What Would J.P. Morgan Say?

Last week it was revealed that derivatives trades gone bad may cost J.P. Morgan Chase bank over $2 billion. The losses apparently are still accumulating at around $150 million per day. A senior manager has already lost her job and perhaps more heads will roll.

Why do banks keep racking up such losses? The bank claims the losses were incurred on trades designed to hedge the bank’s exposure to events in Europe. They failed because relationships among asset prices (really indices of derivatives) diverged from normal patterns. Surprise! That has been the undoing of many financial bets in recent years, starting at least with the spectacular collapse of Long-Term Capital Management in 1998.

A number of factors are at work, which I examine in more detail in a longer post. The short answer is that bad policy is at least partly to blame. Large banks know from experience that they will get bailed out by taxpayers if they incur major losses (the “too-big-to-fail” policy). There are two recognized consequences of that policy. Banks are larger than they would otherwise be, and they are riskier than they would otherwise be.

There is however a third consequence, less recognized than the other two. With growing size comes growing complexity. The major banks are simply too complex too manage. Senior management cannot control the risks being taken, often because they cannot understand them. That was the case in Citibank in the 2000s and appears to be so again with Morgan.

The problems will not go away until public policy changes.