JPMorgan Chase & Co's trading position that led to a $2-billion loss may call for increased Federal Reserve scrutiny of risk management as the central bank steps up its post-crisis supervision of lenders.
Fed officials are gathering more information about the trading position, which they have known about for several weeks, according to a person familiar with the matter.
They don't view it as their role to approve or reject individual trades, the person said. Rather, their job is to ensure firms have enough capital to withstand losses, said the person, who wasn't authorized to discuss the matter and asked not to be identified.
JPMorgan Chief Executive Officer Jamie Dimon announced the "egregious" trading loss on May 10, saying there were "many errors, sloppiness and bad judgment."
Dimon said on a conference call with analysts that while the firm kept its regulators "up to date," he "didn't have great information" to share with them.
"The fact that Jamie Dimon could come out and make some of those statements" raises "lots of questions about who was watching the store," said Robert Eisenbeis, chief monetary economist at Sarasota, Florida-based Cumberland Advisors and a former Atlanta Fed research director. The Fed should be "going in and looking at the internal controls and monitoring procedures that the institution is taking, and stress those."
Dimon announced the trading loss two months after the biggest US bank by assets passed a Fed stress test that put its loans and securities through a scenario of deep recession and a simulated global financial market shock.
"It's a relatively small loss in a bank of that size," said William Isaac, a chairman of the Federal Deposit Insurance Corp in the 1980s and now a senior managing director at FTI Consulting Inc. "The thing that's rattling people is JPMorgan Chase is widely considered one of the strongest and best banks in the world."
JPMorgan shares fell 9.3 per cent, the most in nine months, to $36.96 at the close of trading yesterday in New York. The KBW Bank Index of 24 financial stocks was down 1.2 per cent.
Krishna Guha, a spokesman for Federal Reserve Bank of New York, JPMorgan's regulator, declined to comment. JPMorgan spokesman Joseph Evangelisti also declined to comment.
The Commodity Futures Trading Commission, the main US derivatives regulator, has been reviewing JPMorgan's derivatives trading activities since last month, according to a person who was briefed on the matter and spoke on condition of anonymity because the review is private. The CFTC hasn't opened an enforcement action against the bank, the person said.
The US Securities and Exchange Commission opened a preliminary investigation into JPMorgan's disclosures related to the trades, according to another person briefed on the probe who spoke on condition of anonymity because the matter isn't public.
Fed officials need to examine their own analysis of the bank's risk management procedures and its governance, said Dino Kos, a former executive vice president at the New York Fed. He said Fed supervisors should ask questions about how information on risk is collected and reported, and what is done with it once it reaches the executive level.
"What information is the board of directors being given? What is being sent to the CEO and the senior managers on the risk committee?" said Kos, now a managing director at Hamiltonian Associates, a New York economic research and consulting firm. "There is a separate question about judgment" if Dimon understood the risks the bank was taking, he said.
Daniel Tarullo, the Fed governor in charge of supervision, has emphasized that boards need to serve as independent monitors of risk. The stress-tests were focused on whether a bank's staff and boards can put together a plan to manage capital through times of economic turmoil.
Checks and Balances
"It's exceedingly important for boards to be involved, not in micromanaging, but providing checks and balances on a company," said Timothy Smith, a senior vice president at Boston-based Walden Asset Management, which manages $2.2 billion. "It's a fair question to ask if Jamie Dimon says this was just sloppy, where was the board as the $2 billion was being lost?"
Tarullo has piloted one of the biggest overhauls of financial supervision in the central bank's history. In addition to annual stress tests, the Fed routinely looks at risks across all large banks in a new group formed from economists, examiners, and computer modelers.
The Fed has also boosted its surveillance of financial markets and bank lending to spot asset bubbles that may lead to financial turmoil. Chairman Ben S. Bernanke established a new Office of Financial Stability Policy and Research, which was instrumental in shaping tougher guidelines earlier this year on high-yield, high-risk bank loans.
Fed Letters
At the end of April, the Fed sent letters critiquing banks on their stress-test performance. Among the red flags Fed officials spotted: the amount of capital that risk managers said one bank might lose in stress test scenarios was at odds with the payouts that the board wanted to make in the form of dividends or share buybacks.
Peter Wallison, a former member of the Financial Crisis Inquiry Commission, said boards are "neither equipped to understand the scope of a bank's risks or engaged full-time in the bank's business."
Instead, "What boards can do is appoint a risk committee, to which the bank's risk manager will report, independently of the CEO. The risk committee can then keep the board apprised of the risks communicated by the risk manager. However, this requires very deft management," said Wallison, a fellow in financial policy studies at the American Enterprise Institute in Washington.
Ratings Reduction
Fitch Ratings, which yesterday lowered JPMorgan's credit grade by one level to A+ from AA-, said the $2 billion loss "raises questions regarding JPM's risk appetite, risk management framework, practices and oversight."
JPMorgan's losses weren't large enough to pose a risk to the bank or the broader financial system, said Robert Engle, a winner of the 2003 Nobel Prize in economics and a professor at New York University's Stern School of Business.
JPMorgan's tier 1 common capital ratio, a measure of capital strength tracked by the Fed, never dipped below 5 per cent in the 2012 stress scenario despite a hypothetical $28 billion in trading and counterparty losses and $56 billion in loan losses, according to results of the stress tests released on March 13.
"I don't think this particular number is big enough to get in the way of the capital buffers that JPMorgan has," Engle said of the $2 billion loss.
Systemic Institution
"We think of JPMorgan as being one of the more systemic institutions because it is so big," said Engle, who helped develop a model of systemic risk at the Stern school's Volatility Institute. "But because it is big, a loss like this is not going to bring it to its knees."
The Financial Stability Oversight Council, a group of regulators charged with preventing a financial crisis, wasn't convened to discuss the JPMorgan loss and has no plans to meet, said a Treasury Department official who declined to be identified. The council's chairman is Treasury Secretary Timothy F. Geithner, and it includes Bernanke.
