The news of JPMorgan’s increasing legal problems, coming at the same time as news that Japan’s Fukushima nuclear plant had begun leaking highly radioactive water more than two years after the original meltdown in 2011, inspired me to extend an analogy I made at the time.
The big banks were effectively factories, taking in assets such as loans or mortgages as raw material and processing them – often several times over – transforming them into structured products for investors. Instead of generating power in the way that Fukushima did, these factories generated money.
Like Fukushima, the banks concentrated risks in a very dangerous way. When the production lines for structured securities seized up from 2007 onwards the result was the spewing of financial radioactivity into the global economy and the near-collapse of numerous large financial institutions.
We know how things went wrong. The value-at-risk models used to measure risks inside these factories, and the VaR-based shareholder capital that was supposed to buffer the banks against the unexpected, proved woefully inadequate. That was by design, since if the models had been any good, the capital needed to support the securitisation factories would have made them unattractive to shareholders.
The fact that the bankers running the factories were incentivised by the revenues and bonuses they were making to keep using bad VaR models (and thus arbitrage the system), was really a failure of regulation, particularly the Basel rules covering the capital required for trading portfolios.
Regulators tried to fix these deficiencies with so-called Basel 2.5 rules which European banks implemented in 2011 and US banks last year. The results can now be seen in regulatory filings published by the banks.
Regulators didn’t have the guts to throw out VaR completely, but they did beef it up with something called stress VaR which basically forces a bank’s model to remember how bad things were in 2008. Bank filings from the second quarter of 2013 typically put the capital required for stress VaR at about three times the capital for standard VaR. However, to the degree that bankers have an incentive to keep the risks of financial innovations out of their model, it’s still the same bad old VaR.
Perhaps with this in mind, the regulators looked at what happened in 2007-8, in and particular, how the securitisation factories replicated traditional bank lending by warehousing a lot of credit risk. That’s why we now have the incremental risk charge (IRC) which allows for the fact that loans traded by banks sometimes default in addition to declining in price, which was supposedly captured by VaR.
The Fukushima-type financial radioactivity from 2008 is captured by the IRC, as well as two more Basel inventions, the specific risk charge and the comprehensive risk measure (CRM). They cover parts of the investment bank production line such as securitisation, credit derivatives and correlation trading – activities that caused tens of billions of dollars of losses at banks such as UBS, Deutsche Bank, Morgan Stanley, Royal Bank of Scotland, Merrill Lynch and Citigroup.
You get a feel for how important these charges are to chastened regulators when you see how much the charges actually bite. For example, almost half of Goldman’s and Bank of America’s market risk capital comes from the specific risk charge. It’s also telling that firms such as Morgan Stanley or Deutsche Bank are selling off parts of their trading portfolios to try and reduce these charges.
The CRM is interesting for a couple of reasons. Firstly because it’s the one new charge that banks are allowed to model for themselves (Well, not completely because the Basel Committee spelled out the risks that the banks had to model). Secondly, the CRM cuts to the heart of the credit derivatives innovation bubble set in motion by JPMorgan with its 1997 BISTRO trade celebrated by Gillian Tett in her book Fool’s Gold.
Ironically, the bank with the biggest CRM capital requirement in 2013 happens to be JPMorgan, with a $2.5 billion charge that is more than the other four large US banks combined. It’s most likely that this is a result of the London Whale’s credit derivative trades that lost the bank $6.2 billion last year.
At first sight, this visibility seems like progress. Not only do Basel’s new market risk charges reveal the capital cost of pre-2008 activity still lurking in bank portfolios, but they show, like Fukushima, when the radioactivity starts spewing out all over again.
Unfortunately, by allowing banks to calculate the CRM themselves, Basel left a massive loophole in the system. Suppose that JPMorgan had reported its mammoth CRM charge in early 2012 when the Whale trades were implemented. The bank’s capital ratio would have declined and shareholders might have understood that they were being asked to take additional risk.
As we learned from the March 2013 US Senate report into the Whale fiasco, JPMorgan did something different. It did internally calculate a huge CRM number, and then its quants and traders promptly tried to game the model in order to reduce it down again, arguably deceiving shareholders.
So while Basel may have seemingly caught up with the financial crisis in its last round of tweaks, it left in the modelling incentives that serve as catnip for greedy traders. For bank shareholders, these incentives increase the risk of ‘unknown unknowns’ within banks – in other words, the most dangerous stuff of all.
Now, Basel does have a charge for ‘unknown unknowns’ – it’s called the operational risk charge, which covers Whale-style internal cock-ups and rogue employees as well as external threats like litigation costs or terrorist attacks.
European banks already have to allocate shareholder capital to operational risk under Basel rules. For example, at group level Deutsche Bank allocates €4.16 billion, while Barclays allocates £4.3 billion at group level and £1.9 billion within its investment bank, according to second-quarter filings. You can argue whether this is sufficient to cover things like mis-selling settlements and Libor fixing, but at least it’s there.
US banks on the other hand won’t have to allocate operational risk charges for another couple of years, when they implement Basel III rules. However we do have some inkling of what banks think the charges are likely to be. In its latest quarterly filing, JPMorgan said it would have to allocate an additional $14.1 billion of capital if Basel III was applied today. This includes operational risk as well as other stuff like new charges for derivative counterparty risk (of which JPMorgan has a lot).
Is this sufficient to cover potential Whale scenarios as well as litigation and the whole gamut of operational risks that JPMorgan faces? Given that the bank currently predicts its potential losses from litigation alone to be $6.8 billion, I suspect not.
Comparing JPMorgan’s current available capital (Tier 1 common) of $147 billion to the $127 billion that the bank says it needs under Basel III you have an effective solvency ratio of 115 percent (see Note 1). All it takes is JPMorgan’s own estimate to be off by $20 billion or more and the bank is insolvent on an economic basis (see Note 2).
You might think that $20 billion is an ample buffer but then again JPMorgan has already paid more than that in legal bills since 2008 – something that no analyst predicted would happen. Returning to the Fukushima analogy, $20 billion seems like an awfully thin defence against the leakage of financial radioactivity contained in a bank like JPMorgan today.
Note 1: My figure of $127 billion for JPMorgan’s required capital comes from dividing the bank’s reported Basel III risk-weighted assets of $1,587 billion by 12.5. Since RWAs for operational, market and some forms of credit risk are computed by multiplying a capital charge by 12.5 according to Basel rules, I argue that it is more informative to use the capital charge which is directly comparable to available capital, rather than divide available capital by RWAs to produce a misleading leverage ratio. That is also the approach followed by insurance companies that compute economic solvency ratios.
Note 2: By economically insolvent, I mean that the bank doesn’t have enough shareholder capital to cover the cost of a lot of adverse scenarios happening at once. Having a solvency ratio of less than 100 percent is equivalent to a Basel III core Tier 1 ratio of less than 8 percent, which of course is the reciprocal of 12.5.