Monday, May 21, 2012

JP Morgan: Who knew what when? Who didn't know what and why?

In his Wall Street Journal Heard on the Street column, David Reilly looks at two important questions about JP Morgan's $2 billion trading loss:  Who knew what when?  Who didn't know what and why?

Your humble blogger would like to answer the second question.

The market did not know what was going on and the reason why is current disclosure practices that leave banks like JP Morgan resembling, in the words of the Bank of England's Andrew Haldane, 'black boxes'.

An example of this is Value at Risk which attempts to measure how much a firm could lose from a trade.
For Congress, questions about the bank's risk measures are particularly important. That is because issues around them also touch on the way banks manage capital and report risk to investors. 
In some cases, value-at-risk models help to determine how much capital banks hold against trading assets. That gives them leeway since these are internally generated models. 
The danger: Banks have an "incentive to game their model to lower their regulatory capital requirement," says former Federal Deposit Insurance Corp. Chairman Sheila Bair. The risk grows if banks can tinker, as J.P. Morgan's episode shows may be possible. 
J.P. Morgan's experience is also a reminder that the risk measure varies among banks. Indeed, the Office of the Comptroller of the Currency, in a quarterly report on derivatives activity, "cautioned" that the risk gauge can mislead. 
The OCC said that J.P. Morgan, Goldman Sachs and Morgan Stanley calculate the measure with confidence there is a 95% chance that losses will be within the reading. If the firms used a 99% confidence level like "Bank of America and Citigroup,their Var estimates would be meaningfully higher," the OCC said. 
In light of that, J.P. Morgan is a reminder for both banks and investors that attempts to measure risk, let alone tame it, are fraught with hazard.
This is the reason that Jamie Dimon didn't want to see summary reports or analyzes of the trade, but rather wanted ultra transparency and the ability to see the trading position himself.  He wanted the detail data so he could see what was going on.

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