Friday, February 1, 2013

'London Whale' demonstrates why transparency ends banks taking proprietary bets

The Wall Street Journal carried an article on how the 'London Whale' sounded the alarm over concerns about the risk of his trading position.

In doing so, he demonstrated why transparency ends banks taking proprietary bets.  Specifically, transparency when banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
The J.P. Morgan Chase & Co. trader known as the "London whale" tried to alert others at the bank to mounting risks months before his bets ballooned into more than $6 billion in losses, according to people familiar with emails reviewed by J.P. Morgan and a U.S. Senate panel..... 
In one instance, Mr. Iksil told another trader that the size of his bets was getting "scary," according to emails in a Jan. 16 report by J.P. Morgan and to the people familiar with the emails.... 
The panel, led by Sen. Carl Levin, D-Mich., also is looking into whether J.P. Morgan failed to disclose crucial information to its primary bank regulator, the Office of the Comptroller of the Currency, and whether the OCC failed to press the bank for details about how it managed its risks. The bank acknowledged previously that its information was wrong early in 2012. 
The OCC prepared an assessment of its performance and shared it with the subcommittee, said people familiar with the OCC report. ...
Like the Bank of Italy with the Monte Paschi derivative scandal, the OCC was in position, but failed to take action.

Your humble blogger is not surprised that the OCC did nothing.  Financial regulators do not see it as their role to question individual positions as this get them into allocating capital across the economy.  Instead, the regulators focus on whether the bank has the ability to absorb the 'expected' losses on the position.

Rather than change the regulatory focus to allocating capital across the economy, your humble blogger has argued that the regulators' information monopoly must be ended and the banks required to provide ultra transparency.  With this data, the markets can exert discipline on the banks by questioning individual positions.
Emails reviewed by the subcommittee and J.P. Morgan show Mr. Iksil was worried about the trades as early as January 2012, according to the people familiar with them. 
Mr. Iksil and another London trader, Javier Martin-Artajo, also suspected in early 2012 that other traders in a different part of J.P. Morgan leaked their positions to outside hedge funds and took opposing positions to those held by Mr. Iksil's group; both later communicated these suspicions to internal investigators, said people familiar with the case....
Please re-read the highlighted text again as it explains exactly why requiring the banks to provide ultra transparency will end the banks taking proprietary bets.

Simply put, if other traders know your positions, they will trade against you.

At a minimum, their involvement minimizes the amount that can be made on the position.  More likely, and this is what Mr. Iksil and his trade experience, their involvement maximizes the size of the loss on the proprietary bet.

I know I have repeated this point endlessly, but the Volcker Rule is simple to write and enforce.  The rule simply states that banks are not permitted to take proprietary bets and the banks are required to provide ultra transparency so that the market can enforce discipline so no proprietary bets are taken.
Messrs. Iksil and Martin-Artajo were key members of the London team that built a complicated, bearish position in an index that tracks the health of a group of investment-grade companies. Last year, the bets morphed into a not-easily-liquidated position on corporate credit. The wagers accumulated losses when the traders added to their positions instead of unwinding them and the market went the other way. 
On Jan. 30, 2012, according to emails in J.P. Morgan's report and the people familiar with the emails, Mr. Iksil said to Mr. Martin-Artajo that the size of the positions was becoming "scary" and suggested that the bank's chief investment office should take losses, or "full pain," immediately. Mr. Iksil then asked for a Feb. 3 meeting with his managers, including Chief Investment Officer Ina Drew. 
Mr. Iksil told Ms. Drew the portfolio could lose an additional $100 million and that it was possible J.P. Morgan didn't have the right positions in place. 
One of the advantages of requiring the banks to provide ultra transparency is that the banks are not going to take on a position that they cannot easily explain to market participants.
To Mr. Iksil, Ms. Drew didn't appear overly concerned by this potential $100 million loss....  
One week later, Mr. Iksil told those who attended the Feb. 3 meeting aside from Ms. Drew that he would need to expand his positions. He was told to proceed, while concentrating on managing profits and losses. He and the other traders added to their trades in February. Losses reached $169 million by the end of that month. 
At one point, Mr. Iksil told a trader to stop trading a certain credit index because he wanted to observe its behavior. He told Mr. Martin-Artajo about his plans, but Mr. Martin-Artajo, who was Mr. Iksil's direct superior, told him to keep trading. 
In March, traders overseeing the positions began to discuss whether they should place higher estimates for the values of certain trading positions of the CIO group, a step crucial in how they viewed the positions and reported them to investors and other outsiders.... 
Another advantage of ultra transparency is that this internal debate over how to value the trading positions goes away.  The market is going to value the positions so the bank has an incentive to make sure its values are always conservative (it is better to error on the side of undervaluing than overvaluing a position).
But on April 10, losses mounted again, and traders were at odds over how bad it could get. The estimates for that day ranged from $5 million to $700 million; the final number landed at roughly $400 million.... 
Then, on six trading days between April 23 and April 30, losses went up by nearly $800 million more. 
The losses caused Mr. Dimon and other top executives to question whether the traders "adequately" understood the trading portfolio "or had the ability to properly manage it," J.P. Morgan said in its Jan. 16 report.
Requiring the banks to provide ultra transparency removes the issue of whether the traders adequately understand or have the ability to properly manage a trading portfolio.

It is far better to eliminate proprietary bets upfront by having the market discipline of the market trading against a bank position than it is to have the banks lose money because their traders do not adequately understand or have the ability to properly manage a trading portfolio.

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