The core conceptual problem with financial regulation is this:
- It is not illegal to make stupid mistakes.
- Most financial harm is caused by stupid mistakes.
This is endlessly unsatisfying. People Lost Their Life Savings In The Financial Crisis And No One Went To Jail but someone losing her life savings is just not a reason for someone else to go to jail, the two things have nothing to do with each other, the whole thing is a non sequitur. But it's an emotionally compelling non sequitur. Since there was a fair amount of actually illegal misbehavior during the financial crisis, and since much of it is at least loosely related to the life-savings bit, rough justice is often available, but it doesn't really satisfy anyone.*
Anyway today JPMorgan was fined $920 million by a bunch of regulators for, oh, y'know, stuff. The stuff arises out of the fact that a while back JPMorgan employed a whale who lost a lot of JPMorgan's money trading credit derivative indices, all while Jamie Dimon was going around saying unfortunate things like "this is a tempest in a teapot" and "our net income for 2Q2012 was $5.4 billion." Whoops, no, it was $4.9 billion, after the Whale's hidden losses were exposed. The third quarter was rather worse, and all in all JPMorgan lost $6.2 billion on its whaling expedition.
Here is the Securities and Exchange Commission's announcement of its $200 million penalty, which I expect people to make much of because it involves the company "admitting the facts underlying the SEC's charges, and publicly acknowledging that it violated the federal securities laws." What laws were those? The actual SEC order is 20 pages of naughtiness,** mostly around mismarking the portfolio and concealing the losses, and then summarily concludes "As a result of the conduct described above, JPMorgan violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-11, 13a-13, and 13a-15 thereunder." Go read those sections and rules (13a-11, 13, and 15) at your leisure but the gist is that you gotta have accurate 8-Ks and 10-Qs, and controls in place to make sure they're accurate. Mismarked books and hidden losses tend to contribute to inaccurate disclosure. So, QED, the fine and the admission of guilt should be pretty unsurprising.
To get it out of the way: The fine is a number of dollars that is bigger than some numbers and smaller than some other numbers; if you have any insight into how it was arrived at then, hey, that's super for you. Obviously the fines here are pretty arbitrary. Obviously they come out of shareholders' pockets. Obviously JPMorgan's main concern in not doing this again is more about the money-losing trades, and the public embarrassment, than it is about the fines. That's probably how it should be.
But the other settlements are more interesting. Here's the UK Financial Conduct Authority one, for £137,610,000.*** Here are the rules that the FCA found JPMorgan violated:
5.3 Principle 2 of the Principles for Businesses states that a firm must conduct its business with due skill, care and diligence.
5.4 In breach of Principle 2 the Firm has not conducted its business with due skill, care and diligence by virtue of:
(a) The Firm's failure to manage appropriately the trading strategy for the SCP (in the first quarter of 2012). The Authority agrees with the Firm's characterisation of the SCP's trading strategy as "flawed, complex, poorly reviewed, poorly executed and poorly monitored."
5.5. Principle 3 of the Principles for Businesses states that a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems.
5.6. In breach of Principle 3 the Firm has not taken reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems by virtue of:
[things mostly related to the mis-marking]
If you're used to American securities-law settlements this makes for jarring reading. The FCA didn't fine JPMorgan for poor disclosure; it fined it for failures of "skill, care and diligence" and risk management. You can tell how surprising this is because the FCA quotes Jamie Dimon's own characterization of the trading strategy as "flawed, complex, poorly reviewed, poorly executed and poorly monitored." He probably wouldn't have said that if he knew that it would create liability. The SEC doesn't punish you for flawed, complex, poorly reviewed, poorly executed and poorly monitored trading strategies.
But the OCC does! I mean, now it does. Here is the settlement with the Office of the Comptroller of the Currency, which is for $300 million, and which is about the bank's failures to monitor and protect itself from risk.**** The focus here is not that JPMorgan got the disclosure wrong -- to the public or even to regulators -- but that its practices "were inadequate to protect the Bank from material risk" and that "the credit derivatives trading activity constituted recklessly unsafe and unsound practices."
(The Fed order, fining JPMorgan $200 million, is sort of in-between: The Fed is mad that JPMorgan "exercised inadequate oversight over the CIO and failed to implement adequate controls to ensure the full and adequate disclosure of relevant information to senior management and to the JPMC board of directors" and "failed to ensure that significant information related to the valuation of SCP positions by the CIO and deficiencies identified in risk management systems and controls needed by Reserve Bank examiners to adequately assess the risks related to the SCP was provided in a timely and appropriate manner to the examiners." So it's mostly a dislcosure-to-regulators thing but with an overtone of substantive risk failings.)
The upshot is that about half of the JPMorgan fines so far are not for the traditional bread-and-butter of financial enforcement, disclosure failings, but for just doing dumb trades.*****
Mostly I just want to flag how odd that is. But I guess there are a few other things to think about it.
Thing one is: There's a reason why regulators tend not to pursue cases against big companies just for dumbness. I mean, there are a lot of reasons, like a general assumption that businesspeople know their business better than regulators do, and a policy desire not to deter innovation by punishing mistakes. But there's one big reason, which is that dumbness is its own reward. You actually don't need to fine JPMorgan $900 million for losing $6.2 billion! Losing $6.2 billion completely and accurately punishes them for losing $6.2 billion.******
Thing two is: How dumb was this trade, really? I have myself been pretty sneery about some of the decisions made in putting it on, but the basic crash-hedge theory at its heart was not nuts. More importantly, though, the notion that this trade exposed JPMorgan to material risk of unsoundness is odd. I mean, $6.2 billion is a lot of money to lose. But JPMorgan's net income in 2012, after those losses, was $21.3 billion. The $6.2 billion loss was less than 2 percent of the assets in JPMorgan's Chief Investment Office, and less than 0.2 percent of JPMorgan's total assets. Spinning it into an existential threat to the bank looks ... I mean, just sort of wrong.
Thing three is: Why just JPMorgan? One thing that has been in the news a lot is that, in an environment of broadly rising interest rates, banks' portfolios of investment securities -- the part of the bank that, at JPMorgan, housed the London Whale -- have lost a lot of value. One thing that I've been fond of harping on is that these losses are in some ways analogous to the London Whale losses: While they're accounted for differently, they have a similar effect on capital. Also, they tend to be bigger than the Whale losses. If losing $6 billion on credit derivatives in your investment portfolio incurs the wrath, and fines, of every regulator, why shouldn't losing $6 billion on agency bonds in that same portfolio incur the same wrath? The answer is probably "well, that's a dumb thing that every bank is doing, so you can't really fine them all." That's not an entirely satisfying answer.
* I mean obviously there are big bad problems caused by intentional malfeasance. Bernie Madoff ran a Ponzi scheme that cost a lot of people a lot of money. The mortgage crisis did not not involve actual instances of intentional fraud. But, really, some people bought dodgy mortgage bonds because they were bamboozled, but most people bought them because they were lazily wrong about future housing prices. Lehman Brothers might have deceived some people a little in its final days, but the reason those days were final is that it made bad illiquid investments and then was unable to roll its financing.
The rough justice comes mostly from the fact that lots of things are illegal, and from the facts that disclosure violations are both (1) particularly illegal and (2) particularly tempting when your business is in trouble and you don't want to tell anyone about it. But it's pretty rough.
** Ooh, bizarrely, it is then followed by a 15-page Annex A of stuff JPMorgan admits to. Annex A consists entirely of 73 numbered paragraphs, which correspond verbatim to paragraphs 12-84 of the SEC's order. (I ran it through track changes, obvs.) I do not understand why everything needed to be written twice? I guess they wanted to be super duper clear about what JPMorgan admits to.
*** Because they settled they got a 30 percent discount to what the FCA wanted to fine them, which was £196,586,000, a number that comes from the FCA taking percentages of the revenues involved in relevant lines of business, manipulating them in various not especially intuitive ways, and then adding them to some round numbers that they just came up with off the top of their heads. Still a significantly more defined and predictable system than the SEC's approach of just making up one big round number.
**** Key passage:
(9) The OCC has engaged in several targeted examinations of the Bank and the CIO. The OCC's examination findings establish that the Bank had deficiencies in its internal controls and engaged in unsafe or unsound banking practices and violations of 12 C.F.R. Part 3, Appendix B (Market Risk Management Amendment) with respect to the credit derivatives trading strategies, activities and positions employed by the CIO on behalf of the Bank. The deficiencies and unsafe and unsound practices include the following:
(a) The Bank's oversight and governance of the credit derivatives trading conducted by the CIO were inadequate to protect the Bank from material risks in those trading strategies, activities and positions;
(b) The Bank's risk management processes and procedures for the credit derivatives trading conducted by the CIO did not provide an adequate foundation to identify, understand, measure, monitor and control risk;
(c) The Bank's valuation control processes and procedures for the credit derivatives trading conducted by the CIO were insufficient to provide a rigorous and effective assessment of valuation;
(d) The Bank's internal audit processes and procedures related to the credit derivatives trading conducted by the CIO were not effective; and
(e) The Bank's model risk management practices and procedures were inadequate to provide adequate controls over certain of the Bank's market risk and price risk models.
(10) The credit derivatives trading activity constituted recklessly unsafe and unsound practices, was part of a pattern of misconduct and resulted in more than minimal loss, all within the meaning of 12 U.S.C. § 1818(i)(2)(B).
***** There are still other ongoing investigations, including the CFTC's rather fascinating investigation into whether the Whale, by virtue of his whaleosity, manipulated the market. My initial view here was that coming after JPMorgan for market manipulation in a trade where they lost $6 billion is a little harsh, but here is an excellent explanation of the issues that makes me a bit more sympathetic to the CFTC's theory.
****** Here of course the dumbness is bound up with the traditional disclosurey violations so it's a harder case. Still.
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Matthew S Levine at email@example.com