In 2011, senior executives at JPMorgan Chase & Co (NYSE:JPM) told one of the bank's trading and hedging groups to scale back its riskier positions as new regulations would make these bets much more expensive to maintain.
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The group, called the Chief Investment Office (CIO), was asked to cut risk-weighted assets, a key measurement that regulators use when assessing a bank's stability and how much capital it needs to hold, according to a U.S. Senate subcommittee report on Thursday.
In December 2011, the CIO came up with a plan to change its risk models. It estimated that by calculating risk differently, the bank could reduce its risk-weighted assets by $7 billion - more than half the targeted amount - without having to actually sell the securities.
The CIO famously went on to lose more than $6 billion last year from bad credit derivatives bets that came to be known as the "London whale" trades. One of the main reasons the losses grew so large, according to Senate investigators, were the changes that JPMorgan made to its risk models.
A JPMorgan spokesman declined to comment. The largest U.S. bank has acknowledged mistakes but said senior management acted in good faith and never had any intent to mislead anyone.
Investors say they fear that JPMorgan is not alone in tinkering with risk models to meet tougher capital requirements laid out in new regulations known as Basel III.
Global banks are spending hundreds of millions of dollars to install elaborate computer models to measure risk and make sure they are adequately capitalized. Under Basel III, banks can shrink their risk-weighted assets - and boost profits - if they can build a model to prove the bond or loan is not so risky.
While banks can use these models legitimately, they can also be tweaked to try to game the system, said Adam Compton, a portfolio manager at Atlanta-based hedge fund GMT Capital Corp.
"You're naive if you don't think it ever happens," said Compton, who scrutinizes financial statements for banks.
Capital is a key source of safety for the global banking system, and bad models could lead to undercapitalized banks. Many big banks were not holding enough capital when the financial crisis erupted in 2008, forcing some to fail or take government bailouts as they were unable to absorb losses. But keeping capital levels high makes banks less profitable.
As JPMorgan's experience with the CIO shows, the line between optimizing capital and manipulating it is fine, and often hard for outsiders - including regulators - to discern, say experts in regulatory measurements of risk.
JPMorgan Chief Executive Jamie Dimon himself pointed out in 2010 that "some banks have far more aggressive risk-weighted asset calculators than we do."
GOING INTO BOOKS
Banks need to seek regulatory approval for new risk models, but regulators may not have the time or sophistication to figure out when they are being duped, according to financial risk experts.
Basel III rules run to 616 pages, compared with 347 pages for Basel II and 30 pages for the 1988 Basel I accord.
An examiner of bank books, who is stationed inside one of the biggest U.S. banks by a regulatory body, said regulators can - and do - back-test model changes, ask for detailed information on what specifically changed, and fight the banks on changes if they are inappropriate.
"We are going into their credit books all the time, literally pulling out securities and testing them on the models every quarter," the regulatory examiner said, declining to be identified because he was not authorized to talk to the media.
The Federal Reserve's stress tests of the largest U.S. banks this month showed that some banks' own calculations of capital levels differed sharply from the central bank's.
The problem is acute enough that at the end of January, the regulators behind Basel III said they found wide variations in how banks implement the rules, and they might revise them as a result. A survey by a research analyst at Barclays Capital last year found that half of investors distrust banks' risk-weighted asset figures.
Some regulators say the rules need to be simplified as banks are wasting time and effort on getting the best possible treatment for their assets instead of making their holdings safer.
"The amount of money being spent on this is just incredible," said Thomas Hoenig, vice-chairman of the U.S. Federal Deposit Insurance Corp, in an interview.
A senior regulatory head at one large European bank said his firm alone had spent about $500 million to optimize systems to move from Basel I to Basel III over the last decade.
On both sides of the Atlantic, 13 of the biggest financial institutions have together announced plans to reduce their risk-weighted assets by 20 percent, or $1 trillion in total, according to consulting firm McKinsey & Co.
JPMorgan, for example, wants to reduce its risk-weighted assets by $80 billion to $100 billion. Goldman Sachs Group (NYSE:GS) plans to shed $28 billion worth of risk-weighted assets by the end of this year, from $728 billion as of September 30.
Goldman is using new technology so that traders can assess risk-weightings of individual securities more quickly, Chief Executive Lloyd Blankfein said in November. The bank has said that without its modeling efforts, upcoming Basel III rules would result in 40 percent higher risk-weighted assets, compared with the prior risk-weighting regimen.
McKinsey estimates that slashing risk-weighted assets will boost return on equity by 3 percentage points for the 13 financial institutions. The group only earned a 4 percent return in 2011. Return on equity is a widely watched measure of how effectively a bank uses shareholder funds to generate profit.
"Risk-weighted assets used to be done by some department of the bank and no one concentrated on them; they were insignificant," the European bank source said. "Now, we're all trying to optimize them."
In the case of the London whale trades, JPMorgan executives fought with the Office of the Comptroller of the Currency and failed to disclose information about the bank's new value-at-risk model until weeks after it was implemented, according to the report from the Senate's Permanent Subcommittee on Investigations, chaired by Michigan Democrat Carl Levin.
In March 2012, Levin's committee found that the chief quantitative analyst for JPMorgan's CIO, Patrick Hagan, wrote an email in which he proposed to "optimize the firm-wide capital charge," meaning he would tweak the way the group measured risk to ensure its assets got better treatment under firm-wide capital requirements.
Later, a colleague told him to be careful about leaving a paper trail when discussing these moves.
"I think what I would do is not put these things in email," said Anil Bangia, who helped the group develop risk and capital models, according to the Senate's report.