If smart JP Morgan can get it so wrong, what can we learn from their experience?

The story is still developing, and there will be more repercussions, but JP Morgan recently announced a $2 billion dollar loss on trades it initially called hedging. It was a material event that was disclosed publicly. JP Morgan can absorb the loss, but it still stings - every $2 billion counts. See here for some background on the story. As the story continues to develop, the loss may yet be substantially larger (numbers like 3-6 billion dollars have been talked about).  The disclosure has wiped out over US$25B of shareholder value. (The stock sagged from about $40 to presently around $33, and there are almost 4B shares outstanding).

In a very related sidestory, JP Morgan’s CEO, Jamie Dimon has been a vocal critic of further regulation arising from the 2008 Financial Crisis. He steered his bank adroitly through the crisis and had a tremendous amount of credibility that he was using to fight or at least weaken, among other things, the Volcker rule. The Volcker Rule, being discussed in Congress and by regulators, would put significant restrictions on the trading of derivatives for banks own accounts. JP Morgan’s credibility on the Volcker Rule fight is an early casualty of this very surprising loss.   

How did this happen at a place that is universally respected, and staffed with some of the smartest, most capable people in the business?

What actually happened?

What makes the loss such a stunning event is less the magnitude, than the fact that this happened to JP Morgan at all. JP Morgan is mostly pretty good at risk management.  For a bank, especially a big bank, the nature of risk management has changed substantially in the last 20 years, along with many of the developments in modern banking and finance. A big modern bank does legitimately need to be able to hedge its activities. But the line between “hedging” and “speculating on its own account” can have substantial grey areas. 

To manage this risk, JP Morgan consolidated much of its hedging activity in its Chief Investment Office (CIO), run by Ina Drew, a woman described as “scary smart” by a number of colleagues. She has successfully, over many years, been a key team member in driving down the bank’s overall risk through clever hedging.

But slowly, gradually, something changed. The CIO started making money. It went from being a support unit, to a profit centre. And it started contributing some real cash. As it did, it started reaching farther across the line from "pure hedging."

The details of these trades, and how the so-called “London Whale” (one of Ms Drew’s senior people) got stung on the wrong side of big trades is a fascinating developing story, but not our focus. A short video shows Jamie Dimon talking about the situation and the handling of the risk - see the link at the end of the article.

What Executives Should Take Away from This

JP Morgan illustrates for us one of the critical issues in Enterprise Risk Management. The biggest risks can come from blind spots.  Places you weren’t looking because you “trusted” everyone there.  It is what sunk News of the World in the UK Phone Hacking Scandal.  News Corp’s best people were on it or didn't see what it could become. (Some of them are now facing charges). 

Similarly, JP Morgan’s best people were on it.  They provided the assurances that, “yes, it’s offside now, but we’ll turn it around….” Or something like that.  CEOs can’t be everywhere all the time, and yet they are accountable for it all.  They need an early warning system that indicates early and often when things they want to trust are starting to poke outside the expected boundaries.  At JP Morgan that maybe should have been when the CIO starting making money. At least when the trades started to show up offside. Instead Jamie Dimon learned about this particular red flag by reading an article about his “London Whale” in the New York Times.   No matter how you slice it, that’s a crummy early warning system for a major bank. 

The Board is also getting a lot of scrutiny. The Board has a Risk Committee – which is pretty useful in a modern bank.  But the members of the Risk Committee are three: an Investment Fund manager, the President of the American Museum of Natural History, and the Chairman and CEO of Honeywell, a technology and manufacturing ‎company.  Distinguished, smart, and hardworking presumably. But schooled in the complex risk instruments being hedged in the remote corner of international bond market? Highly doubtful. Aware that any day the Bank might announce a $2 Billion dollar loss (or larger) on activities?  Again, highly doubtful.  If the Board does not have the skills to oversee the risks properly, how can they be effective stewards of their shareholder responsibilities?  Shareholders here have lost over $25 dollars.

Another casualty is the Board’s responsibility to the company.  If the risk of increased regulation is as bad for JP Morgan as Jamie Dimon portrays, then it is clearly in the Bank’s interest to fight it. Their abilty to do that has been a clear casualty of this mis-step. The US Treasury Secretary Timothy Geithner is quoted as saying "I think this failure of  risk management is just a very powerful case for ... financial reform."

Agenda-Defining

The last take-away is that these risks, when they occur, become agenda-defining.  Everyone drops everything. 

Ina Drew, after a long and distinguished and pretty successful career has taken retirement.  Sadly for her, it won’t be on the wings of a glorious exit.   More “departures” and restructuring are sure to follow.  While Jamie Dimon doesn’t want the SEC telling him how to run his bank, he sure will implement further changes to how he does it himself. 

All of this has crowded out whatever other important activities were on his schedule for the last month and will have impacts for the next month or two. Finding a trustworthy and capable replacement for Ina Drew is going to be a big issue by itself. 

Congressional hearings are going to take yet more time. Then there's the FBI probe looking for evidence of a crime. The SEC is investigating, looking for regulatory breaches. At least two separate shareholder lawsuits have been launched.  

All of this and more is due to, ultimately, as Jamie Dimon an “egregious, self-inflicted” set of errors that happened on his watch. 

Preparing For Your JP Morgan Moment

Some key take-aways for even the smartest executives:

• If it can happen to JP Morgan and Jamie Dimon, it can happen to you
  
• A robust risk management program is a critical asset in flagging early warnings in places you aren't looking
  
• You need your team looking in places you aren't
  
• You need to be ready for the crisis, what-ever it will be - an off-the-cuff response is wholly inadequate.  Preparation is key.
  

See the video here that shows Jamie Dimon discussing their mis-handling of the red flags. 

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