Friday, May 18, 2012

JP Morgan’s Trading Losses: Regulation and Governance

There has been a great deal of debate surrounding JP Morgan’s hedging losses announced last week. There is some mystery surrounding the nature of the transactions involved, without full clarity yet on the amount of losses. Andrew Ross Sorkin has a brief explanation of the episode in the New York Times:
... Here’s an overly simplistic primer, but you’ll probably get the idea: The company’s chief investment office originally made a series of trades intended to protect the firm from a possible global slowdown. JPMorgan owns billions of dollars in corporate bonds, so if a slowdown were to occur and corporations couldn’t pay back their debt, those bonds would have lost value.
To mitigate that possibility, JPMorgan bought insurance — credit-default swaps — that would go up in value if the bonds fell in value.
But sometime last year, with the economy doing better than expected, the bank decided it had bought too much insurance. Rather than simply selling the insurance, the bank set up a second “hedge” to bet that the economy would continue to improve — and this time, traders overshot, by a lot.
This episode has given rise to renewed debate on matters of regulation of the financial services sector as well as corporate governance.
On the regulatory side, the key question relates to whether it will strengthen the hands of regulators around the world to more closely scrutinize the financial services sector. The US has already taken giant steps through enactment of the Dodd Frank Act, but the current development would have an impact on the scope, nature and implementation of the Volcker rule which curbs proprietary trading by banking institutions.
There are a number of issues on the governance side as well. For example, it raises questions regarding oversight of the company’s board and whether they ought to have exercised greater vigilance regarding activities undertaken by the chief investment office. Arguably, more effective risk management systems might have mitigated the effects of such transactions. Lastly, this has also triggered the debate regarding executive compensation, on this occasion pertaining to the specific issue of claw back of excessive compensation to affected officers of the company.
While the enormity of JP Morgan’s balance sheet size appears to have dwarfed the losses from the hedging transactions, their impact on the mode of regulating Wall Street and on governance concerns rings loud and clear.

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