Morgan flattened by Whale

Robert Peston
Economics editor

image copyrightAFP

It is hard to know where to begin in describing the savage indictment by regulators in the US and UK of how JP Morgan Chase came to lose a breathtaking $6.2bn from the notorious "London Whale" trades.

However there seem to me to be two big issues:

1) How and why the reputation and good name that JP Morgan boasted for generations was no guarantee of either competence or honesty

2) The lamentable transatlantic arrangements for regulating and supervising a bank of critical importance to the functioning of global markets and the economy.

The aggregate fines and penalties of $920m imposed on JP Morgan by three US regulators and one British regulator may be wholly fitting - but it would surely have been preferable for these regulators, or at least one of them, to have had better oversight of what was going on in Morgan's Chief Investment Office and the so-called Synthetic Credit Portfolio (SCP) that generated the humungous loss.

Regulatory gap

Here's the gaping supervisory flaw. The poisonous SCP was built and traded in London.

But it was part of a subsidiary of Morgan which was American and was under the oversight of the US Office of the Comptroller of the Currency (OCC); and the subsidiary was in turn owned by a holding company, whose lead regulator was the US Federal Reserve.

This means that the formal responsibility of the British regulator - at the time the Financial Services Authority, which has since been superseded by the Financial Conduct Authority - to keep the London-based part of the CIO on the straight and narrow was a bit fuzzy.

If the CIO had been a UK subsidiary of JP Morgan, the duties of oversight of the FSA would have been less ambiguous.

Or to put it another way, the FSA was supervising the CIO with - perhaps - one arm tethered behind its back.

Even so, the FSA registered concerns with JP Morgan about the size of the CIO and the risks it was taking.

How did Morgan respond?

Well one verdict from the Financial Conduct Authority today is that Morgan was not "open and co-operative" with the FSA, and the FSA was "deliberately misled" by Morgan on one occasion in the first half of 2012 about the extent of the losses and other serious lapses.

It was this breach of all banks' duty to supply appropriate, accurate and timely information to regulators that led to the biggest chunk of the British $220m (£138m) fine imposed on Morgan by the FCA.

Reckless management

The beaching of this Whale may well therefore re-open the debate about how the overseas operations of international banks should be supervised and regulated.

To put it in the jargon, it once again raises the question whether economically important activities of banks away from the mother country should be forced to become "subsidiaries" registered in the places where they operate rather than "branches" of the foreign based bank.

To perhaps labour the point, if the CIO in London had been a UK registered subsidiary of JP Morgan, as opposed to being a branch of the US bank, it would have been much more clearly the duty of the FSA to deter it from being reckless and dishonest.

All that said, effective regulation and supervision can reduce the scale and frequency of banking disasters, but cannot eliminate them.

Most would say that bank management, directors and owners should be most held to account when things go wrong.

So, for someone of my generation, what is shocking about the saga of the Whale is that for all my professional life JP Morgan has been seen as among the world's best managed and best behaved banks.

But what regulators have uncovered too late is that a huge part of this bank - the notional size of the SCP was $51bn at the end of 2011 - was being managed incompetently and recklessly.

Huge punts

Before elaborating on JP Morgan's fall from grace, it may be worth reminding you what the SCP was.

Created seven years ago, it was largely a vast collection of "credit instruments", with big positions in indexes of Credit Default Swaps.

Presumably a good number of you now fear I am speaking Martian.

So what you need to know is that a credit default swap is insurance against a company going bust. And an index of credit default swaps groups together loads of different credit default swaps, although usually swaps that share certain characteristics.

In theory, JP Morgan was trading this stuff in the SCP to offset its exposure to the fortunes of big companies via its loans to them. In practice it was taking huge punts on whether at any one time the market thought there was a bigger or lower probability of companies going bankrupt.

When things went right - which was quite often when things went very wrong for real businesses - the SCP generated big profits. Good news for the SCP, for example, was the collapse into bankruptcy of American Airlines, which generated $400m for it.


The fateful credit default swap index for JP Morgan was the "IG9 10-year" index - which grouped together swaps for good quality, low risk companies - to which we will return.

Anyway, the damning findings against JP Morgan are these:

  • Its processes for containing the risks being taken by the SCP were found to be woefully inadequate.
  • The traders of the SCP were given far too much discretion to value the very trades that determined their perceive success (and their bonuses).
  • And for some of 2012 they failed to use best practice when choosing market prices for internal valuations of their investments - so they understated the losses they were generating.

Worse still, these traders subsequently hid losses.


There is something else, of particular interest to me, given how often I bang on that the global Basel Rules for assessing the riskiness of banks' activities have been at best useless and at worst highly damaging to the health of the financial system.

This is to do with they way that those who ran the SCP tried to comply with an instruction from their bosses to reduce the size of their trading book, or rather the "risk-weighted" value of the book based on the Basel rules.

Rather than selling assets, which would have been the sensible thing to do, they tried to come up with a new valuation model that would exploit the elasticity of the Basel rules to shrink the perceived size of the book by accounting (and not in any real economic sense).

In the event, the SCP grew and grew in size, as imprudent new trades were done in a frantic attempt to reduce escalating losses.

And, as the FCA says, at least one set of these trades was an attempt to manipulate a market price - that of the IG9 10-year index (I told you it would return) - and that this was a breach of the requirement to "observe proper standards of market conduct".

So is today's humiliation as bad as it gets for JP Morgan?

That is difficult to say, because the FBI is taking a look at what went on, and the FCA is liaising with the Serious Fraud Office about it, and the US derivatives regulator, the CFTC, is yet to pronounce.

Today may be a black day for JP Morgan, but it may not yet be the blackest.