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Dimon hearing raises questions about bank's risk models

June 13, 2012: 3:45 PM ET

JPMorgan Chase's CEO says his bank's hedges are safe.

Fortune -- In banking, it appears, the model is always risk on.

In Congressional testimony on Wednesday JPMorgan Chase's CEO Jamie Dimon spent a lot of time trying to prove to members of the Senate Banking Committee that the bulk of what his bank does - London Whale aside - is prudent. He said he believes in stress testing. And that he has an open door policy with regulators. He has a whole committee of people assigned to develop risk models. On the surface, it all seemed to prove Dimon's argument that JPMorgan's recent $2 billion and counting trading loss was a one-off. Frankly, Dimon said that he would rather be spending more of his time thinking about Europe.

And it appears investors liked what they heard. Shares of JPMorgan (JPM) reacted positively, up $0.45, or just over 1.3%, shortly after Dimon finished testifying. But if you dig a little deeper into what Dimon said there is a lot of reason to believe that recent banking reforms passed in the wake of the financial crisis have done little to rein in risk at JPMorgan or elsewhere.

MORE: What caused JPMorgan's Whale-sized trading losses

Dimon said that while the credit derivatives trades that were made out of London violated the firm's risk rules, the rest of the $350 billion managed by the firm's chief investment office is in liquid, generally low-risk investments. To prove that, Dimon said that on average the portfolio has a yield of just 2.6% and a duration of 3 years. But while 2.6% might sound low, these days that's rather hefty. If Dimon's portfolio was truly low-risk, you would expect it to have a similar yield to U.S. Treasury bonds. But the average yield on a 3-year Treasury bond is currently 0.375%. JPMorgan's portfolio is yielding seven times that. That's hard to do without taking a lot more risk.

What's more, while it's well known that Wall Streeters like bespoke when it comes to suits, that appears to be their taste in risk models as well. Dimon said that his firm has dozens of risk models, each individually tailored to different lines of business. And those risk models are regularly updated depending on the economic environment. That seems foolish. Credit derivatives have the same risk no matter what division of the bank is trading them. And markets, and economic environments, can quickly change. What you want is one risk model that will be sufficiently strict to protect you when things are good and when things are bad.

MORE: The 5 Myths of the Great Financial Meltdown

In the current instance, Dimon says the firm introduced a new value-at-risk model for its CIO office to be compliant with new banking regulations put in place by the Basel III accords. But those accords were supposed to make banks less risky, not more so. Instead, the opposite happened. The updated risk model allowed the CIO to take on more risk, and more losses.

Lastly, JPMorgan and Dimon prove once again that instituting and policing the Volcker rule, which is supposed to limit risky trading at the banks, will be very hard to do. Hedging is allowed under the Volcker rule. Prop. trading is not. But Dimon said he can't "draw a bright line" between the two. And if Dimon can't see the difference proprietary trading and hedging, it's very likely his bank's traders don't make much of a distinction either.

Dimon is right about one thing. He's got to put his extra cash somewhere. Regulators wouldn't let him lend it all out either. And anywhere he puts it will have some risk. The problem is he has come to rely on that portfolio as a source of income as well as protection. In the past, he has said he has got to worry about interest rate risk as well. And if he were to put all his extra money into Treasury bonds he would open himself up to loses if rates were to go up. But that's only partially true. On top of Treasury bonds, Dimon could also buy swaps that would limit or eliminate the risk of rising rates. As a result, the only risk he would be taking on was the risk that Uncle Sam defaults, which is still relatively small. Of course, that portfolio would generate very little income as well, which is exactly why he won't do it, even if he should.

"This is why we need oversight," says Michael S. Barr, a law professor at the University of Michigan, who served in the Treasury Department from 2009-2010 helping to write banking reforms. "Left to their own devices financial institutions are going to push the envelope."

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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