Bank regulators are casting new nets to catch excessive risk-taking in the financial system. But future London Whales may find plenty of ways to slip right through them.
The story of JPMorgan Chase’s multibillion-dollar trading loss is now well known. Traders, including Bruno Iksil, nicknamed the London Whale, amassed large positions in credit derivatives as part of a complex trading strategy that eventually soured.
The motivations for the trades were unclear. While the bank says they were intended to offset other risks on the books, the strategy also appeared to have a speculative element.
Nearly four years after the collapse of Lehman Brothers incited a worldwide financial crisis, such blowups are all too probable.
Banks in the United States are still operating in a sort of regulatory no-man’s land. Many of the new post-crisis rules have not yet become effective. And even when they do, the loopholes remain large.
The Volcker Rule, part of the Dodd-Frank legislation that will be phased in over the next two years, is intended to catch certain types of trading. But it may not snag the wagers of JPMorgan’s Whale.
While this regulation prevents banks from doing speculative trades with their own money, it will not stop hedging activities, which JPMorgan has said were at the root of the trading losses. The Volcker Rule contains guidelines that are meant to help regulators decide whether a hedge masks a proprietary bet. But even with these prescriptions, speculative trading could still slip through.
In JPMorgan’s case, the bank wanted to hedge the large amount of loans and bonds on its balance sheet. To do that, its hedging strategy initially centered on buying bearish derivatives that would rise in value as the creditworthiness of large companies deteriorated. Then, in January, JPMorgan started putting on a huge bullish credit position, to help temper the bearish bet — essentially, a hedge on a hedge.
To help distinguish between hedges and speculation, the rule asks the banks to be able to show that the hedges have a relationship with the assets being hedged. However, it requires only that they be “reasonably correlated.” The rule says that hedges are allowed if they are “made in connection with, and related to, individual or aggregated positions.” JPMorgan could point to that and argue that the Whale’s trades were related to the bank’s corporate loans and bonds.
Other parts of Dodd-Frank try to temper risk in more subtle ways. The regulatory overhaul tries to move many derivatives onto central clearinghouses, entities that handle the underlying payments on a trade. This is supposed to strengthen the derivatives markets, because the clearinghouses will force participants to back their trades with margin payments made in cash or very safe securities. In theory, the financial burden of supplying margin to clearinghouses could make Whale-type trades prohibitively expensive, and therefore less attractive for banks.
But the main type of derivative in the Whale’s loss-making trade — a credit index called the CDX.NA.IG.9 — is already centrally cleared in large amounts, according to figures from ICE Clear, a clearinghouse that handles that index. If JPMorgan’s positions are executed through a clearinghouse, it would mean that the added costs of clearing did not prove a deterrent, and might not stop similar traders in the future.
However, one part of this net may work. Some derivatives analysts think JPMorgan may be exposed to “tranches” of the CDX.NA.IG.9 index. Tranches slice up credit indexes in such a way that participants can choose to take on more or less credit risk. Tranches of the CDX.NA.IG.9 are not executed through a clearinghouse.
That is a crucial issue, because regulators are planning to demand much higher margin payments on derivatives that are not centrally cleared. If regulators do set this margin above clearinghouse levels, such trades may become too expensive for banks.
But some analysts think the extra margin may not be a sufficient deterrent. “If it is a trade you really believe in, you may still go ahead and do it, even if it is more expensive,” said Olu Sonola, an analyst at Fitch Ratings.
Another effective measure may stem from the new international banking regulations set by the Basel committee. On paper, they will force banks to hold a lot more capital against certain trading positions, even ones using centrally-cleared derivatives.
The new Basel rules’ impact on JPMorgan’s credit bets could prove substantial, which the bank’s chief executive, Jamie Dimon, indicated last week in his Congressional testimony. In the fourth quarter of last year, he said, the latest Basel rules stood to increase the “risk-weighted” value of the credit derivatives portfolio that contains the Whale’s trades to $60 billion, from $20 billion.
Under Basel, a bank sets capital as a percentage of risk-weighted assets. Consequently, a tripling of the position’s risk-weighted size would lead to a tripling of capital held against it. Notably, proposed Basel trading rules could force banks to hold more capital if regulators see evidence that hedges may not perform effectively in stressed situations, said Jerome McCluskey, a lawyer at Milbank, Tweed, Hadley & McCloy.
But again it seems there may be an out. In his testimony, Mr. Dimon implied that JPMorgan thought the large bullish bets would actually make its credit derivatives portfolio less onerous under new Basel rules. It’s possible that JPMorgan misread the Basel rules, or miscalculated the risks of the trade when setting its risk-weighted value. Even if both are true, it remains that the bank thought tens of billions of dollars in new trades — trades that ultimately blew up — would sail straight through Basel net.
All that means the Whale is far from extinct on Wall Street.