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When Banks Game the Risk Picture

Joseph McCafferty | March 22, 2013

Used to be that companies played games with their earnings numbers, backing a few million from the current quarter into last month to squeak out that earnings beat.

Sure, that game will always be played, but there's a new kind of fudging going on, particularly at big banks: fooling regulators into thinking you are taking on less risk than you really are.

The champion of this game, at least until it got caught, is JPMorgan Chase. Cloaked in a reputation as a prudent risk manager—after all, this was the only major financial institution to post a profit during the financial crisis—the bank pushed the envelope on reckless speculation while it misled regulators through a combination of false reports and bullying.

A report out last week from a U.S. Senate panel detailed the lengths to which JPMorgan Chase went to fool regulators into believing it was taking a more conservative trading approach while traders, such as the “London Whale,” gambled billions.

JPMorgan's in-house regulator from the Comptroller of the Currency told a Senate sub-committee that it was common for bank executives to push back on examiner filings and recommendations. The regulator recalled a confrontation when bank executives yelled at OCC examiners and called them “stupid.”

“In contrast to JPMorgan Chase's reputation for best-in-class risk management, the whale trades exposed a bank culture in which risk limit breaches were routinely disregarded, risk metrics were frequently criticized or downplayed, and risk evaluation models were targeted by bank personnel seeking to produce artificially lower capital requirements,” the Senate report concludes.

The massive trades were conducted in the London office of JPMorgan Chase's chief investment officer. According to the report, released by the Senate Permanent Sub-committee on Investigations, over the course of the first quarter of 2012, the CIO used the company's Synthetic Credit Portfolio to engage in high-risk derivatives trading; mis-marked the trading book to hide losses; disregarded multiple indicators of increasing risk; manipulated risk models; dodged regulatory oversight; and misinformed investors, regulators, and the public about the nature of its risky derivatives trading.

Nobody is suggesting, at least not yet, that JPMorgan's reported financials are inaccurate. The shenanigans, according to the Senate report, are in the bank's risk picture. Of course companies have always played games to make themselves look healthier than they are, but the false impression of the bank's risk taking goes further than that. Because the financial system itself rests on how stable are the big banks that underpin it, attempts to muddle that assessment could have far wider implications for the financial system as a whole than if JPMorgan was manipulating earnings. And that it happened so soon after the banking industry brought the entire economy to the brink is even more troubling.

Gaming the Stress Test?

Bank investors have breathed easier as one after another of the big banks have passed stress tests and capital reserves have climbed. But are these numbers to be believed? Are banks really back on terra ferma? The JPMorgan report puts all of that in question now. In fact, bank investors have been suspicious of bank balance sheets for some time. Many of the largest banks, including Bank of America and Citigroup, are trading at below reported book value, meaning investors don't trust the value of the assets on banks' balance sheets. In other words: If the banks can't be trusted, than we are not out of the woods yet.

This spring JPMorgan's Jamie Dimon will face shareholder calls to give up his dual role of chairman and CEO. Major pension funds, including the California Public Employees' Retirement System, and the two major proxy advisory firms, ISS and Glass Lewis, have backed the move to strip Dimon of his chairmanship. “CalPERS believes if the chairman was independent the board may be able to exercise stronger oversight of management,” the fund said in a statement outlining its position. It's not clear how the vote will go, but JPMorgan's dishonesty on its risk position should play a large part when shareholders consider splitting the CEO and chairman jobs.

Meanwhile, the Securities and Exchange Commission is still contemplating how to carry out the Volcker Rule—the Dodd-Frank Act provision that will put major restrictions on the types of trading banks backed by the Federal Deposit Insurance Corp. can conduct for their own account. There's no doubt SEC commissioners are pouring over the Senate's JPMorgan report with raised eyebrows, as they consider their Volcker Rule options. Banks have lobbied hard for a less extreme version of the Volcker Rule, watered down with lots of exceptions and loopholes. But if the banks' own assessments of their risk-taking can't be trusted, why should regulators give them an inch?