What J.P. Morgan Chase’s Loss Should Remind Us About Risk Measurement
Last Thursday’s revelation of a multibillion-dollar trading loss at JPMorgan’s Chief Investment Office has reverberated through Wall Street and Washington, stiffening the resolve of tighter regulation’s most outspoken advocates. For the weekend’s op-ed columnists and a herd of elected officials, the loss adds to prima facie evidence of a deep flaw in the current model of investment bank risk-taking.
In the case of a large institution, they argue that risk-taking intimates broader threats to stability that must be contained. For the bankers careful to adopt a contrite demeanor, it also represents an ill-timed misstep by their most credible ideological counterweight and champion of self-regulation.
Writing for The New York Times’ Opinion Page, Paul Krugman offered that the prior days’ events included “a large heap of poetic justice—as well as a major policy lesson.” If nothing else, the intended lesson is closer to a pep talk that exhorts regulatory advocates to gather their wits and keep up the good fight. Running for office and adopting a populist tone, Elizabeth Warren called for Jamie Dimon to resign his appointment as a director of the New York Fed. For his part, Mr. Dimon described the loss as a “terrible, egregious mistake.”
In the realm of tangible power, the Securities and Exchange Commission announced Friday that it was opening a preliminary investigation into JPMorgan’s accounting practices. Presidential campaign teams on both sides are evaluating how best to position new developments. Normally garrulous detractors of Dodd-Frank and the Volker Rule have been unusually quiet as they consider distancing from Wall Street’s apologists. Andrea Saul, press secretary for Governor Romney’s campaign, wrote that the loss “demonstrates the importance of oversight and transparency.” It seems the entire apparatus of Washington is in motion.
The difficulty with the current framing of the bank debate—and most other issues that now rise to national prominence or lend themselves to doctrinal interpretation—is a binary worldview. Regulation is a blanket term for something monolithic, uniform and undifferentiated that will either solve our problems or worsen them materially. The notion that flexible, well-considered regulatory authority that addresses specific market failures might mingle with a poorly conceived counterpart is too centrist for our epic tastes.
While the political machinations are unsurprising, JPMorgan’s trading loss highlights a crucial secular issue that has received remarkably little scrutiny. How could a systemically threatening loss occur if the most recent stress tests undertaken by the Federal Reserve clearly indicate otherwise? While they are not positioned as such, the tests undertaken as part of the Comprehensive Capital Analysis and Review process are blunt tools at best.
Default or loss estimation relating to even a single loan or financial instrument can be a haphazard exercise as much as a statistical one. The idea that a large institution’s entire portfolio of exposures could be evaluated with sufficient care so as to uncover esoteric risks is speculative if not naive. We cannot assume that measurement errors are independent and unbiased if our concern is that behaviors are systematically risk-seeking.
The stress tests may ultimately succeed in uncovering obvious problems, much as ratings often capture changes in creditworthiness ex post. But beyond the obvious, the risks we need concern ourselves with are the ones we consistently fail to anticipate. Such is the case with JPMorgan’s loss.
The espousers of heightened regulation (I count myself amongst them on many points) would do well to concede that their advantage lies in the authority to regulate and in their differential incentives, not in a fundamentally more nuanced understanding of risk.
Sam Chandan, PhD, is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.