The loss at JPMorgan Chase, reported at the beginning of May, has already grown to more than $7 billion, and some analysts expect it to grow further. JPMorgan Chairman and Chief Executive Officer Jamie Dimon testified earlier this month at a Senate Banking Committee on his bank’s trading loss. Previously, in a May 10 conference call to discuss the loss, Dimon called the credit derivatives trades: ‘flawed, complex, poorly reviewed, poorly executed and poorly monitored’.

SO, WHERE DID IT ALL GO WRONG?

JPMorgan Chase claim that in December 2011, as ‘part of a firm wide effort’ to prepare for the new Basel capital requirements the company’s Chief Investment Office (CIO) were instructed to reduce risk-weighted assets. Rather than simply reducing its existing positions, the CIO embarked on a complex strategy that entailed overlaying position that it believed would offset the existing ones.

This strategy, however, ended up creating a position that was larger, riskier and more difficult to manage and resulted in the much publicised losses.

Following Dimon’s Senate Committee evidence, we now understand that the following series of events led to the breakdown of control over the synthetic credit portfolio:

  • The CIO’s strategy for risk reduction in the synthetic credit portfolio was ‘poorly conceived and vetted’.
  • The CIO’s strategy was not ‘subjected to rigorous stress testing’ or sufficiently well analysed within CIO, nor was it reviewed by any internal ‘group’ outside the CIO.
  • Dimon rather scarily admitted that, ‘traders did not have the requisite understanding of the risks they took’. It has become clear that as the CIO began to experience losses in March and into April, they ‘incorrectly concluded that those losses were the result of anomalous and temporary market movements, and therefore were likely to reverse themselves.’
  • The risk limits for the synthetic credit portfolio appear to have been ill conceived and ‘should have been specific to the portfolio and much more granular, i.e., only allowing lower limits on each specific risk being taken’.
  • Most damning was the revelation that ‘personnel in key control roles in CIO and risk control functions were generally ineffective in challenging the judgment of CIO’s trading personnel’.
  • The Risk committee structures and processes in the CIO were found, not to be as ‘formal or robust as they should have been’.
  • In common with many other bank control breakdowns, it appears that, the complexities of CIO’s activities (in relation to the synthetic credit portfolio) were not properly understood by executive management and surprise, surprise, the firm’s risk control function.

SO, WHY DOES HISTORY KEEP REPEATING ITSELF?

Unfortunately, the JPMorgan Chase debacle is not unique but rather just the latest in a long litany of uncontrolled risk taking by major banking institutions.

Little has been mentioned by JPMorgan Chase about the VaR methodology employed to manage the positions, and why the bank allowed a mark-to market position to become so large that it could not be liquidated.

This is yet another case of a bank relying on VaR models, then ‘paying the price’ during a period of market stress. Clearly, when a position cannot be liquidated, VaR is no longer the appropriate management tool.

THE RISK CONTROL GAP

Against the backdrop of well-publicised failures, complexity and the ever-changing…regulatory environment, it is clear that a ‘Risk Control Gap’ exists, leaving senior bank executives exposed, and with escalating personal accountability.

Today’s environment requires an external, highly specialised, proactive and practical approach to risk assessment – complemented by solid risk-reduction policies and procedures.

It is not enough, just to rely on internal audit and risk managers using VaR models. Bank self regulation is also essentially important and robust internal risk identification/measurement techniques should be employed.

XMI fills this gap by reviewing the effectiveness of controls over key risks that exist in Treasury & Capital Markets activities, covering front, middle and back offices. In particular, we focus on the interface between the people in these areas and work to develop their levels of knowledge and understanding – recommending ways in which the key risk controls may be improved and/or implemented.

The XMI`s risk control programme has been developed from extensive, ‘hands-on’ experience within Treasury and Capital Markets, and looks in-depth at the following:

  • Human Factor Risk – rewards, measures, metrics, behaviours and the ability to challenge.
  • Control of Dealers – checking reporting lines, management responsibilities, segregation of duties, escalation procedures and management action triggers, the potential for trade manipulation and, limit & mandate control.
  • Management Information – examining the relevance, quality and accuracy of data produced its distribution, interpretation and effectiveness.
  • Board Reporting and Education – developing relevant measurement, monitoring and reporting output for senior ‘non-technical’ stakeholders. Providing clarity and knowledge transfer for Board Members.

XMI has a wealth of practitioner experience identifying and addressing the true risk gaps in the Treasury environment – risks that can be sometimes missed or wrongly assessed by others, mitigating potential losses.

RECENT XMI PROJECTS

Development of Treasury Sales Strategy – UK & Offshore Banking Group

We assisted our client with the development of a Treasury Sales Strategy, for the Institutional and Mid/Large Corporate market. This involved working with their Treasury & Corporate Banking Divisions to strengthen their customer value proposition with a focus on interest rate, foreign exchange and commodity hedging solutions.

Treasury Risk Review and Development of Future Strategy – Middle Eastern Commercial Bank

We conducted a comprehensive Risk Review of the Treasury and Investment Management activities of the Group, providing recommendations for improved Risk Control. In addition, we developed options for a Future Strategy for the Treasury and Capital Markets Business.