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Author's profile photo Derek Klobucher

The Right Kind of Risk Management

“You should not put your own money at risk,” Rep. Barney Frank said to federally-insured banks Wednesday on CBS This Morning. “We now have a stronger argument for a Volcker Rule that says ‘No’ to a bank: ‘Your main job is lending and managing the money of your clients.’”

Frank’s argument got a shot in the arm last week when JPMorgan revealed that a set of trades aimed at hedging wound up costing the firm more than $2 billion.

JPMorgan and Risk Management 05-17-12-AThe bungle may have also tipped the industry’s hand. A bank using its own money to hedge against losses would be permissible under the work-in-progress Volker Rule, but using that capital for what some have characterized as bad bets — and even gambling — as JPMorgan seems to have done, may have been a big part of plans to evade the nascent regulation.

“We are not trying to stop financial institutions from losing money; that’s their business,” Frank said. “We have a particular concern about banks [that] get federal deposit insurance.”

But what about those institutions whose losses aren’t federally insured? The ones that have to risk their own capital?

Shaping Reform

“In most financial institutions there are multiple dimensions to risk management; organizations need to protect themselves from volatilities in the market and threats posed by poor or inadequate internal process controls,” Sybase CTO Irfan Khan wrote in trading intelligence site ATMonitor. “While there’s no doubt that rigorous policies exist to create checks and balances that manage risk in new trading paradigms, in reality, the technologies we need to enforce these policies lag well behind our ambition.”

Validation of Kahn’s assertions has repeatedly splashed across the front page. Before JPMorgan this month, there was a rogue trader at UBS last year and the €4.9 billion trading fraud at Société Générale in 2008.

JPMorgan and Risk Management 05-17-12-B“The type of high-risk trading that these individuals participated in, primarily derivatives and futures, offers the enticement of high returns,” Khan said. “When done properly, risk control should nullify the temptation to take on excessive leverage.”

While JPMorgan was more adept at risk management than most, this colossal blunder could provoke unwanted intervention, as Gary Townsend, CEO of Chevy Chase-based Hill-Townsend Capital, noted on market watcher Seeking Alpha. This is an election year after all, and politicians have already indicated that the JPMorgan scandal could influence the final forms of Dodd-Frank and the Volcker Rule this summer.

Why Are We Here?

So it becomes a question of who should drive the capital markets reforms. The real trick is finding agreement in a world where people have different ideas of why we even have banks.

JPMorgan and Risk Management 05-17-12-C“We should expect banks to take risks,” Townsend wrote, contradicting the Volcker Rule’s core tenant. “It is why they exist.”

If the financial services industry wants the public and authorities to deem it trustworthy enough to govern itself, it must act responsibly; refrain from circumventing the spirit of regulations; and install the proper controls for the trading in question. Otherwise taxpayers, voters and regulators will take control.

Much Ado About Nothing?

The instigator in this may not see the worst of it.

“Regulators checked out JPMorgan just a couple of months ago, and found that the bank was doing fine,” securities and investment publication Wall Street & Technology wrote this week. “And if they were to go back in time and carry out those tests again, they would probably say the same thing.”

In short, this $2 billion hit won’t topple the giant with market capitalization around $135 billion. But it will bruise all of his neighbors.

Related Articles:

Barney Frank: Chance Now for Stronger Bank Rules by CBS News

Breaking Tradition by Irfan Khan

JPMorgan’s Hedging Losses Invite a Political Response by Gary Townsend

For Regulators, JP Morgan’s $2 Billion Loss Is Really Not A Big Deal by Melanie Rodier

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