In seeking to improve its oversight of JP Morgan, Fed misses credit default swap trade

Periodically an article comes out and confirms everything that your humble blogger has been saying about a topic.  The NY Times Dealbook carried such an article on bank supervision and the $5 billion trading loss at JP Morgan.

For example, your humble blogger has been saying the the purpose of bank supervision is not to approve or disapprove of any specific exposure, but rather to estimate the potential for loss from an exposure and ensure that there is adequate book capital to absorb the loss.

Regular readers know that I proposed a new model for bank supervision based on ultra transparency.  With banks required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants can assist the regulators in supervising the banks.  This addresses a number of the problems the Fed encountered in trying to supervise JP Morgan.

First, with this data, nobody is dependent on the bank's internal models or reports.  Instead, market participants including competitors can apply their analytical expertise to assessing the risk of each bank.  As a result, regulators have the benefit of being able to tap the market experts and comparing their findings to the regulators' own internal analysis.

Second, with this data, market participants will adjust the amount and price of their exposure to each bank to reflect the current risk of the bank.  This is known as market discipline and acts as a restraint the bank takes on its risk.

Third, with this data, regulatory capture becomes a non-issue.  Market participants are not susceptible to being captured by the banks nor can officials of the banks push them around.

After the financial crisis, regulators vowed to overhaul supervision of the nation’s largest banks. 

As part of that effort, the Federal Reserve Bank of New York in mid-2011 replaced virtually all of its roughly 40 examiners at JPMorgan Chase to bolster the team’s expertise and prevent regulators from forming cozy ties with executives, according to several current and former government officials who spoke on the condition of anonymity. 

But those changes left the New York Fed’s front-line examiners without deep knowledge of JPMorgan’s operations for a brief yet critical time, said those people, who spoke on the condition of anonymity because there is a federal investigation of the bank.

With ultra transparency, regulators at all times would have access to the best expertise the market can provide without the cozy ties.

Forced to play catch-up, the examiners struggled to understand the inner workings of a powerful investment unit, those officials said. At first, the examiners sought basic information about the group, including the name of the unit’s core trading portfolio....

They “couldn’t ask tough questions,” said a former official who was based at JPMorgan.

With ultra transparency, this would have been a non-issue as the market experts could have gotten them up to speed and helped them identify what were the tough questions to ask.

The situation highlights the fundamental challenge of policing big banks, even after the crisis.... 

Even so, the current and former officials said the Fed examiners faced a daunting task, given that the bank has more than $2 trillion in assets. 

Faced with overseeing large banks like JPMorgan, regulators cannot possibly comb through every loan document or trade.

Since the 40 examiners cannot comb through every loan document or trade, it makes sense to end the regulators' monopoly on this information and let market participants who could have access to the data. Hence the reason for requiring ultra transparency.

Instead, they rely primarily on a bank’s own analysis of its risk, a broad portrait that can mask problems. 

“They aren’t examiners as much as they are overseers, forced to peer over the banks’ shoulders,” Bart Dzivi, who served as special counsel to the Federal Crisis Inquiry Commission, said in reference to the general state of large bank supervision.

The New York Fed’s shake-up only aggravated a continuing struggle between JPMorgan executives and regulators from the Office of the Comptroller of the Currency, which supervises banks. 

For years, the agency, with dozens of its own examiners at JPMorgan, worried that the bank had been miscalculating how much money it could lose in extreme situations, according to the current and former officials.

Examiners are overseers whose main mission is to estimate the size of the loss that could occur as a result of the exposure and ensuring there is adequate book capital to absorb the loss.

Examiners challenged the executives who stonewalled, and the conflict left agency supervisors with an incomplete picture of the bank’s risk. At one point in early 2012, JPMorgan briefly stopped providing examiners with an important risk estimate for the chief investment office, the group at the center of the recent trading losses, the current and former officials said. Executives told examiners not to worry. 

For their part, regulators say it is not their job to micromanage or remove risk altogether. Their goal is to protect the financial system broadly....

Examiners do not approve or disapprove of any position the bank takes as this would put them into the role of allocating capital across the financial system.

Years before the multibillion-dollar losses, the embedded staff from the Office of the Comptroller of the Currency questioned how JPMorgan was estimating its risk.... 

One report, for example, estimated that the bank’s chief investment office would lose no more than $400 million in a two-week period even under the most stressful market conditions, one of the government officials said.

Confirmation of the focus by examiners on the potential for loss.

Some of the agency’s examiners said they had battled to get senior executives at JPMorgan to share how the bank’s internal stress tests were structured. One of the former officials described the analysis as a virtual black box, in which the bank provided few details about the variables.

One of the reasons for requiring ultra transparency is that the important information is the actual exposures and not some 'black box' model.  The model is a form of opacity that hides what is really going on.

The model also provides the bank with a convenient excuse if one of its gambles blows up.  It was the "fault" of the model and not the simple fact that the bank was gambling that was to blame.  As a result, the focus is on developing a new model and not stopping the gambling.

JPMorgan executives resisted providing any additional information about the stress tests, including how they chose the variables used to forecast potential losses. The bank routinely pushed back scheduled meetings to review the matter, the current and former officials said. 

“We were most concerned with the fact that the stress test is one of the most important risk management reports,” said one of the former bank examiners, and the test’s methodology “had not been reviewed by regulators.”....

Having adopted the Japanese model for handling a bank solvency led financial crisis and with it policies like regulatory forbearance, the bank supervisors have lost their moral authority to compel the release of information.  What is worse is the actions by JP Morgan's executives confirm this and they are not concerned that the bank supervisors will take any action against them.

Without ultra transparency, bank supervisors are at the mercy of bank management in analyzing the risk the bank is taking.

With ultra transparency, bank supervisors can turn to market experts outside of the bank for help in analyzing the risk the bank is taking.  More importantly, because the data is made available to all market participants market discipline can be enforced to restrain risk taking.