Author and derivatives manager Satyajit Das, ironically a neoliberal, has a superb article at the Minyanville, which elaborates on how regulations and government policies, which I earlier posted, has shaped the incentives of Too Big to Fail institutions to take excessive risks and the failure of regulators to prevent them (all bold emphasis mine)
The large investment portfolio is the result of banks needing to maintain high levels of liquidity, dictated by both volatile market conditions and also regulatory pressures to maintain larger cash buffers against contingencies. Broader monetary policies, such as quantitative easing, have also increased cash held by banks, which must be deployed profitably. Regulatory moves to prevent banks from trading on their own account -- the Volcker Rule -- have encouraged the migration of trading to other areas of the bank, such as liquidity management and portfolio risk management hedging.
Faced with weak revenues in its core operations and low interest rates on cash or secure short term investment, JPMorgan may have been under pressure to increase returns on this portfolio. The bank appears to have invested in a variety of securities, including mortgage backed securities and corporate debt, to generate returns above the firm’s cost of capital.
Again, the failure of models…
Given JPMorgan vaunted risk management credentials and boasts of a “fortress like” balance sheet, it is surprising that the problems of the hedge were not identified earlier. In general, most banks stress test hedges to ensure their efficacy prior to implementation and monitor them closely.
While the $2 billion loss is grievous, the bank’s restatement of its VaR risk from $67 million to $129 million (an increase of 93%) and reinstatement of an older risk model is also significant, suggesting a failure of risk modeling.
The knowledge problem…
Banks are now obliged to report positions and trades, especially certain credit derivatives. This information is available to regulators in considerable detail. Given that the hedge appears to have been large in size (estimates range from ten to hundreds of billions), regulators should have been aware of the positions. It is not clear whether they knew and what discussions if any ensued with the bank.
External auditors and equity analysts who cover the bank also did not pick up the potential problems. Like regulators, they perhaps relied on assurances from the bank’s management, without performing the required independent analysis.
Hayek’s “Fatal Conceit” or the pretentions of knowledge by regulators to apply controls over society or the marketplace…
Legislators and regulators now argue that the rules for portfolio hedging are too wide and impossible to police effectively. In addition, the statutory basis may not support the rule. The legislative intent was intended only to exempt risk-mitigating hedging activity, specifically hedging positions that reduce a bank’s risk. Interestingly, drafters of the portfolio hedging exemption recognized the potential problems, seeking comment on whether portfolio hedging created “the potential for abuse of the hedging exemption” or made it difficult to distinguish between hedging or prohibited trading.
In a recent Congressional hearing, Former Fed Chairman Paul Volcker, who helped shape the eponymous provision, questioned whether the volume of derivatives traded was “all directed toward some explicit protection against some explicit risk.”
The pundits have been quick to suggest that the losses point to the need for more stringent regulations. But it is not clear that a prohibition on proprietary trading would have prevented the losses.
In practice, without deep and intimate knowledge of the institution and its activities, it is difficult to differentiate between legitimate investment and trading of a firm’s surplus cash resources or investment capital.
It is also difficult sometimes to distinguish between hedging and speculation. The JPMorgan positions that caused the problems were predicated on certain market movements -- a flattening of the credit margin term structure -- which did not occur.
Hedging individual positions is impractical and would be expensive. It would push up the cost of credit to borrowers significantly. All hedging also entails risk. At a minimum, it assumes that the counterparty performs on its hedge. But inability to legitimately hedge also escalates risk of financial institutions. Ultimately no hedging is perfect. or as author Frank Partnoy told Bloomberg: “The only perfect hedge is in a Japanese garden.”
Additional regulation assumes that the appropriate rules can be drafted and policed. Experience suggests that it will not prevent future problems.
Bankers and regulators have always been seduced by an elegant vision of a scientific and mathematically precise vision of risk. As the English author G.K. Chesterton wrote: “The real trouble with this world [is that]…. It looks just a little more mathematical and regular than it is; its exactitude is obvious but its inexactitude is hidden; its wildness lies in wait.”
In reality it is not just “without deep and intimate knowledge of the institution and its activities” but about having the prior knowledge of the choices of the individuals behind these institutions. This is virtually unknowable.
Finally, the monumental government failure…
How do regulatory initiatives and monetary policy action affect bank risk taking? Central bank policies are adding to the problem of banks in terms of large cash balances which must be then invested at a profit. The implementation of the Volcker Rule may have had unintended consequences. It encouraged moving risk-taking activities from trading desks where the apparatus of risk management may be marginally better established to other parts of banks where there is less scrutiny.
The most important question remains whether any specific action short of banning specific instruments and activities can prevent such episodes in the future. It seems as Lord Voldemort observed in Harry Potter and the Deathly Hallows Part 2: “They never learn. Such a pity.”
People who are blinded by power and or the thought of power never really learn.
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