J.P. Morgan Chase & Co. (JPM), one of the nation’s leading banks, revealed that a London trader racked up trading losses reportedly amounting to $2.3 billion over a 15-day period. The losses averaged over $150 million per day, sometimes hitting $200 million daily. The bank states the trades were done to hedge existing risks.
How did this happen and what are the lessons? The two questions are related.
It appears the individual traded on the basis of observed relationships among various derivative indices. The relationships broke down. Such a breakdown has been at the heart of a number of spectacular financial collapses, notably that of Long-Term Capital Management in 1998 and a number during the financial meltdown of 2007-08.
In short, there is nothing new in what happened. Yet financial institutions permit their traders to make the same kind of dangerous bets. In a Cato Policy Analysis, Kevin Dowd and three co-authors examined some of the technical problems with standard risk models utilized by banks. It is an exhaustive analysis and I commend it to those interested. The analysis goes to the question of how these losses happened.
Now to the lessons.
Major financial institutions continue to take on large risks. Why? The trades made by Morgan ostensibly were to hedge the bank’s exposure to events in Europe. That implies, of course, that risky investments had already been put in place (since they then needed to be hedged). Additionally, the risks were so complex that even a highly skilled staff (which Morgan certainly employs) could not successfully execute hedges on them.
Reports indicate that senior management and the board of directors were aware of the trades and exercising oversight. The fact the losses were incurred anyway confirms what many of us have been arguing. Major financial institutions are at once very large and very complex. They are too large and too complex to manage. That is in part what beset Citigroup in the 2000s and now Morgan, which has been recognized as a well-managed institution.
If ordinary market forces were at work, these institutions would shrink to a size and level of complexity that is manageable. Ordinary market forces are not at work, however. As discussed on this site before, public policy rewards size (and the complexity that accompanies it). Major financial institutions know from experience they will be bailed out when they incur losses that threaten their surivival. Morgan’s losses do not appear to fall into that category, but they illustrate how bad incentives lead to bad outcomes.
Large financial institutions will continue taking on excessive risks so long as they know they can off-load the losses on taxpayers if needed. That is the policy summarized as “too big to fail.” Banks may be too big and complex to close immediately, but no institution is too big to fail. Failure means the stockholders and possibly the bondholders are wiped out. Until that discipline is reintroduced (having once existed), there will be more big financial bets going bad at these banks.
Changing the bailout policy will not be easy because of the time inconsistency problem. Having bailed out so many companies so many times, the federal government cannot credibly commit in advance not to do so in the future. (Think of Lehman.)
What to do in the meantime? The Volcker Rule was a modest attempt to rein-in risk taking. Industry lobbying has hopelessly complicated the rule and delayed its issuance. Morgan’s CEO, James Dimon, asserted the London trades would not have violated the rule. If true, it suggests to me that an even stronger rule needs to be in place. Various suggestions have been made to address excessive risk taking by financial firms. It is time to take them more seriously.
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