JP Morgan report confirms RWA reduction led to CIO loss
JP Morgan has finally lifted the lid on the events that led to its chief investment office (CIO) losing $6 billion in a credit derivatives trading misadventure last year.
An internal report released attributed the error to a misguided attempt to reduce the CIO’s risk-weighted asset (RWA) consumption under Basel 2.5 while maintaining profitability.
For one senior credit portfolio manager at a large European bank, the report highlights the dangerous incentives that have been baked into the market risk capital framework by the Basel Committee on Banking Supervision.
“People are being pushed into the direction of managing RWAs rather than managing actual risk. So what you get in some cases is RWA decreasing but economic risk massively increasing. There is increasing recognition that this is a problem, but there have been no specific proposals from the Basel Committee on how to deal with it. A pattern is developing of regulation being ill-thought out but pushed through anyway because of political pressure. The consequences of this are making themselves apparent, and we’ll need to wait a while before these problems are resolved,” he says.
The report does not identify which specific Basel 2.5 measure the CIO was trying to mitigate, but Risk reported last October that numerous industry experts believe it was the comprehensive risk measure (CRM), which requires banks to hold capital against correlation trading exposures (Risk October 2012, pages 23-26). In its second-quarter 2012 earnings report, the bank pointed to the CRM as being responsible for a $40 million jump in RWAs under Basel 2.5.
The latest report describes the timeline of events. In December 2011, the CIO was told by senior management to cut RWA consumption. The team first tried to do this by unwinding positions – but a $10 billion cut in RWAs was estimated to cost $500 million, and after a mark-to-market loss of $15 million in the early part of January 2012, the exercise was abandoned.
Chief investment officer Ina Drew then asked the department’s traders for other RWA-cutting options. In response, traders came up with the idea of selling protection on a 10-year investment-grade corporate credit default swap (CDS) index and related tranches, both to generate premium to help fund high-yield short positions and to help reduce RWAs on those positions.
This gets to the heart of what some participants claim is a major flaw in the CRM. The Basel Committee allows banks to mitigate capital charges under the CRM by putting in place new, partially offsetting hedges, but the committee sets strict rules on any maturity mismatch between hedge and hedged item under the more basic standardised approach. In contrast, it allows more freedom for banks that use their own internal models – in short, sophisticated banks can attempt to offset RWAs generated by short-dated positions by hedging with longer-dated trades.
In the case of JP Morgan, the CIO had added $20 billion notional in long 10-year index trades by the end of January 2012, but also put on a further $12 billion notional in short five-year trades on the same index.
By January 31, one trader became concerned at the performance of the strategy – the movement of the bought and sold positions was not as correlated as expected, leading to a slow drip of mark-to-market losses. The trader recommended that the CIO stop increasing its notional amounts in these positions, but the advice was ignored. The mark-to-market losses continued to mount, reaching $28 million between February 7 and February 13 alone. By the end of February, the year-to-date losses on the positions had hit almost $170 million. According to the report, Drew and other senior CIO executives failed to alert their superiors to the RWA-reduction strategy, or to the fact it was losing money.
On March 23, trading in the CDS index positions was halted. Soon after that, the firm abandoned a new value-at-risk model, which had been in use since early January, and returned to the older one. On March 30, a senior executive at the CIO emailed a colleague to tell him he’d lost confidence in the team’s “ability to achieve the targeted RWA and their understanding of the synthetic levers to achieve the RWA objectives”.
News of the CIO’s credit positions leaked out into the market on April 10. On that same day, the CIO suffered a $412 million mark-to-market loss, and senior traders began bickering over the faulty positions. Chief executive Jamie Dimon officially announced the losses, which then stood at a total of $2 billion, at a press conference on May 10.
The Office of the Comptroller of the Currency has also released a report into the episode, which requires JP Morgan to remedy the deficiencies in its risk management framework as part of a broad oversight and governance plan. The bank must ensure risk limits and risk reporting accurately reflect the activities undertaken by traders, and that risks are appropriately identified, understood and controlled. Structural risk management strategies will have to be authorised and periodically reviewed by senior management.
This article was first published on Risk