Acouple of weeks back, JPMorgan Chase reported a trading loss of $2 billion (which may well go up further), in its chief investment office (CIO). As per JPMorgan’s 2011 published balance sheet, the function of the CIO is to “manage capital, liquidity and structural risks of the firm" (a strange combination of functions), presumably by taking positions in various markets. The Dodd Frank regulations (which are still to come into force) also permit hedges “in connection with and related to individual or aggregated positions" including, presumably, the loan book.

The CIO had made a profit of $5.09 billion in the three preceding years (The Wall Street Journal, 17 May). This would include earnings on the surplus liquidity managed by it, and both fair value and realized gains/losses on the macro-level hedges of “structural risks". Focusing on the latter, on first principles, the change in the value of the derivative contract used as a hedge has to be opposite to, and compensate for, the change in the value of the underlying exposure(s), either fully or substantially. How effective were the hedges in earlier years? What is the correlation between various credit risk indices used and JPMorgan’s own historical losses from “structural risks"? In any case, should not any value at risk (VaR) measure or limit apply to the combined portfolio of the CIO’s book and the changes in the value of the exposures it was hedging, for reporting or disclosure purposes? Curiously, JPMorgan corrected the VaR of the CIO portfolio to almost double the earlier number, after the loss was acknowledged more than a month after the financial media publicized the strange goings-on. Was the revision a simple calculation/methodology error—or something else?

Shyamal Banerjee/Mint

While, even in genuine hedging of structural risks in the market, there would inevitably be “basis" risk, this surely goes up with the aggregated credit exposures and complexity of the hedges. The so-called hedges were positions in a complex, synthetic credit index. Were the positions genuine hedges, taken in full consciousness of the basis risk or were they aimed at making profits on their own? (Is “hedging" supposed to be a profit-making activity?) This suspicion gathers strength by considering another of the CIO’s activities: the surplus liquidity was invested in residential mortgage-backed securities and highly complex collateralized debt obligations/collateralized loan obligations to increase yields. Given what happened in the market for such securities barely a few years back, these investments clearly had significant liquidity risks: surplus liquidity seems to have been “managed" by investing in instruments which increased liquidity risks but gave higher yields.

Complex instruments and operations, and the JPMorgan case, remind me of a story from Hindu mythology, of Bhasmasur, an asur created by the surs (gods), to kill their opponents, the asurs. Bhasmasur had the unique gift of converting anybody into ash (bhasma) by putting his hand on the head of the enemy. After killing all the asurs, Bhasmasur turned on the surs themselves. Banks created complex derivatives to render pricing and risks opaque, describing them as “hedges" (or safe investment instruments) to fool less knowledgeable customers. Too many unsophisticated players (including in India) have lost huge sums by looking at hedging as an avenue of making money. Has JPMorgan too fallen into that temptation? JPMorgan was not only the creator of the VaR models and methodology for managing risk now at the heart of capital regulation, but also of credit derivatives. Has JPMorgan itself become yet another victim of the Bhasmasur of complexity—of organization, of instruments, of difficulties in controlling risks? Or was the CIO merely a fig leaf for proprietary trading, a way to evade the so-called Volcker Rule?

The incident also raises several questions over the regulatory philosophy of the last couple of decades.

?Is it safe to allow banks to develop their own risk measurement models for calculating capital charges?

?Is the quasi-ideological faith in the wisdom and ability of the participants in financial markets, their rational expectations, really warranted? Or is this a way for regulators to reduce their own responsibility?

There are reports that the Basel committee is reviewing the use of VaR to measure risks and capital. But this apart, as our central bank takes steps to implement Basel III, there is a strong case for it to develop its own skill base, in both domain knowledge and mathematics, to have an independent view having regard to our needs and environment, rather than blindly “copy paste" Basel regulations.

A.V. Rajwade is a risk management consultant, columnist and author.

Comments are welcome at theirview@livemint.com

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