“The big lesson I learned: Don’t get complacent despite a
successful track record”, is what James Dimon, the Chairman and Chief Executive
of JP Morgan Chase & Co. said in an interview recently. Dimon, who is known
as one of Wall Street’s savviest risk and financial managers and also the vocal
critic of Volker rule has also said, “No one or no unit can get a free
pass.”
How true Dimon’s learning is! But then, at what cost? The
bank is said to be holding derivative wagers with a face value of roughly $100
billion in a derivative index that tracks the health of corporate debt, which
according to the bank itself is “…a sloppy, stupid and shouldn’t have happened”
strategy it has designed to hedge itself, which incidentally had already
inflicted a trading loss of $2 billion—according to market watchers, it might touch
$ 5 billion in course of time—that made its share price fall by around 18%, cutting off about $27 billion from its market
value.
As the index tracking the health of corporate credit in which
JP Morgan bet is continuously deteriorating, analysts believe—as also Dimon
says, “The portfolio still has a lot of risk and volatility going forward…. We’re
willing to hold as long as necessary inventory and we’re willing to bear
volatility”—that the losses, in all likelihood, are set to mount further. Simply put, the cost of learning, be it to
the bank, to the CEO of the JP Morgan, to its stakeholders, to the regulators
and in turn to the government is certainly going to be pretty high.
It’s however worth recalling here what Romney, the Republican
Presidential candidate, said about JP’s losses: “This was a loss to
shareholders and owners of JP Morgan and that’s the way America works. Some
people experienced a loss in this case because of a bad decision. By the way,
there was someone who made a gain.” True,
if it were the money of JP’s owners, nothing much to worry of the losses—even
if they be $10 billion or even more. But that’s not the case here. The true
position is: money used for betting belongs to the depositors—the common
American citizens who have left their life savings to the trust of the JP
Morgan for safe keep. Which is why, the
gain of somebody—in the present case, probably a few Hedge Fund players—is made
good by the loss of JPMorgan’s depositors whose number runs into millions; and
hence it is not OK for banks to take such risks.
Indeed this point was proved beyond doubt by the global
financial crisis of 2008 when institutions like AIG, Citibank and others were
to be bailed out by pumping in huge amounts of taxpayers’ money simply to avoid
a mad run on banks, which if allowed is sure to jeopardize the very nation’s
economy as a whole. So, the wise insist that banks, being special, must be well
regulated. And this episode, some believe, is only hastening up the need for a
more rigorous Volker rule, that too, quickly.
That said, there is an argument that the present trading at
Morgan that has caused losses might very well fall within the allowances
granted by the proposed Dodd-Frank’s laws, for it is intended to hedge the “aggregate
positions” of the bank.
Now the moot question is: What is a hedge? It’s simply a
mechanism whereby one can reduce the financial exposure faced in an underlying
asset due to volatility in prices by taking an opposite position in the
derivatives market in order to offset the losses in the cash market by a
corresponding gain in the derivatives market. It is of course a different
matter that construction of an exact opposite position to the existing risk
exposure in the face of uncertainty and the risk of opportunity loss is always
a big question mark. Secondly, hedge has a cost and this makes it further
complex.
Against this backdrop, JPMorgan’s argument that its current
loss is out of trading on derivatives for hedging its credit portfolio is not
tenable because: theoretically, loss in underlying asset must be set off by the gain in the position taken
in the derivatives market and vice versa. But that didn’t happen here, which
means, the current hedging is so designed that it is not only intended to protect
the bank’s credit portfolio from any losses but also result in profits. It is
perhaps this speculative element embedded in the whole trading on derivatives
that had resulted in a whopping loss of $2 billion, which again is speculated
by market pundits to go up to $5 billion as the positions unwind in course of
time.
However the whole transaction is still shrouded in secrecy, for
Morgan fears that such revelation is likely to worsen the chances of unwinding
the positions without much of bleeding. Nevertheless, one thing is clear: rules
or no rules, banks continue to cause systemic risk and the bigger the bank, the
bigger will be the contagion.
Therefore, some pundits argue that making banks bear their
losses themselves by directing them to induct more capital is better than any
regulation that merely attempts to curb speculative trading. Secondly, it is
often found that regulation is far behind the practice in the market. In a
dynamic market like banking, everyday a new risk-transferring product is
evolving, understanding of which in itself takes time for the regulators to
monitor effectively. Thirdly, players in dynamic markets are adept at circumventing
regulations. Fourthly, regulations are ambiguous but there is no ambiguity in
the capital requirement. Hence,
increased capital is suggested as an effective antidote for arresting contagion
than regulations.
The summum bonum of
the argument emanating from this episode is that risk is all pervading and it
can at best be transferred but not mitigated and hence, banks, particularly those
supposed to be too big to fail, like JP Morgan, are monitored by regulators
against set parameters that are unambiguous to ensure that ab intio banks take less risk, and once taken monitored by all the
concerned to minimize the contagion. And if prescription of high level of
capital is the best means to make banks sensitive to risk, fine that should be
the priority.
GRKMurty
Image - courtesy: en.wikipedia.org
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