The Dangerous Fallacy in JPMorgan’s ‘Whale’ Report

The Dangerous Fallacy in JPMorgan’s ‘Whale’ Report

REUTERS/Larry Downing

JPMorgan Chase’s internal report on the “London Whale” trading losses was long on detail (132 pages worth) and short on surprises.

Although no one escapes a share of the blame for the more than $6 billion loss – and CEO Jamie Dimon had his pay cut from $23.1 million in 2011 to $11.5 million in 2012 – nothing in the analysis appears to recognize the inherent difficulty associated with the kind of trading involved. Rather, the report’s bottom line centers on the importance of having enough well-trained risk professionals on hand, and ensuring that they are listened to by everyone from the rank-and-file traders right up to CEO Jamie Dimon himself. That’s an unsurprising point of view, particularly from an institution headed by someone who famously described the 2008 financial crisis as one of those things that rolls around every five to seven years.

But the assumption that risk can be managed with the right people, the right models and the right systems, doing the right things at each step along the way, is in itself a fallacy. The risk that this report creates is that the bank will take comfort in a conviction that its new models, people, systems, policies and procedures now cover every contingency. Based on that conviction, it could take on more risk in quest of profits.

The JPMorgan Chase (NYSE: JPM) bankers may understand the vast majority of those risks, but the odds are that one day, something that couldn’t have been anticipated – the infamous black swan – will come along and wreak havoc once more. After all, had one asked Dimon what he thought of the bank’s risk procedures prior to the Whale trades, he would likely have said that gaps and weaknesses revealed during the financial crisis had been tightened up.

While the JPMorgan Chase report said what investors and regulators needed to hear – it provided a detailed analysis of what went on and outlined strategies to address it – the document would have been more convincing had its authors simply acknowledged that ultimately, not every risk can be anticipated and removed. Perhaps they know better – after all, they’re in the business of risk transfer – or perhaps it isn’t politically acceptable to say that, just as one day we’ll die, one day every organization will find that, despite careful planning, something goes awry.

The one respect in which the London Whale report is accurate is in its evaluation of the minimal role of compensation policies in the fiasco at the Chief Investment Office. “There does not appear to be any fundamental flaw in the way compensation was and is structured for CIO personnel,” the report concludes. “What the incident does highlight is the particular importance of clear communication to front office personnel engaged in activities not expected to generate profits (such as the winding down of a trading portfolio) that they will nonetheless be compensated fairly for the achievement of the Firm’s objectives, including effective risk management.”

The members of Ina Drew’s Synthetic Credit Portfolio team in London might have been thinking that they would score a big bonus if they got the trade right. But the worst of the problem was the way they reacted when things started to go wrong; traders didn’t act promptly enough to close out their positions. Instead, the report points out, they “did not show the full extent” of the losses.

It’s called career risk, and in this case, it’s related to compensation. Managers needed to do a better job of telling the team that they would still be “properly compensated” for safeguarding the bank’s wellbeing and minimizing losses, even if they negatively affected the company’s overall profits. The traders need to understand that, in many circumstances, managing risk and minimizing losses can be of as much value to the firm as capturing profits.