JPMorgan case puts Volcker Rule and SIFIs back in the spotlight

May 23, 2012

By Patricia Lee

NEW YORK, May 23 (Thomson Reuters Accelus) – The massive losses which resulted from JPMorgan Chase hedging its positions against derivatives has once again cast the spotlight on the Volcker Rule and whether systemically important financial institutions (SIFIs) are too big to fail, industry observers said. Questions have also been raised about the firm’s hedging strategy, and what constitutes hedging in the first place.

Industry officials in Asia suggested that JPMorgan’s $2 billion hedging losses might embolden regulators to strengthen the Volcker Rule, on the premise that it would be of benefit to SIFIs. The rule, named after former Federal Reserve chairman Paul Volcker, forms part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and has proposed the separation of proprietary trading from commercial banking activity. Most notably, it has argued against investing in derivatives or using derivatives as a hedge on investments. The rule has, however, faced strong opposition from many of the large global financial institutions.

The JPMorgan case has also prompted the industry to take a closer look at the over-the-counter (OTC) derivatives business at a time when new regulations governing the industry are imminent.

Top five SIFIs’ OTC derivatives exposures

A look at the 2011 fourth quarter bank trading and derivatives activities report released by the U.S. Office of the Comptroller of the Currency (OCC) showed that the top five SIFIs — Bank of America, Citibank, Goldman Sachs, HSBC and JPMorgan — collectively accounted for more than 50 percent of the $700 trillion OTC derivatives trades worldwide in total notional value. JPMorgan alone accounted for more than $70 trillion of the $700 trillion, the report said. “That [$70 trillion] represents one-tenth of the global OTC derivatives exposures. This is what I call concentration of risk and what is defined as an institution that is too big to fail,” an industry official told Thomson Reuters on condition of anonymity.

The official said he found it alarming that, when the top five banks’ assets and total exposures to derivatives activities were added up, they showed a leverage of one to 45 times. The OCC report showed that JPMorgan Chase North America has total assets of $1.8 trillion to cover $70 trillion worth of OTC derivatives exposure. JPMorgan Chase & Co has total assets of $2.26 trillion, the report also stated.

“Five to 10 years ago, a leverage of one to 10 times was considered scary but now we are talking about a leverage of one to 45 times. The questions to ask JPMorgan are: ‘Were you using these derivatives for speculation or for hedging purposes?’ and ‘Can you qualify your definition of hedging?'” he said.

According to an industry expert who declined to be named, hedging is supposed to be an activity that reduces risk and can help to produce more stable net profit and net risk. “Hedging only reduces risk and does not eliminate it. There is no such thing as zero risk in financial investment. You need a balance between risk and rewards, i.e. to have a better return on risk adjusted capital. The financial performance of the hedge is supposed to be the opposite of the financial performance of the underlying exposure. On the flip side if you lose money on the underlying exposure then the corresponding hedge should have generated a compensating profit,” he told Thomson Reuters.

The industry official said JPMorgan’s massive losses should also raise the question of whether banks had stepped out of their basic core duty, which was that of safeguarding customers’ and depositors’ interests and shareholders’ value. “The fundamental duty of banks is to channel savings surplus to savings deficit to support, for instance, infrastructure developments and industries such as healthcare and manufacturing that serve the real economy. That’s how banks started to exist in the first place,” he said.

Bordering between hedging and speculation

Industry sources have said that JPMorgan had tried to make a case for its losses by arguing that it was trying to hedge its deposits against interest rate risk.

The industry official suggested that financial institutions should refrain from hedging deposits against complex synthetic products such as credit derivatives and should instead hedge them against less risky products. “Hedging interest rate risk against derivatives could be bordering the line between hedging and speculation,” he told Thomson Reuters.

He also pointed out how important it is for financial institutions to ensure that they always have sufficient assets to cover their exposures, and that their investment strategies are able to back up their hedging positions.

The industry official said regulators could prevent financial institutions from falling into the trap of concentrating risks on any one product by coming up with guidelines on what institutions are allowed to do to hedge their risk and what are considered permissible investments.

A compliance officer said the JPMorgan case has also raised issues about governance and demonstrated the limitations faced by regulators. He said the various fraud and insider trading cases that came to the fore during and after the crisis, and the latest event involving JPMorgan, all showed that regulators have been forced to take ownership of banks’ activities and to impose controls and legislation.

“Regulators are spending too much time figuring out regulations rather than taking ownership of a proper regulatory framework to govern banking activities,” he told Thomson Reuters.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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