JPMorgan's Whale in a Fishpond

Former Kansas City Fed President Thomas Hoenig suggested banks that are too big to fail are also too big to exist, and should be broken up.

LONDON - Former Kansas City Fed President Thomas Hoenig suggested banks that are too big to fail are also too big to exist, and should be broken up ("Financial reform: post-crisis?" Feb 23, 2011).

But are banks that are too big to fail also too big to trade and too big to manage properly?

JPMorgan Chase & Co's reported hedging losses suggest the bank, famed for a disciplined approach to measuring and managing risk, is struggling to cope with increased demands of scale, after swallowing up a string of other institutions in the last decade.

Massive hedging losses by the bank's Chief Investment Office are the second time in under two years JPMorgan has been forced to own up when a big trade went wrong and the bank struggled to extricate itself because of the size of its positions.

In 2010, the bank lost several hundred million dollars on coal trades. Blythe Masters, the head of the bank's commodity trading division, owned up to a "rookie error" when the bank's management and risk oversight functions failed to prevent a large position that overwhelmed the liquidity available in the thinly traded coal market, and proved expensive to exit.

Now Chief Executive Jamie Dimon has issued a similar apology for big loss-making positions at the Chief Investment Office. "In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored," he told a conference call on May 10.

HUBRIS AND COMPLACENCY

The CIO hedge is an order of magnitude larger than the earlier problem in coal. And it was supposedly a hedge where the coal trade was speculative.

But the common element of both is that the bank took positions that were so large relative to the rest of the market they were dangerously illiquid. When the trade went wrong JPMorgan could not get out without making its losses even worse.

The question is why the bank is repeatedly taking such dangerously large positions?

The short answer is over-confidence among the bank's traders and managers, coupled with a failure of proper systems and controls.

Dimon has admitted the trade was poorly reviewed and monitored.

In a front-page article today, the "Wall Street Journal" suggests the operations of the Chief Investment Office were scrutinised less closely than other parts of the bank, perhaps because it had contributed $4 billion of net income or around 10 percent of the bank's profits over the last three years ("Inside JPMorgan's blunder" May 18).

"The big lesson I learned: Don't get complacent despite a successful track record," Dimon said in an interview earlier this week. "No one or no unit can get a free pass."

But it is too simplistic to blame the problems entirely on hubris and occasional lapses of risk control. JPMorgan has been a consistent pioneer of more sophisticated approaches to measuring and controlling risks in both its trading book and its banking portfolio.

Unlike most investment banks, JPMorgan escaped largely unscathed from the subprime mortgage crisis. The success of JPMorgan's risk management gave Dimon a bully pulpit to lecture regulators and lawmakers on the banking system's ability to manage its own risks without micro-management by banking supervisors.

SIZE IS THE ROOT PROBLEM

The real problem arguably stems from JPMorgan's size. As the bank has expanded through a series of acquisitions (including Chase, Washington Mutual, Bear Stearns, parts of Sempra Commodities), as well as organic growth, it seems to have been encouraged or even compelled to take larger positions.

There are several strands to the size problem. First as the bank gets bigger, the size of trades needed to "move the needle" of its results has increased significantly. For a bank of JPMorgan's size, putting on oil trade expected to produce an extra $10 million of profits is immaterial. The bank needs trades that will yield tens of millions, hundreds of millions or even billions of dollars.

JPMorgan has suggested the Chief Investment Office was set up to hedge the bank's aggregated risk exposure. But the fact that it contributed so much of the bank's profits over the last three years suggests it may have been seen as a profit centre.

That leads on to the second part of the size problem. Even if the bank thought it was hedging, the aggregated risks across all its divisions are so large it needs enormous hedges to offset them. But there are very few markets and instruments which can provide that much liquidity and hedging capacity. In effect, JPMorgan has become a whale in a fishpond.

From the press reports, the recent failed hedge was an attempt to hedge the bank's exposure to a broad macroeconomic downturn especially in Europe.

I have cast doubt elsewhere on whether such large portfolio hedges are really effective and should receive special hedging treatment by regulators. But even if the logic of portfolio hedging is valid, there is no way a bank of JPMorgan's size can effectively hedge macroeconomic or systemic risks.

The amount of potential macroeconomic and systemic risk in the portfolio of a bank the size of JPMorgan is enormous. Who or what could possibly take it on? Moreover, macroeconomic and systemic risks are by their nature common across the entire financial system.

It is almost impossible to identify other market participants willing to take them on in anything like the required size.

Moreover, if JPMorgan tries to hedge certain macro risks, other big investment and commercial banks are likely to try the same strategy, assuming they have the same information and roughly similar outlooks.

The only way JPMorgan could successfully execute this type of hedge would be to find another set of hedge funds or investment banks that were as optimistic about the outlook as JPMorgan was gloomy. If JPMorgan was right in its gloomy call, however, would the other banks and hedge funds be in a position to pay?

Systemic and macro risks are by their nature difficult if not impossible to hedge. The only effective hedge is to have lots of cash and other liquid assets on hand, a reasonably well-matched set of assets and liabilities, and the backstop of a lender of last resort to maintain confidence and provide unlimited liquidity.

Finally, JPMorgan seems to have fallen victim to control problems associated with managing risks across an enormous diversified institution.

The bank's portfolio model relies on aggregating and managing risks centrally through a powerful chief executive and Chief Investment Office. But any centralised system of control is likely to struggle with a bank and portfolio as large and diverse as JPMorgan's has become.

Dimon's response has been to call for renewed rigor within the existing process, painting losses as an unfortunate aberration. But the real problem appears structural.

The solution is to decentralise risk management closer to the frontline, leaving the centre with a more detached and impartial supervisory role, or more radically to think about reducing the size and complexity of the bank.

Dimon has been fiercely critical of regulators like Hoenig who have called for large institutions to be broken up and subject to much more intrusive supervision. But Dimon's failed hedging strategy has proved Hoenig right. (Editing by Alison Birrane)