A U.S. Congressional committee has released a report into JPMorgan Chase & Co.’s massive derivatives trading loss that criticizes the firm and recommends a number of reforms.
The report, from the U.S. Senate Permanent Subcommittee on Investigations, examines the losses suffered by the bank’s chief investment office (CIO), which placed a massive bet on a complex set of synthetic credit derivatives that, in 2012, lost at least US$6.2 billion.
Its investigation found that the CIO mismarked its trading book “to hide hundreds of millions of dollars of losses; disregarded multiple internal indicators of increasing risk; manipulated models; dodged oversight; and misinformed investors, regulators, and the public about the nature of its risky derivatives trading.”
The subcommittee says its investigation exposed “not only high risk activities and troubling misconduct at JPMorgan Chase, but also broader, systemic problems related to the valuation, risk analysis, disclosure, and oversight of synthetic credit derivatives held by U.S. financial institutions.”
Indeed, it says the CIO trades, “demonstrate how inadequate derivative valuation practices enabled traders to hide substantial losses for months at a time; lax hedging practices obscured whether derivatives were being used to offset risk or take risk; risk limit breaches were routinely disregarded; risk evaluation models were manipulated to downplay risk; inadequate regulatory oversight was too easily dodged or stonewalled; and derivative trading and financial results were misrepresented to investors, regulators, policymakers, and the taxpaying public…”
The trades “provide another warning signal”, it says, about the need to tighten oversight of banks’ derivative trading activities, “through better valuation techniques, more effective hedging documentation, stronger enforcement of risk limits, more accurate risk models, and improved regulatory oversight.”
It recommends that federal regulators should: require derivatives reporting, and carry out annual reviews to detect undisclosed derivatives trading; require banks to establish hedging policies and procedures that mandate detailed documentation when establishing a hedge, and that they should provide periodic testing results on the effectiveness of large hedges; strengthen credit derivative valuation procedures; investigate trading activities that cause large or sustained breaches of risk limits; and, require disclosure of, and investigate, any risk or capital evaluation model which materially lowers the purported risk or regulatory capital requirements for a trading activity or portfolio.
It also calls on regulators to adopt the Volcker Rule to stop high risk proprietary trading activities and the build-up of high risk assets; and, it says that regulators should impose additional capital charges for derivatives trading, and that they should prioritize enhancing capital charges for trading book assets when implementing the new Basel III capital adequacy regime.