Many of the incidents that have been subject to recent settlements between banks and regulators actually date back to 2008 or even earlier. Controls have been strengthened since that time in part due to pressure from regulators to make such improvements. Key controls center around price models and independent price verification. Banks employ large teams of risk managers responsible for ensuring that each position on the books is associated with a certified valuation model and authoritative data source. In addition, price testing is generally conducted on each position on a monthly or quarterly basis by an independent valuation unit. Given all this focus on price controls then, it was somewhat dispiriting, though perhaps unsurprising, to read in the JP Morgan Internal Report on 2012 CIO (Chief Investment Office) losses, published January 16th, that valuation issues played a role in the “London Whale” story. First, the report documents, in a section on valuation of the Synthetic Credit Portfolio (this was the source of the losses),that one of the junior traders in the CIO was responsible for estimating the fair value of each position in the portfolio on a daily basis. The report also identifies that this junior trader had some latitude to exercise judgment in determining the actual price that was inputted and that did so often in consultation with another trader.
The bank's final report continues on to say that, “on a number of days beginning in at least mid-March, at the direction of his manager, he (the trader) assigned values to certain of the positions in the portfolio that were more beneficial to the CIO than the values indicated by the market.” Second, the report indicates that independent valuation controls were not functioning properly. During its quarter-end independent price review, VCG (Valuation Control Group) concluded that prices were acceptable though the team observed that many positions were marked at or near the boundary of the bid-offer spread. The report goes on to say that subsequent audits found errors in the VCG’s work and on March 30 2012, Internal Audit assigned a rating of “needs improvement” to CIO risk and valuation practices in Europe.
It is clear then, that despite efforts to strengthen controls, investment banks still have exposure to price manipulation risk owing to continuing reliance on manual processes and human intervention for certain hard-to-value securities. Risk managers therefore need to continue to focus on improving controls in this space, in particular, to ensure that independent valuation control groups are able to attract high caliber valuation experts, that traders are not able to manage the pricing process directly, that valuation models are certified and consistently followed and that manual processes are kept to a minimum. Case studies of best practices in this space will be reviewed in a later column.