Many details of the credit derivatives position that caused JP Morgan (JPM) to recently lose at least $2 billion are unknown. Yet based on the company's disclosures and media accounts of the trade, the Volcker Rule as proposed in October 2011 may end up encouraging the type of risk taking underlying JPM's losing position, if the Rule is implemented as proposed.
The Volcker Rule bans proprietary trading by banks and their holding companies, affiliates, and subsidiaries. As noted on page 67 of the proposal, the Rule's "hedging exemption" permits banks to engage in otherwise prohibited trading to hedge, but only if the hedging transaction does "not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a [second] contemporaneous transaction."
The problem is that while entering into a secondary hedging transaction may initially reduce risk, it may also leave banks with even riskier positions that are difficult to manage in the long-run. Indeed, JPM's losing trade exemplifies just this sort of risky secondary hedging transaction.
To hedge its exposures from holding high-grade corporate bonds, JPM bought credit protection on a credit default swap (CDS) index referencing corporate bonds. However, this primary hedging transaction itself exposed JPM to at least two new risks. First, in accordance with accounting rules, JPM had to mark-to-market the value of its CDS index hedging transaction, which means that the primary hedge exposed JPM to market price risk. Second, the primary hedge also exposed JPM to the risk that the other side of the hedging transaction would be unable to pay, or counterparty risk.
To hedge these new risks, JPM also entered into another hedging transaction where it sold protection on a related CDS bond index. To borrow a metaphor from the New York Times, JPM put an umbrella on an umbrella. Importantly, not only was this sale of CDS protection the part of the transaction that ultimately led to JPM's $2 billion loss, but it was also the type of secondary hedging transaction that could be required by the Volcker Rule. When the secondary hedge was entered into 2011, it seems to have been an appropriate hedge for the primary hedging transaction.
None of the foregoing implies that JPM's loss was caused by anything other than its own mismanagement. However, given that secondary hedging transactions seem ripe for such mismanagement, the fact that the Volcker Rule seems to encourage them to qualify for one of its exemptions is troubling. It suggests attempts to micro-manage bank risk taking through regulation could seriously backfire, and that higher capital requirements or limiting the size of banks will be more effective in reducing systemic risk than the Volcker Rule.
In other words, while Jamie Dimon's credibility may have died, so has Paul Volker's.
Limiting the size of banks is very much part of USA tradition. The USA went into the Great Depression with a plethora of unsophisticated banks, 40% of which had failed by the end of 1934. 80% of Canada's deposits are in 5 huge banks with a nationwide branch system, yet Canadian banks are far more robust than American ones.
Unlike size limitation, I support more stringent capital requirements in principle. Trouble is, regulators and accountants play endless games of stretching the definition of what constitutes bank "capital". In my view, the only unambiguous capital for a USA depository institution is excess reserves at the Fed. A silver lining to this cloud is that such reserves now pay interest -- 25 basis points per annum.
Posted by: philip meguire | May 23, 2012 at 10:29 PM