The great strength of any organization – and indeed our country – lies in our ability to face problems, to learn from our experiences and to make necessary changes.
Jamie Dimon, CEO & Chairman of JPMorgan Chase (January 13, 2010)
2 billion is the number that represents the stunning loss revealed at JPMorgan Chase & Co. this week. The losses came from poor trades executed by an entity nicknamed “the London Whale.” According to the latest Bloomberg report, the London office held a massive position on synthetic credit securities that led to the $2 billion loss. In response, the stock fell 8.4% from $40.74 to $37.30 during last Friday’s trading session. Two rating agencies have already taken notice. Fitch Ratings has downgraded JPMorgan Chase’s long-term credit rating from AA- to A+. The agency notes that the continued positions in complex securities raise questions on the bank’s risk management and liquidity. Standard & Poor’s followed suit by downgrading the outlook for the company.
In comparison to other notable trading losses, JPMorgan’s blunder is not all that shocking. Morgan Stanley’s $9 billion trading loss is the largest in history. Mitsubishi UFG wrote a cheque to prevent the investment bank from failing in 2008.
This Time is Different
However, this loss is different from the myriad of bad bets. JPMorgan is known as one of the strongest banks and is the largest by assets under management. Jamie Dimon, its CEO, is regarded by the industry as a supreme risk manager. Duff McDonald who authored a 2009 biography on Dimon, said “He’s not where he is because he’s a maker of mistakes.” At the young age of 50, Dimon took over as the head of JPMorgan Chase. Graduating with a MBA from the Harvard Business School and having worked his way up in American Express, he was well-trained for the role.
JPMorgan’s reputation during the financial crisis has been nothing short of remarkable. The bank remained in the black throughout 2008 and 2009. In the same period of economic turmoil, the bank acquired two of its largest competitors: Bear Stearns and Washington Mutual. These acquisitions prevented some of the otherwise largest bank failures in history. The ability of JPMorgan to buy out these institutions reflects its strong balance sheet and robust risk management.
As a result, the $2 billion loss sends a shockwave throughout the financial industry. The financial crisis of 2008 was caused partly by the derivatives trading market, and the excessiveness of risk-taking by financial institutions. As the top student among a class of financial institutions fails, the future of the derivatives trading market is likely to change. As well, not every bank can survive after a $2billion loss.
Secondly, the U.S. Congress will be meeting this week to discuss the implementation of the Volcker Rule, part of the larger 2010 Dodd-Frank Bill Wall Street Reform and Consumer Protection Act aimed at regulating the financial industry. Although the Volcker Rule is not yet finalized, an October 2011 draft summarized the major implications the Volcker Rule will have on financial industry. With this event occurring, regulators are likely to move forward with a set of stringent rules despite large opposition from Wall Street and Bay Street.
The Volcker Rule
One of the goals of the rule is to reduce the risk in the financial system in order to prevent a similar crisis that occurred in 2008. Banks would be restricted for trading proprietarily. In other words, banks would only be permitted to make trades on the clients’ behalf, for hedging purposes, and for market making. According to Standard & Poor, proprietary trading is already being shifted out of many financial institutions and will not have significant impact on their performance.
The Volcker Rule also aims to differentiate the operations between commercial and investment banks, and those of hedge funds and private equity firms. Banks are limited to invest up to 3% of their Tier 1 capital (equity capital and disclosed reserves). In anticipation of the rule, banks have begun their transition in selling off their positions in hedge funds and private equity firms.
Kian Abouhoussien, a JPMorgan bank analyst estimated that bank revenues would fall by 12-46%. In general, analysts believe that the ROE ratios of banks that stood at double-digits prior to the financial crisis are not likely to return anytime soon.
Implications on the Canadian Financial Regulatory Scene
According to the OSFI, Canada’s financial institutions’ regulator, the Volcker Rule would significantly affect Canadian financial institutions in managing their own risk. Many of the systems that Canadian banks use are based in the US. Thus, despite being in different regulatory territories, the U.S. rules will inevitably apply to Canadian financial institutions as well.
The liquidity of Canadian assets would also be affected. In a written letter in response to the Volcker Rule, Canada’s five largest banks believe that the transactions would restrict the ability of US investors to purchase Canadian securities. More rules means higher compliance costs to keep up with regulatory standards and compliance policies.
The Canadian banking sector is in a much different position compared to the rest of the world in terms of risk. Standard & Poor’s BICRA economic and industry risk scores indicate that only Switzerland is in the same peer class. Canada’s regulatory track record has proven to be highly effective. There have been no bank failures since 1985. Since 1982, OSFI has placed a leverage limit of a 20x multiple of assets to capital. In consideration of all these factors, the Canadian regulatory framework is considered strong, and does not require additional rules.
It is apparent that even the management teams of these financial institutions do not fully know or understand the trades that are occurring from within. In the words of Jamie Dimon in the wake of the financial crisis: “The great strength of any organization – and indeed our country – lies in our ability to face problems, to learn from experiences and to make necessary changes.” These changes are coming into place, and despite outcries on bank profits, the financial industry will need to adapt. Perhaps managing $2 trillion in excess of assets is not too big to fail, but is simply too large to manage.