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August 22, 2013

Would Better Regulations Have Prevented the London Whale Trades?

President Obama this week pressed financial regulators to work more quickly on rules aimed at better regulating Wall Street and avoiding another financial crisis. His forceful comments, which came three years after the legislative overhaul known as the Dodd-Frank Act set the stage for the writing of these rules, were the latest reminder that exotic and outsized financial bets by banks continue to pose a massive risk to the global financial system.

It’s also worth bearing in mind, however, that the new rules are likely to improve things only if banks and regulators live up to their responsibilities. Last week, federal authorities criminally indicted two former JPMorgan Chase & Co. employees who allegedly hid losses related to a trading scandal last year that cost the bank more than six billion dollars. The details of the indictment underscore the fact that one of the most significant instances of Wall Street misbehavior in recent years had less to do with a deficit of rules than with JPMorgan’s failure to follow the ones that already existed, and the government’s failure to notice. The most troubling questions emerging from those trades are these: How did JPMorgan—which played a key role in creating the method of measuring risk that is most common on Wall Street—end up misusing its risk-measurement tool? And how did the government miss the red flags?

The risk-measurement tool known as “Value at Risk,” or VaR, emerged from the seismic changes that shook the financial industry during the last two decades of the twentieth century. Commercial and investment banks were merging, going public, and increasing in scale. Just as these financial supermarkets began attracting ever-larger pools of capital from investors, there was an explosion of trading in exotic and complicated securities based on mortgages and other consumer debt. After the stock-market crash of 1987, banks became much more interested in developing more sophisticated risk-control mechanisms for their increasingly large and volatile portfolios. (Joe Nocera writes that senior managers who had come up through commercial banks, like Dennis Weatherstone, J. P. Morgan’s chairman at the time that VaR took off, were especially concerned: they were accustomed to managing the risks posed by lending to consumers and companies, but they needed help understanding the risks posed by these newly invented trading operations.) To fill this void, J. P. Morgan—the bank that later became part of JPMorgan Chase through an acquisition—helped to develop, and popularize, VaR.”

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Read full New Yorker article here

 
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