before they morphed were meant to hedge credit risk. This is JPM’s largest risk, as befits its business as a bank. Thus, if one wants to bar trades of the sort this was meant to be, one needs to eliminate either credit risk – the point of being a bank – or hedging – the bulwark against undue risk that, when done right, needs to be done a lot.
How does a hedge “morph” into a huge losing trade in a matter of weeks? A broad principle should guide thinking about this case: hedges are supposed to protect the bank from losing money, not be so clever that they make a lot on the side. If a hedge is a profit-making venture, then it isn’t a risk-management operation. JPM apparently housed the unit making what is described as a hedge in a broader office dedicated to investing the bank’s funds – an activity that should not only be prudent, but also profitable. This is a conflicting objective that may well have blurred the lines within the unit, corrupted its culture and encouraged traders that were supposed to be hedgers to take bets akin to those on the other side of the trading floor.
On his hastily-assembled conference call last night, Mr. Dimon acknowledged that the loss resulted from a serious risk-management lapse and vowed to repair it. He also argued that the hit doesn’t damage JPM’s capital or fundamental profitability. These are two key points, especially given the brou-ha-ha over how this incident supposedly proves right both Volcker and Vickers. Banks, even very big ones, are still allowed to be private-sector entities. As such, they not only make money, but also lose it. As long as the money they lose is that of their shareholders, that’s fine – not to investors, of course, but to the fundamental point of private enterprise. The policy problem Volcker and Vickers mean to solve is the risk that banks can lose not just shareholder investments, but also holdings of innocent depositors and hapless taxpayers. Since this sadly happened in huge amounts in the financial crisis, it’s a reasonable fear, but the JPM case doesn’t prove that it is still upon us post Dodd-Frank because big banks are still doing “risky” things. Here, a bank was supposedly doing a risk-management thing – it just did it very, very wrong.
That’s a challenge to JPM’s senior management and its board, as what lay behind the “morphing” is a vital corporate-governance issue as well as a risk-management fiasco. It’s also a question for supervisors, who need to redouble their efforts to ensure that a hedge is a hedge, not a dressed up topiary designed by high-flying financial engineers with profit, not prudence, in their hearts.