The content and tone of JP Morgan chief Jamie Dimon’s telephone call to analysts explaining JP Morgan Chase's regulatory filing to the Securities and Exchange Commission, which reported a $2 billion loss in derivative trading, demonstrates that the true cost to the bank should be measured in ideational and reputational terms.
The trading loss was an "egregious” error, the result of "self-inflicted" mistakes that "violate our own standards and principles" and which "plays right into the hands of a whole bunch of pundits out there,” Dimon conceded.
The reputational damage is magnified by the fact that the losses reflected poor risk management within what the firm terms its chief investment office. Buried within the filing (on page 9), the firm notes that the "CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the firm previously believed.”
The frank admission of "sloppiness and bad judgement,” and determination that the firm would "admit it, we will learn from it, we will fix it, and we will move on” was an exercise in damage limitation.
It is an exercise that is by no means assured of success. Although by no means itself materially catastrophic for a firm which such formidable reserves, the losses have significantly reduced the authority of the bank to lead the campaign to dilute the proposed ban on proprietary trading.
The regulatory filing also notes (ironically on the same page) that JP Morgan:
"…expects heightened scrutiny by its regulators of its compliance with new and existing regulations, and expects that regulators will more frequently bring formal enforcement actions for violations of law rather than resolving those violations through informal supervisory processes.
"While the firm has made a preliminary assessment of the likely impact of these anticipated changes, the firm cannot, given the current status of the regulatory and supervisory developments, quantify the possible effects on its business and operations of all of the significant changes that are currently underway.”
The immediate impact will be seen in the United States itself through the application of the Volcker Rule, a provision of Dodd-Frank named after the formal chairman of the Federal Reserve who first suggested its implementation.
The provision is designed to prohibit proprietary trading by those institutions covered by an implicit government guarantee. The most vocal critic of both the rule and its application was Jamie Dimon himself, who described it as a misguided attempt to prohibit legitimate market making activity that derived from the thinking of a man who "does not understand capital markets."
The failure of the risk management systems within JP Morgan significantly reduces the authority of its chairman and chief executive to lead the charge for a weakening of external oversight. It also highlights, however, the very real global risks associated with derivative trading.
Very famously, the late Donald Rumsfield noted that strategic defence policy was confined by capacity to deal with "known knowns, known unknowns and unknown unknowns."
The global financial crisis has provided evidence of all three dangers. The international architecture designed in the aftermath of the crisis is predicated on the need to significantly expand the degree of disclosure within and and oversight of the OTC derivative market.
In its latest report to the G20 last November, the Financial Stability Board noted that the failure to design and implement the requisite legal and regulatory frameworks represented a material risk.
The dangers have been highlighted by the rapid expansion in the value of derivative trading, which has returned to pre-global financial crisis levels. As the senior OECD economist, Adrian Wignall-Blundell, put it we are once more "off to the races.” The JP Morgan bet demonstrates that the costs of excessive wagering are very real.
The policy problem is that policy design and implementation is constrained by the pace of reform in the major jurisdictions, most notably the United States itself. Here in Australia, Treasury has begun a second stage of consultation, with private briefings with key stakeholders scheduled to run until June 15 on a consultation paper that provides a framework for the Minister for Financial Services and ASIC to make rules covering the disclosure required.
The JP Morgan fiasco provides a granular case study to inform the debate. It also highlights the need for the discussions themselves to take place in an open environment. Warranted trust necessitates nothing less.
Justin O'Brien is a professor of law at the University of New South Wales. He writes a column for The Conversation, The ethical deal and is director of the UNSW Centre for Law, Markets and Regulation portal, where this story also appears.