JPMorgan's Loss: What Banks Still Haven't Learned
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By Knowledge Wharton,
Knowledge@Wharton
May 29, 2012

When JPMorgan Chase (JPM) announced its $2 billion trading loss on May 10, some analysts asked, "What's the big deal?" Even though the loss now appears to have grown to $3 billion, and could, by some accounts, soar to $5 billion or more, that's pocket change to this enormous bank, which is healthy and making money.

Even the trading operation that booked the loss is in the black overall. Aren't losses part of the game? Why does one loss matter if it is more than offset by other trades' gains? The problem, says Scott E. Harrington, professor of insurance and risk management at Wharton, is that JPMorgan's loss struck at a particularly sensitive time. "My first reaction was that $2 billion is a tempest in a teapot," he says. But on closer inspection, the bank's loss raises serious questions about the kinds of risks banks are shouldering. "The incentives really encourage risk-taking," he notes, arguing that excessive risk is still possible four years after the financial crisis struck.

RELATED: JPMorgan: A 'Stupid' Bet with Big Implications

"The particular loss that JPMorgan faced in this instance is clearly easy for them to absorb, but the timing of it is very consequential because it comes while regulators are implementing the Volcker rule," says Wharton finance professor Krista Schwarz, referring to a regulation, still being finalized, that would restrict bank's right to speculate with their own money. 

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Lawmakers continue to wrangle over the best way to moderate the systemic risk caused by financial institutions that are "too big to fail," and the top banks have only grown larger since the financial crisis. Regulators are still writing rules required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. And, of course, it's a presidential election year, with the two candidates and their parties dueling over the best way to spur growth and avert undue risk. "The political backdrop, I think, has heightened the newsworthiness of this particular [incident] beyond what it really means in substance," Harrington notes.

The JPMorgan case is seen by many as a warning shot -- notice that incentives and practices at big financial institutions can still, despite the lessons of the financial crisis, produce a toxic mix. If a bank can lose $2 billion, can it lose $20 billion? $200 billion? What if several banks had big troubles at the same time? Could the ripple effects swamp the innocent, as they did a few years ago?

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"I think the main lesson [from JPMorgan] is how difficult it is to control risk," says Wharton finance professor Franklin Allen. "What's more, although this loss can be absorbed by JPMorgan, one wonders how big a loss is possible. For example, could a major institution be brought down by this kind of loss?"

WHITHER VOLCKER? 
Huge, risky speculations played a major role in the financial crisis, and reforms like the Dodd-Frank bill aimed to curb those practices. JPMorgan contends that the trades in question were part of a hedging strategy designed to reduce risk rather than to speculate, but the case shows how even hedging can go wrong. The bank has not disclosed details of its strategy.

Hedges are designed to reduce risk rather than make money. In the simplest form, an investor with 100 shares of stock could buy a "put" option giving its owner the right to sell those shares at a set price for a given period, insuring against loss if the share price went down. 

In another case, a bank making a loan to a company could buy put options on the company's stock, or a credit default swap that is a kind of insurance against default on a specific debt. If the company went under and defaulted on the loan, the put or CDS would produce an offsetting profit. "That's a simple hedge to understand," says Wharton finance professor Itay Goldstein.