A recent essay published by PolicyMic regarding the announcement of a $2 billion trading loss at JPMorgan is misleading and populist. Jamie Dimon, the JPM chief executive officer, has stated publicly that the bank did not intentionally assume a large transactional risk that led to the loss. Dimon also said that the incident was not a violation of the spirit of the Volcker Rule.
It would be best if talking heads, politicians, and anti-business gadflies waited for the details of the trading loss to become public before condemning the bank and calling for even more regulation.
This essay will clarify what the Volcker Rule attempts to regulate and what actually may have taken place at JPM. Regarding the latter, I have no firsthand knowledge of any of the events surrounding the loss and have no relationship with the bank. I am presenting my personal opinions and observations based upon what I have read and the interviews with Jamie Dimon conducted on Meet the Press.
A derivative is a security that creates an exposure relating to a certain type of asset or an event. It can be risky if unhedged, or it can be benign if an owned asset or another derivative counteracts the effect of the first transaction. For instance, if an airline wishes to lock in the cost of fuel for a finite period of time, it might create a derivative (usually through a financial institution) that essentially immunizes it from price movements, up or down. Essentially, the airline will receive cash if prices go up, or pay cash if prices go down. Its fuel cost is thereby fixed.
As mentioned above, a financial institution such as a bank could arrange this transaction. If the bank acted as the counterparty to the transaction and did not hedge its exposure, it would be making a bet on future oil prices. If prices go down, the bank would receive cash from the airline, if they increased, the bank would pay the airline. It is this decision that the Volcker Rule is meant to regulate. Lawmakers do not believe banks should be betting on oil prices, and so, they are amenable to banks coordinating hedge transactions but not acting as a counterparty. The theory is that large systemic bank risk from these transactions endangers the economy and resultant bank catastrophes will fall on the shoulders of the taxpayers.
Banks are in the risk business. They lend money to businesses after completing intensive credit analysis (according to JPMorgan’s annual report, loans totaled over $700 billion at the end of 2011). Most bank exposure to loans is not hedged, meaning that if borrowers default, banks will likely incur a loss. These institutions reserve against future loan losses. If the reserves are adequate to cover loan losses and profits from loans exceed annual additions to loan reserves, the bank will be profitable, all other things being equal.
It is the banks’ business to lend money to companies, maintain the resources to effectively assess and counteract risk and make significant profits from their activities. Regulators monitor lending activities to ensure that risks are acceptable and loan loss reserves are adequate.
In recent years, banks began to take on much riskier investments. For instance, they have bought blocks of corporate stock for their own account anticipating an increase in value. Or bank traders may have wanted to gamble on the movement of various indices and commodities, exotic securities and real estate. These are the transactions that Volcker addresses. They are risky and far afield from traditional banking business. It should be noted that these “proprietary trading” activities have generated huge profits over the years. Nevertheless, they require that banks take undue risk using depositor money, some of which is guaranteed by the federal government. Most of these operations have already been discontinued in anticipation of final regulations from Volcker.
Another important business at many financial institutions is hedging transactions for customers. If a corporation, a government or a pension fund has exposure, it may want to mitigate it. Banks frequently provide hedges. But, almost immediately, if banks ultimately live up to the spirit of Volcker, they will sell or hedge their exposure with a third party. In the past, some banks retained these exposures if they thought they were good bets. It is this business that critics have dubbed “casino” investing.
Upon selling off the risk, the bank will earn a fee for providing the hedge and will bear no risk moving forward regardless of the movement of the security used to create the hedge.
For example, if Corp A has a monetary risk to Corp B, it may ask a bank to provide a credit hedge. A bank may be willing to accept the risk of default by Corp B for a compensatory fee. If Corp B defaults, the bank must pay Corp A all the money owed to Corp A by Corp B.
If the bank does not transfer the risk to a third party, it is “long” risk to Corp B and is gambling on its future solvency.
Now, let’s get back to JPM. The facts are: JPM lost $2 billion or so in a hedge transaction. Dimon has indicated that the loss was not a violation of the Volcker Rule. (Note: the rule is still being negotiated and is not yet in force.) Dimon has also indicated that the loss was a result of a “mistake.” My take on the situation is that JPM attempted to hedge the risk it assumed with a customer, but was unable to do it successfully for some unknown reason.
Does this mean banks are still taking undue risk from proprietary trading businesses? No. Is the banking system threatened? No. Dimon has said that the JPM will still be highly profitable. (Note: The bank earned $18 billion after taxes in 2011 according to its annual report.) Why hasn’t Dimon revealed the exact nature of the transaction that resulted in the loss? Probably, JPM is still unwinding the hedge and would incur more losses if the marketplace were to be apprised of its strategies to do so.
New regulations are not needed to offset human errors; they are needed to prevent undue risk.