Monday, May 14, 2012

Enterpise Risk Management: JPM and AIG

A post which has had a long, steady readership is one relating to AIG's risk management czar.  It relates very closely to the latest kerfuffle at JP MorganChase.

The whole notion that the JPM unit was hedging its dealer bond portfolio is implausible.  For the sake of argument, let's say that is what Bruno Iksil was doing.  Since he was using the abstruse synthetic index, then he would have had some sort of hedge ratio and not have been hedging dollar for dollar. The size of his bets are implausible for a hedge.  If this wasn't proprietary trading, then we'll never be able to define it, which is why the whole Dodd-Frank regulatory wordsmithing is a waste of time.

The next thought is that Iksil's trading strategy itself was naive and incompetent.  He ventured into what had been a relatively obscure part of the fixed income market place, which is where one might go to find and exploit market inefficiencies.  Except, once the size of his book ballooned, the relatively small club which populates this corner of the casino knew something was up and the name "London Whale" was born.  As one market participant said, Iskil had committed a fatal error, in an inefficient market, he had "become the market."

What happened next seems unclear in journalists accounts.  Someone at JPM said to reverse the trades.  Now the real problems began, because the same JPM brokers who had called hedge funds and others about his initial position now made called the same market players about the opposite position in size.  That could only mean one thing: the whale had been harpooned. Now it was a freebie opportunity for playing the other side.

Inside JPM, no internal controls or proprietary risk management systems had prevented this position from becoming so out sized.  The bank can claim that they were always in touch with the New York Fed, and that they jointly decided to take action.  One small thing: someone forgot to let the outspoken CEO know about it.  His chagrin is palpable in every photograph.  It's impossible for any CEO to have his hands this close to a business whose risk profile changes by the hours. 

Iksil's boss, who made $14 million last year will fall on her sword and move to a hedge fund.  Nothing in the yet to be minted regulations will ever break this vicious cycle of big bets, big wins, big compensation, big bust, and move to the next casino.

Financial innovation is not doing anything to lift the world economy out of the global slowdown.  Then, why is this such a valuable, highly compensated function?  As imperfect as the Volcker Rule is, if it leads to the bifurcation of commercial banking and investment banking, with its proprietary trading that's progress.  Regulation, ERM, and better board governance are pie in the sky, delusional thinking.

If we really and truly want less systemic risk, then normal commercial banking has to become much more like a utility, and investment banking has to find a way to operate without implicit guarantees which will always produce risk seeking behavior.

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