The Federal Reserve Bank of New York, and by extension the Board of Governors of the Federal Reserve, failed to act on knowledge of high-risk trading activities at JPMorgan Chase’s London investment office and should shoulder some blame for a $6 billion loss the bank suffered from its ill-fated “London Whale” derivatives trades in 2012. That harsh criticism is leveled by the Fed’s Office of Inspector General in a new report that caps a two-year investigation.
The Federal Reserve serves as the consolidated supervisor for all bank holding companies, including JPMorgan Chase and the subsidiary through which the London office booked synthetic credit derivatives trading. The report found that its continuous monitoring activities identified risks related to the London office’s trading activities and a series of examinations were planned to further assess the situation. But, despite the discovery of out-sized proprietary trading activities as far back as 2008, those examinations never took place. The New York Fed also failed to share information about the trades with the Office of the Comptroller of the Currency, scuttling what should have been a joint review.
A main reason the Fed backed off: a lack of resources and inadequate staffing. The Inspector General report found that the New York Fed did not conduct the planned or recommended examinations because it “reassessed the prioritization of the initially planned activities… due to many supervisory demands and a lack of supervisory resources.” Other factors cited in the report included that “weaknesses existed in controls surrounding the supervisory planning process” and a 2011 reorganization of the supervisory team at JPMorgan Chase resulted in “a significant loss of institutional knowledge” regarding the London-based Chief Investment Office.
“We acknowledge that [the New York Fed’s] competing supervisory priorities and limited resources contributed to the Reserve Bank not conducting these examinations,” the report says. “These practical limitations should have increased FRB New York's urgency to initiate conversations with the OCC concerning the purpose and rationale for the planned or recommended examinations related to the CIO.” The assessment also determined that “staff were not clear about the expected deliverables resulting from continuous monitoring activities” and the Federal Reserve and OCC staff “lacked a common understanding” of the former’s approach for examining Edge Act corporations, a “disconnect could result in gaps in supervisory coverage or duplication of efforts.”
The report includes a series of recommendations for the Federal Reserve Board's Division of Banking Supervision and Regulation:
Issue guidance that reinforces the importance of effective collaboration and cooperation in joint supervisory planning.
Develop procedures that encourage staff to take immediate action to escalate significant concerns regarding interagency collaboration in executing consolidated supervision.
Develop guidelines for the supervisory planning process that require Federal Reserve System supervisory staff to reassess their strategy and approach for conducting supervision activities in light of emerging risks and changed circumstances within supervised entities and assure that sufficient supervisory resources are assigned to areas exhibiting significant emerging risks.
Develop guidance on how staff should document and track supervisory activities that are included on a supervisory plan, including expectations for assigning priority ratings to supervisory activities using a consistent prioritization scheme and presentation; instructions for documenting the rationale for not performing planned or recommended supervisory activities and required approvals for deviating from supervisory plans; and escalation protocols when activities on supervisory plans are not completed.
Develop best practices for transitioning supervisory staff or teams.
Enhance knowledge management capabilities for supervisory information so that supervisory materials can be searched and filtered as effectively as possible.
Clarify the Board's intentions and expectations regarding Edge Act entity supervision with appropriate counterparts at the OCC.
Detail expectations for documenting and approving the deliverables of continuous monitoring activities, tracking identified issues, and performing follow-up activities.
Issue guidance outlining preferred approaches for mitigating key-person dependency risk on supervisory teams.
The recommendations also direct the Federal Rserve Bank of New York to "assess whether it needs to hire additional supervisory personnel with market risk and modeling expertise."