Capco Blog

Hazards of complexity

Two themes are apparent after the revelation last week that JPMorgan Chase lost $2 billion on complicated derivatives trading: The complexity and velocity of the system has reached such a level that by the time a problem becomes apparent, it’s almost too big to contain. Further, the ever-increasing size of institutions, their positions and hedges causes the magnitude of events associated with them to be large as well.

Even a week later, we still don’t know exactly what happened at JPMorgan. But it is clear that the complexity of the current system has reached a point where transparency remains elusive and managing risk is fundamentally tricky. The sheer size of large institutions — making them “too big to fail” — is still an issue. While it might be tempting to surmise that more regulation is needed, the reality is that even if Dodd-Frank rules were in effect, these hedges would, in all likelihood, have been permitted. So the answer is not more regulation – in fact, regulation, designed to lower risk in the system, needs to be carefully evaluated for unintended consequences to make sure that it is not enabling the opposite outcome.

Enterprise risk management is as much of an art as it is a science. However, the science can only be applied if appropriate information is presented to empowered decision makers in a timely manner. Once forensic analysis of this event is complete, we will be able to determine if controls were adequate, if processes suitably enabled appropriate decision making, or whether the event was an outcome of a judgment call that did not work out as intended. What is clear, however, is that there was insufficient transparency and existing controls did not provide alerts in a timely manner to allow course correction.

A successful enterprise risk management strategy offers well-balanced friction that helps organizations avoid unnecessary losses while responding effectively to the threats and vulnerabilities to which they are exposed. It is entirely possible that the level of friction in internal processes was too high, which prevented JPMorgan from unwinding risky positions or hedges in a timely manner.

Prudent enterprise risk management is not about playing it safe. It’s about playing it smart by minimizing, monitoring and controlling the likelihood and/or fallout of unfavorable events caused by unpredictable financial markets, legal liabilities, project failures and accidents.

The financial services industry needs to consider whether a fundamental reduction in complexity and velocity is required to enable better risk management. The size of large institutions has caused the magnitude of positions and offsets to increase. Add to this the burden of compliance and its impact on returns, and we have a system where institutions have to take on more risk to drive the needed return. Consequently, it might be appropriate to contemplate dampening the system, either in magnitude or velocity. Such moves will likely entail trade-offs, however, they might help increase stability.

Comments

Very good article. Although, as some of the dealings at JPM come to light it seems that an essentially well-meaning construct as the Chief Investment Office (essentially a large asset liability management unit) was deemed to dull by the powers to be. To bring more excitement, rules have been amended to allow for "better" use of the roughly 360bn USD. With dire consequences. It probably didn't help matters when in April the large CDS position was publicly presented in the media - a suicidal move in an industry looking for alpha whereever possible.
It shows that where large sums of money are presented, greed (for lack of better word) breaks through. If JPM had remained "dull" it stands to reason that such loss would probably not have been incurred.
So, case made for regulation? In this highly political environment - yes, of course. But as Sandeep points out. Regulation has to be thought through before put into place. The coming months and years prove to become quite interesting...

Tom, thanks for your comments. You raise a very interesting point around the public disclosure of the large position, and whether it contributed to a potential escalation – i.e., further increased the velocity. While transparency is essential for risk management, care should be taken to avoid any premature public disclosure, as it might have the potential to exacerbate volatility and make it harder for institutions to manage potentially adverse positions.

"JPMorgan Chase lost $2 billion"
Has JPM ever made millions/billions over the years? This looks and sounds to me what we call Capital Markets with shareholders winning on the profits and sharing on the losses.

Thanks Dave – you are absolutely correct. I guess the only reason to worry is if a bank becomes so big that anything associated with it (positive or negative) starts to have systemic impacts.

I'm of the belief that there are a few of key factors at play here.

First, a number of weeks after the revelation, we're learning that $2 Billion is, apparently the tip of the proverbial iceberg. The numbers we're hearing of now are in and around $5 Billion and counting. However, what is happened at JPMC, in the purest terms, is really capitalism 101. When taken out of context of the current global financial climate. With that said, we can't take it out of the context of the current global financial climate.

The greatest majority of the citizens of the world, haven't the foggiest idea of what a CDS is or even a derivative. To people who do not work in financial services, an instrument is something used by a band or orchestra. It doesn't matter that most, if not all of the JPMC losses involved JPMC's money and not money from the average Joe. It doesn't matter that there appears to be nothing untoward that happened. All that matters is that another big bank lost a bunch of money and it's in the press.

We've all heard that the market is based very much on emotion and emotions and cynicism are higher right now than they've been in recent memory when it comes to the financial markets. Throw in the financial crisis in Europe and JPMC is simply more fuel to an already raging inferno undermining the foundations of our financial system for John Q Public.

Secondly, as I mentioned earlier, in its purest form, this is capitalism 101 but, since August 2007 when the subprime crisis first started to show its ugly head, the amount of government meddling in the markets has, arguably, tainted "capitalism 101" While JPMC is still a very healthy bank. The spectre of the financial bailouts of the likes of AIG and General Motors leaves the American public with an ever growing bitter taste in their mouth. Either the US government intervenes with increased regulatory measures or they don't. This "sometimes we'll jump in, sometimes we won't” attitude adds to both the uncertainty and the public angst.

Finally, on the "too big to fail" view; If there is one thing that the last few years have taught is, it's that there is no such thing as too big to fail. The size of financial firms, coupled with the speed and size of transactions simply makes the fall more steep and precipitous. While financial services firms have grown huge, so have the numbers in the environments in which they operate.

The challenge is, that to "dampen" the system will be a challenge. JPMC, specifically, has been making significant investments in their compute back bone (CBB) program since 2003. A key impetus for this was accelerating derivatives pricing, program trading and risk anlytics http://www.wallstreetandtech.com/resourcecenters/riskmanagement/190700085

We've become very jaded about numbers. $5 Billion, in relative terms to the size of the market is not huge, but to people on the street, these are numbers that are just simply foreign to them. If a person on the street made $1 a second 24 hours a day, 7 days a week, it would take 160 years for them to make that sort of money. This is what the public sees and this is what they think about when they hear these numbers.

Thanks Brian - very eloquently stated and spot on. Markets dislike uncertainty – don’t meddle with them and people accept the vagaries of the market – start meddling and uncertainty gets exacerbated. It is certainly starting to appear that any event associated with banking takes on a public (taxpayer) flavour, which is probably not healthy. Couldn’t agree more with your dampening comment to help manage the complexity and velocity in the system.

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