Over the last few weeks, the financial community has paid rapt attention to trading losses at JPMorgan Chase, estimated to be anywhere from $2 billion to as much as $9 billion. The sudden emergence of such a large loss sent a disturbing tremor through an already vulnerable economic landscape. The lesson to be learned here is emphatically not about the bank or its leadership, but about the structure of our financial system.
The loss by the much-admired bank was more than a case of a private sector company taking a private sector hit because of a private sector error. First, if a bank this important were to become endangered, the contagion to global financial confidence would surely necessitate a bailout. Losses in institutions to which we entrust the soundness of our money, or where deposits are guaranteed, put the rest of us at risk. Second, and less widely appreciated, JPMorgan’s trading loss is a minuscule fraction of the bank’s more than $75 trillion in notional value of its current positions in derivative securities. The trading of derivatives — securities whose prices are dependent on valuations of underlying assets but do not represent direct ownership claims on those assets — is exempt from the sensible regulation of disclosure and leverage normally applied to stocks, bonds, and other direct claims. This is still, despite all recent attempts at financial reform, the Wild West of trading markets.
Banks say their trading positions are properly hedged by countervailing positions, leaving them little risk. They “prove” this using statistical models anchored in past price behavior and by noting that market pricing indicates a proper balance between their opposing positions, leaving little residual exposure. The problem is that the models are oversimplifications. They rarely predict unfamiliar possibilities, sometimes called “black swans,” or the impacts of external events such as geopolitical disruptions. Markets usefully gauge the reasonableness of prices, but no one seriously thinks that they are always right. If a bank is mistaken about how well its positions are hedged by a fraction of a percent, it can become insolvent.
All three of the largest US banks have open derivatives positions in excess of 24,000 percent of their equity capital. Neither models nor markets can protect them from small percentage imbalances. In addition, bank trading relationships around the world are so interconnected that if one goes down all are threatened. No CEO or board of directors, however talented and honorable, can oversee trading at the multi-trillion dollar scale with perspective and precision enough to assure the avoidance of systemic impairment. Nor can any government oversight body.
Bank lobbyists insist that all this trading is needed to facilitate commercial transactions, but don’t be fooled. The open derivatives positions at the three largest US banks exceed twice the GNP of the world. Add in large European and Asian banks, and the commercial hedging argument becomes a parody. Hedging is useful in commerce, but its systemic risk should never outweigh its commercial value. A much lower trading intensity than today’s would support all of the hedging needed. The Volcker Rule, limiting proprietary transactions, is a step in the right direction, but it would not curtail the exposure from the imprecise and layered hedges that follow a bank’s client transactions. And that is where the vast bulk of the risk in derivatives trading lies.
Under present rules, banks are free to put us all at risk in derivatives trading without creating any offsetting cushion. Every derivatives transaction involves some basis risk (that two paired commodities will not continue to move in unison), some counterparty risk (that the trade will not honored by the other party), and some human error risk. Accountants and regulators know well that netting massive positions to zero cannot reflect true exposure.
Whenever a new position is taken, there should be a mandatory accompanying reserve or capital charge. This would have a two-fold benefit. It would increase protection for both the public and the banks and it would dull the appeal of hazardously oversized trading accounts. Although regulators should set the actual amounts, imagine that the charge was uniformly 0.1 percent of the notional position value. Open positions of $75 trillion in derivatives would require $75 billion put aside, an amount large enough to make that trading scale unappealing. Charges to match the risk created would bring trading volumes back to sensible size with a minimum of new regulations and no need to outlaw useful commercial practices. They would simply acknowledge that all derivatives positions, however useful, impose some risk on the holders and the public. Current scale imposes an unmanageable risk.
James M. Stone, former chairman of the Commodity Futures Trading Commission and commissioner of insurance for Massachusetts, is CEO of the Plymouth Rock group of property and casualty insurance companies.