Uncovering the JP Morgan Credit Exposure Situation

This guest post is written by Matt Streeter, Product Manager of F3 at FINCAD.

It is surely a daunting task to be the key decision maker at any organization and I’d wager it’s a whole lot more complicated at JP Morgan Chase. I certainly wouldn’t be envying the backpedaling and reshuffling that the Executive has had to do as of late, following the disclosures around the multi-billion dollar trading losses. It’s a complex problem, but the best answer is straightforward. It all comes back to effective risk management and the ability to capture all risk exposures across your business and manage that risk effectively. And engage in trading activity within your investment mandate. The news at JPM has been quite interesting to follow, not only because it involves class action suits and criminal investigations. It is also interesting to see the interplay of market, credit, and operational risk: all key elements in this story.

It is certainly easier said than done and it’s all the more challenging when you consider the complex, correlated nature of some of the derivatives used at JPM, but I can hear my father’s voice now while I was at basketball practice: “Great performance will always start with great fundamentals”. And you could say basketball is no different to risk management and trading in that regard – it is all fundamentals. Don’t ever forget what your core business is. If you are starting to get into markets and deviate from core hedging actions as a risk manager, this goes against your core fiduciary responsibilities to shareholders and customers. You have to be aware of the risks that can hit you sideways (the ones you disregarded) when you’re a financial market participant.

The JPMorgan incident puts the spotlight on the need for transparency.  Their current state of affairs doesn’t do a good job supporting their stance. And you can be sure that advocates of Dodd-Frank and Basel III will be quick to pull the JPM card now.  It also highlights the on-going need for better coordination of trading strategy and risk management, even when near real-time risk technology may be in place.

And from what appears on the loss, the ratio of total credit exposure to risk based capital was quite high. With Basel III implementation this type of risk exposure would be mitigated through higher capital, or lower exposure levels.  It will certainly be interesting to see how this plays out. We might see this at other banks when basis plays go wrong, in credit or in other asset classes, and I wouldn’t call it a layup for any institutional investor in this market place. I will be interested to see Dimon’s testimony to the senate banking committee next month on these events.