JPMorgan Chase

I. Abstract

The credit derivatives were introduced in the early 1990s, as large derivatives dealer searched for ways to transfer risk in financial markets. Although the financial innovations have only been used for decades, activity in credit derivations has grown rapidly. According to the Bank for International Settlement, the credit derivatives market reaches $21 trillion in 2014, and the main players for credit derivatives are investment banks, corporations or insurance companies. (Bank for International Settlement, 2014) Credit derivatives are relatively complex financial instrument, since it utilizes the leverage technique to mitigate the credit risk. One the one hand, credit derivatives allow banks to mitigate credit risk, reduce undesired risks and customize their risk profiles. On the other hand, the use of credit derivatives contains potential risks to the company since the market is still new. Users of credit derivatives must recognize and mange numerous associated risks. In fact, the historical evidence has shown that credit derivatives are the major causes to financial crisis. (Borodovsky & Lore, 2000) Although it is important to assess credit risk and market risk in the bank investment, operational risk is the fundamental part to the ultimate success of investment. “Operational risk is the risk of a breakdown in the operations of the derivatives program or risk management system.” (Chance & Brooks, 2012)

Operational risk was generally defined as the failure in internal processes, people and systems or from external events. It could be interpreted that the risks result from human error and inadequate internal control. In addition, another cause of internal control is strategic risk which is aroused from mismanagement and poor business decisions. Moreover, the risk of compliance violence is crucial in banking sectors, since the compliance risk could poses detrimental loss of reputation. The largest derivatives losses documented so far can be attribute to operational risk management controls. One of the largest losses in derivatives transactions was the London Whale trade. The London Whale trades were the series large size credit derivatives conducted by the investment giant, JPMorgan Chase. In early 2012, the bank’s Chief Investment Office (CIO), which was charged with managing $350 billion in excess deposits, placed a massive bet on a complex set of synthetic credit derivatives. And the risky investment finally resulted in a loss of $6.3 billion.

The magnitude of the losses shocked the investing public and drew attention to the CIO which was found to be bankrolling high risk credit derivative trades that were unknown to its regulators. The scandal demonstrated the failure in internal risk management in a reputational bank. Although the corporate governance failed to detect earlier, the internal management intentionally concealed the fact to regulators who should account for the disaster. The lack of proper risk management plan, the bank resulted in taking excessive risk, which led itself to catastrophic consequence. The core risk was the operational risk in the case of London Whale trade, the bank failed to detect the significant risks within the dangerous investments and made the proper risk treatment plan. Besides, the senior management made unwise decision posed serious strategic risk. Moreover, the bank concealed the fact that exposed the risk of compliance.

II. Core Risk Principal in Credit Derivatives Transaction

i. Introduction of credit derivatives

Despite slow economic growth in the U.S. and most countries worldwide, global derivatives markets are 20 percent larger than in 2007. The Bank for International Settlement announced in early 2014 that the global derivatives market reaches $710 trillion, and credit derivatives were account for 21 trillion for the growth. (Bank for International Settlement, 2014) Although it was not a measurement of credit and market risks, but the figure drew attention from regulators and the public. Since credit derivatives was one of the vital causes to the global financial crisis in 2008, and many of the victims including individual investors and banking industries continues to suffer the negative effects from the disaster. However, higher volumes are a strong indication that derivatives players’ operational risk is rising.

There are three main categories of risk when banks operate in financial markets which are market risk, credit risk and operational risk. (Hussai, 2000) Credit risk is the largest single risk in banking. Credit derivatives, a market that has grown from 1990, have emerged as an increasing popular tool. Credit derivatives are financial instruments derive their value from the creditworthiness of a specified financial instrument such as a corporate bond or stock. Credit derivatives allow banks to mitigate credit risk, reduce undesired risks and customize their risk profiles that unavailable in the cash markets. (Borodovsky & Lore, 2000) These benefits of credit derivatives explain the continuous growth of the market, nevertheless, such advantageous innovation accompanies with various associated risks that people easily ignore. In practice, the main player of credit derivatives, commercial banks, are pushing too aggressively into the market, distorting prices and raising the possibility of unexpected losses could crash the entire system.

ii. Operational risk of credit derivatives transaction

Although it is crucial for banks to manage market risk and credit risk involve in the credit derivatives transactions, they are by no means exhaustive. The unforeseen circumstances can occur in daily operations. Operational risk is the risk of the failure in operations of the derivatives program or risk management system. (Chance & Brooks, 2012) The mistakes from human resource including failing in monitor transactions properly, lack of knowledge in complex investments and fraud. These risks also appeared in other business operation, but derivatives transactions are more complex and involved large amount of money. Therefore, the operational risks in the credit derivatives transactions are critical to investment banks.

According to Basel Committee’s definition of operational risk, namely: “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.” (Bank for International Settlement, 2001) Operational risk is receiving a great deal of attention today. Unfortunately, it is one of the most difficult risks to manage. First, it is difficult to identify the internal processes or human error. Second, it is not easily to analyze the operational risk, while credit risk and market risk could be assessed by financial model and statistical techniques. Although operational risk losses do not occur often, they can lead to tremendous disaster when these risks really take place. (Chance & Brooks, 2012) The largest derivatives losses documented so far can be attribute to operational risk management controls. Since operational risks are typically expected to increase with the growth in volume of transactions, each derivatives contract must be properly executed and managed. (Padmalatha, 2011)

The losses of London Whale trades indicated that JPMorgan Chase had numerous flaws in its internal operations. In the first three months of 2012, when the CIO breached all five of the major risk limits on the Synthetic Credit Portfolio, rather than divest itself of risky positions, JPMorgan Chase disregarded the warning signals and downplayed the risk by allowing the CIO to raise the limits, change its risk evaluation models, and continue trading despite the red flags. (Levin, et. al, 2013) Therefore, the lack of rigid risk management process made so many risks involved in daily operation with large-size investment decisions.

Case Study

JPMorgan Chase is the largest financial holding company in the United States, with more than $2.4 trillion in assets. JPMorgan Chase is also the largest derivatives dealer in the United States, active in derivatives markets involving commodities, credit instruments, equities, foreign currencies, and interest rates. It is also the largest participant in global credit derivatives markets. Furthermore, it operates in more than 60 countries and constitutes 260,000 employees worldwide. (JPMorgan Chase, 2014) However, as an expert in risk management, JPMorgan Chase kept posing itself into risky credit derivatives transactions. In early 2012, the bank’s Chief Investment Office (CIO), which is charged with managing $350 billion in excess deposits, placed a massive bet on a complex set of credit derivatives that, in 2012, lost at least $6.2 billion.

Of the many scandals that have put Wall Street into troubles, the “London Whale” trades, which cost banking giant JPMorgan Chase more than $6 billion in 2012. These “London Whale” trades, so named because their sheer size caused serious impact on the international credit derivatives markets, the trades triggered intense scrutiny by the investing public, media attention, a nine-month investigation by the Senate Permanent Subcommittee on the investigations and renewed calls for more stringent financial regulation. (Rechtschaffen & Trichet, 2014) The London Whale debacle revealed the poor risk management and lack of effective internal control of the biggest bank. The Senate’s report describes a bank where complex derivatives and other methods were used to hide risk from bank regulators, investors and themselves, all in an effort to boost profits.

The serious of breakdowns in credit derivatives deals started from 2005, Jamie Dimon became CEO of JP Morgan and appointed Ina Drew to head its chief investment office (CIO). JP Morgan's CIO was in charge of managing the bank's risks through hedging and was charged with investing the bank’s excess deposits. Another key players in this case, Bruno Iksil, was a trader in the CIO’s London office joined the CIO in 2005, and served as the head trader managing the Synthetic Credit Portfolio from January 2007. Dimon pushed for the CIO to make more money by making bigger bets on riskier assets such as credit derivatives, but he was not completely aware of the risks behind the transactions. (Wall Street Journal, 2012) The strategy by Dimon to make the CIO into a 'profit centre' initially proved very successful, since the CIO's assets quadrupled from 2006 to 2011. On April 5, 2012, trader Bruno Iksil was reported to have positions with excessive risks that he was moving prices in the $10 trillion credit markets. While the bank responded that those positions were meant to hedge structural risks. Dimon called the media coverage on the matter “a tempest in a teapot.”(Bloomberg, 2012) Regardless of the confident deny previously, after the May 10, 2012, announcement of huge credit derivatives losses, Dimon admitted that the strategy was “flawed, complex, poorly reviewed, poorly executed, and poorly monitored.” The Firm disclosed that its credit derivatives portfolio had incurred $2 billion losses up to that point in the second quarter, with the possibility of additional future losses and volatility. By the end of June, the losses jumped to $4.4 billion; and by the end of the year, the total reached at least $6.2 billion. At last, the bank agreed in September 2013 to pay $920 million to resolve related U.S. and U.K. probes into its internal controls and handling of the trades. (Wall Street Journal, 2012)

The London whale debacle was definitely a disaster to a reputational bank like JPMorgan Chase. The JPMorgan Chase whale trades provide an instructive case of how synthetic credit derivatives have become a multi-billion dollar source of risk within the banking system. Ironically, the $6 billion London Whale loss occurred in an area of the bank, as part of this effort to manage the bank’s risk, the CIO bought credit derivatives designed to hedge against big downturns in the economy. These derivatives theoretically functioned much like an insurance contract, whereby JPMorgan was paid large sums in the event that certain companies defaulted on their debt. If those same companies stayed current on their debt, JPMorgan was obliged to continue making regular premium payments. (Mathrews, 2013) At some point along the way, the CIO seemed to lose sight of the purpose of these hedges. Furthermore, the portfolio became a source of profit for the bank during the financial crisis. The details of these trades are complicated, but the upshot is that derivatives give traders the ability to rack up big, risky positions very quickly. The Senate report makes it clear that it took traders in the CIO office just a few months do most of the damage that led to the $6 billion loss, before regulators were aware the mistake.

The main causes of the considerable losses is the sequence of poor risk management, which could contribute to the mismanagement of the senior management. Based upon the Subcommittee’s investigation, the London Whale trades failed as the reasons that the bank took excessive risks in credit derivatives and disregarded the overbearing risks. In addition, the bank intentionally hided the losses and misinformed the investors, regulators and the public. (Levin, et. al, 2013) It could be seen from the London Whale case that the bank put itself significant threat of operational risk, strategic risk and compliance risk. First, the inadequate valuation of the risky credit derivatives exposed the banks to continuous operational risks in the large-scale transactions. The flaws in internal operation included the lack of proper process and system to ensure investments under control. Second, the mismanagement by senior managers in JPMorgan Chase led the banks into serious circumstances. The amount of credit derivatives trades was relatively large in the case, thus, the senior managers should account for the high-leveraged strategies. Third, the bank intended to hide significant losses to regulator and the public, it was taking a risk of compliance violation that could push the whole company into disaster.

V. Reference List

1. Bank for International Settlement. (2014). http://www.bis.org
2. Hussain, A., (2000) Managing Operational Risk in Financial Markets p.76
3. Borodovsky, L. & Lore, M. (2000) Professional's Handbook of Financial Risk Management
4. Chance, D. & Brooks, R. (2012) Introduction to Derivatives and Risk Management
5. Padmalatha, S. (2011) Management Of Banking And Financial Services
6. Brose, M. et al, (2014) Handbook of Financial Data and Risk Information
7. Rechtschaffen, A. & Trichet, J. (2014) Capital Markets, Derivatives and the Law: Evolution After Crisis
8. Mathrews, C. (2013) Too Big To Fail: 3 Lessons of the “London Whale” Debacle. Retrieve from http://business.time.com
9. Wall Street Journal. (2012) “London Whale Unfolded.” Retrieve from www.wsj.com
10. Bloomberg. (2012) Retrieve from www.bloomberg.com
11. Levin, C. et al. (2013) “JPMorgan Chase Whale Trade: A case history of derivatives risks and abuses.”