On Sensitivity to Market Risk, Susceptibility and Vulnerability

In this issue of The Institutional Risk Analyst, IRA CEO Dennis Santiago talks about the implications of the revelations about a rogue hedge fund operation at JPMorgan Chase.

It was a bit of a shock to me and many of our readers when the current trouble in JPMorgan's derivatives desk erupted. Not because the vulnerability to this type of problem in the desks of these big banks was not there - IRA's stress testing methodology has tracked off-balance sheet exposure as part of our CAMELS analysis regime for years -- but because I had not expected that this particular bank would be the one where this risk would first realize in the market place. In retrospect, that aspect of the letter S in the term CAMELS which stands for "sensitivity to market risk" is in fact uniformly distributed among the participants in derivatives market making and the susceptibility to a future beta event remains for any of them.

The question at this point is not whether the rest of the banks have this risk. The going forward questions are more appropriately, how should banks manage their susceptibility and vulnerability to this class of risk? How should insurers and markets price the risk-reward nature of such exposures? And in what direction should regulators aim the going forward definition of safe and sound practices?

IRA has commented a number of times in the past that we believe that risk and stress testing needs to be done in the context of benchmarking as opposed to the myopia of internally focused analysis. In this case, the need is even more acute given the fact that the banks (a) have trillions upon trillions of notional balances exposed and (b) bank counterparties view these derivatives exposures as material investments. So let us look at a catalog of banks so exposed. As is the case whenever it's an IRA analysis, we winnow from a census of all the active banks and look at the individual FDIC Certificate holders. In this particular illustration of systemic vulnerability, the unit institutions with assets over $10 billion - the Dodd-Frank stress testing and reporting threshold - that have derivatives operations that reported a fair value estimates of the traded portion of their exposures in the 1st Quarter of 2012 reporting cycle.

Table 1 - Over $10B Asset FDIC Certificate Holders, 1Q2012

NAME	DERIVATIVES FOR TRADE (Notional) $K	DERIVATIVES NOT FOR TRADE (Notional) $K	TOTAL DERIVATIVES (Notional) $K
JPMORGAN CHASE BANK NA	63,650,436,000	6,735,675,000	70,386,111,000
CITIBANK NATIONAL ASSN	48,584,581,000	3,127,381,000	51,711,962,000
BANK OF AMERICA NA	40,110,943,370	6,229,087,191	46,340,030,561
GOLDMAN SACHS BANK USA	42,270,359,000	483,791,000	42,754,150,000
HSBC BANK USA NATIONAL ASSN	3,777,639,035	624,804,016	4,402,443,051
WELLS FARGO BANK NA	3,085,841,000	603,658,000	3,689,499,000
MORGAN STANLEY BANK NA	2,543,674,000	23,167,000	2,566,841,000
BANK OF NEW YORK MELLON	1,324,329,000	48,569,000	1,372,898,000
STATE STREET BANK&TRUST CO	912,454,345	6,075,991	918,530,336
PNC BANK NATIONAL ASSN	144,085,198	245,974,999	390,060,197
SUNTRUST BANK	212,838,953	54,670,445	267,509,398
NORTHERN TRUST CO	236,579,751	6,063,973	242,643,724
REGIONS BANK	126,481,777	23,191,409	149,673,186
U S BANK NATIONAL ASSN	69,801,437	42,854,555	112,655,992
KEYBANK NATIONAL ASSN	67,703,029	16,040,052	83,743,081
FIFTH THIRD BANK	46,571,169	22,149,571	68,720,740
BRANCH BANKING&TRUST CO	23,132,303	45,959,894	69,092,197
UNION BANK NATIONAL ASSN	40,620,251	10,150,020	50,770,271
RBS CITIZENS NATIONAL ASSN	29,700,353	7,884,815	37,585,168
BOKF NATIONAL ASSN	26,262,687	91,000	26,353,687
CAPITAL ONE NATIONAL ASSN	16,312,132	12,524,821	28,836,953
BMO HARRIS BANK NA	22,921,436	4,375,739	27,297,175
HUNTINGTON NATIONAL BANK	16,632,280	9,623,040	26,255,320
DEUTSCHE BANK TR CO AMERICAS	22,350,000	0	22,350,000
COMERICA BANK	13,346,622	2,384,148	15,730,770
COMPASS BANK	13,950,591	2,307,861	16,258,452
FIRST TENNESSEE BANK NA	12,575,654	7,009,789	19,585,443
MANUFACTURERS&TRADERS TR CO	15,476,745	1,987,079	17,463,824
BANK OF THE WEST	9,671,287	5,306,737	14,978,024
FLAGSTAR BANK FSB	12,541,133	68,954	12,610,087
WEBSTER BANK NATIONAL ASSN	7,557,676	812,904	8,370,580
CITIZENS BANK OF PA	5,909,044	1,659,980	7,569,024
PRIVATEBANK&TRUST CO	6,529,482	426,069	6,955,551
ASSOCIATED BANK NA	3,393,915	1,140,487	4,534,402
FIRST NIAGARA BANK NA	2,414,551	1,942,247	4,356,798
ONEWEST BANK FSB	21,000	4,188,151	4,209,151
ZIONS FIRST NATIONAL BANK	2,533,297	1,007,383	3,540,680
FIRSTMERIT BANK NA	2,498,353	248,033	2,746,386
FROST NATIONAL BANK	1,315,800	90,968	1,406,768
SYNOVUS BANK	1,420,627	337,803	1,758,430
RABOBANK NATIONAL ASSN	1,289,000	141,000	1,430,000
SILICON VALLEY BANK	1,086,802	281,065	1,367,867
FIRST NB OF PENNSYLVANIA	1,398,124	16,282	1,414,406
MORGAN STANLEY PRIVATE BK NA	580,857	436,198	1,017,055
FIRST REPUBLIC BANK	602,163	364,780	966,943
AMEGY BANK NATIONAL ASSN	575,434	129,561	704,995
CALIFORNIA BANK&TRUST	271,851	418,713	690,564
BANK OF HAWAII	538,673	147,407	686,080
COMMERCE BANK	73,942	557,407	631,349
WHITNEY BANK	616,524	0	616,524
ING BANK FSB	4,226	445,031	449,257
STATE FARM BANK FSB	215,171	0	215,171
SIGNATURE BANK	70,000	0	70,000

As can be seen, within this group, there are four large players followed by five medium sized players and then a collection of lesser - but still exposed - participants. All told, fifty three banks in this highly focused peering. Biggest of them in terms of the size of the notional derivatives book is JPMorgan Chase Bank N.A.

What is far more important to understand though is the context of the risk undertaken by JPMorgan versus this peer group. Was it extraordinary? Does analysis of it help us understand where the line of what is systemically unsafe might lie? For that we first turn to leverage. For this we look at the ratio of these institutions' traded derivatives to the fair value envelope of these instruments as reported in their CALL reports. The resulting number is an indicator of "the amount of scrambling that is likely to have to happen in the event of a glitch in the Matrix". The larger the total notional balance size combined with the leveraging factor help quantify the potential nightmare of each billion of realized loss. It's the kind of thing that makes a Tums and Xanax a food group for Chief Risk Officers; maybe for corporate treasurers too.

Table 2 - Derivative Desk Operating Leverage Multiplier Estimates, 1Q2012

NAME	FAIR VALUE ENVELOPE OF TRADED BOOK Reported $K	DERIVATIVE DESK OPERATING LEVERAGE MULTIPLIER Computed	IMPLIED FAIR VALUE OF NOT FOR TRADE PORTION Computed $K
JPMORGAN CHASE BANK NA	153,680,000	458.0	14,706,574
CITIBANK NATIONAL ASSN	111,839,000	462.4	6,763,680
BANK OF AMERICA NA	45,531,246	1,017.8	6,120,369
GOLDMAN SACHS BANK USA	32,116,000	1,331.2	363,413
HSBC BANK USA NATIONAL ASSN	15,133,688	290.9	2,147,805
WELLS FARGO BANK NA	44,542,000	82.8	7,287,747
MORGAN STANLEY BANK NA	169,000	15,188.4	1,525
BANK OF NEW YORK MELLON	9,186,000	149.5	324,973
STATE STREET BANK&TRUST CO	7,400,437	124.1	48,953
PNC BANK NATIONAL ASSN	1,958,763	199.1	1,235,211
SUNTRUST BANK	2,155,245	124.1	440,464
NORTHERN TRUST CO	1,253,612	193.6	31,329
REGIONS BANK	988,166	151.5	153,113
U S BANK NATIONAL ASSN	1,558,409	72.3	592,822
KEYBANK NATIONAL ASSN	1,466,130	57.1	280,821
FIFTH THIRD BANK	2,026,473	33.9	653,158
BRANCH BANKING&TRUST CO	1,403,773	49.2	933,785
UNION BANK NATIONAL ASSN	1,944,329	26.1	388,711
RBS CITIZENS NATIONAL ASSN	1,829,382	20.5	383,777
BOKF NATIONAL ASSN	355,222	74.2	1,227
CAPITAL ONE NATIONAL ASSN	716,553	40.2	311,222
BMO HARRIS BANK NA	952,920	28.6	152,753
HUNTINGTON NATIONAL BANK	518,196	50.7	189,928
DEUTSCHE BANK TR CO AMERICAS	1,755,000	12.7	0
COMERICA BANK	863,140	18.2	130,817
COMPASS BANK	1,137,550	14.3	161,473
FIRST TENNESSEE BANK NA	263,981	74.2	94,481
MANUFACTURERS&TRADERS TR CO	825,001	21.2	93,871
BANK OF THE WEST	804,388	18.6	284,996
FLAGSTAR BANK FSB	83,122	151.7	455
WEBSTER BANK NATIONAL ASSN	85,179	98.3	8,272
CITIZENS BANK OF PA	388,152	19.5	85,127
PRIVATEBANK&TRUST CO	197,914	35.1	12,123
ASSOCIATED BANK NA	144,105	31.5	36,245
FIRST NIAGARA BANK NA	117,873	37.0	52,547
ONEWEST BANK FSB	203	20,734.7	202
ZIONS FIRST NATIONAL BANK	152,286	23.3	43,328
FIRSTMERIT BANK NA	116,959	23.5	10,563
FROST NATIONAL BANK	150,759	9.3	9,749
SYNOVUS BANK	152,092	11.6	29,218
RABOBANK NATIONAL ASSN	70,000	20.4	6,902
SILICON VALLEY BANK	21,521	63.6	4,422
FIRST NB OF PENNSYLVANIA	97,906	14.4	1,127
MORGAN STANLEY PRIVATE BK NA	139	7,316.9	60
FIRST REPUBLIC BANK	27,201	35.5	10,262
AMEGY BANK NATIONAL ASSN	30,214	23.3	5,553
CALIFORNIA BANK&TRUST	9,426	73.3	5,715
BANK OF HAWAII	66,923	10.3	14,379
COMMERCE BANK	2,182	289.3	1,926
WHITNEY BANK	25,922	23.8	0
ING BANK FSB	22	20,420.8	22
STATE FARM BANK FSB	15	14,344.7	0
SIGNATURE BANK	115	608.7	0

Notice that there are a variety of strategies with regards to derivatives that begin to be exposed by this relatively simple calculation. There are institutions that clearly pursue very conservative approaches to these instruments and others that make use of them more aggressively. That's not an unexpected result for anyone that has taken the time to understand that the pathways to operating a financial institution are not at all homogeneous, never have been.

Among the big four houses, there seem to be two schools of thought on this ratio, JPMorgan and Citibank electing to run their desks at one ratio and Bank America and Goldman Sachs operating at another one. It implies that a future beta event of similar magnitude as what beset JP Morgan would impact Citi similarly and the other two would have to scramble twice as hard. These are consequence management planning factors and are in fact most useful for costing how much to put into things like compliance oversight and risk taking authorization in the now so as to mitigate consequences if and when.

As one goes down the food chain the differences in strategy become broader straddling the middle ground of the big four with a few institutions electing higher leverage while most seek a more conservative path. Notable among these are the computed ratios of Well Fargo NA and Morgan Stanley NA which exhibit computational differences in the fair value estimates reported to the FDIC. Morgan Stanley basically says the balance sheet value is next to nothing. They may or may not be right but from a benchmarking standpoint, it is a real artifact in the numbers. A number of other smaller institutions also have this reporting approach.

Wells Fargo NA is notable because it pursues the most conservative leveraging approach even as the bank competes head on against its commercial banking competitors. In relative terms, the Wells Fargo desk would have to make a positioning error maybe five times the magnitude of what happened to JPMorgan to realize the same amount of turmoil. Interestingly, it indicates to someone like me to caution that Wells Fargo be the one most on guard against future complacency. Their competitors have incentives to be more hyper-diligent going forward and in the competitive space of derivative zero sum games, that means something.

Finally let's look at how much of the real balance sheet is affected by these derivatives. Using the assumption that the traded leverage ratio is a fair indication of leverage in the remainder of the derivatives book, we can perform a CALL report based apples-to-apples estimate of the book value of these instruments. The caveat is that this analytical assumption may or may not be true but confirming this would have to involve performing a proprietary review to increase the fidelity of the calibration. Still, the question of just how much a derivatives desk impacts the overall portfolio of a bank is an important piece of information to have.

Table 3 - Portfolio Analysis of Estimated De-Leveraged Derivatives Value vs. Total Assets

NAME	TOTAL ASSETS, $K	ESTIMATED BALANCE SHEET VALUE OF DE-LEVERED DERIVATIVES, $K	PERCENT OF TOTAL ASSETS, %
JPMORGAN CHASE BANK NA	1,842,735,000	168,386,574	9.1
CITIBANK NATIONAL ASSN	1,312,764,000	118,602,680	9.0
BANK OF AMERICA NA	1,448,261,695	51,651,615	3.6
GOLDMAN SACHS BANK USA	101,927,000	32,479,413	31.9
HSBC BANK USA NATIONAL ASSN	206,808,958	17,281,493	8.4
WELLS FARGO BANK NA	1,181,817,000	51,829,747	4.4
MORGAN STANLEY BANK NA	67,651,000	170,525	0.3
BANK OF NEW YORK MELLON	229,715,000	9,510,973	4.1
STATE STREET BANK&TRUST CO	183,994,204	7,449,390	4.0
PNC BANK NATIONAL ASSN	287,766,197	3,193,974	1.1
SUNTRUST BANK	172,289,330	2,595,709	1.5
NORTHERN TRUST CO	91,340,913	1,284,941	1.4
REGIONS BANK	124,712,987	1,141,279	0.9
U S BANK NATIONAL ASSN	330,227,426	2,151,231	0.7
KEYBANK NATIONAL ASSN	84,838,858	1,746,951	2.1
FIFTH THIRD BANK	114,402,170	2,679,631	2.3
BRANCH BANKING&TRUST CO	169,026,116	2,337,558	1.4
UNION BANK NATIONAL ASSN	91,575,684	2,333,040	2.5
RBS CITIZENS NATIONAL ASSN	106,242,373	2,213,159	2.1
BOKF NATIONAL ASSN	25,733,983	356,449	1.4
CAPITAL ONE NATIONAL ASSN	133,000,029	1,027,775	0.8
BMO HARRIS BANK NA	94,826,410	1,105,673	1.2
HUNTINGTON NATIONAL BANK	55,584,664	708,124	1.3
DEUTSCHE BANK TR CO AMERICAS	39,839,000	1,755,000	4.4
COMERICA BANK	62,503,279	993,957	1.6
COMPASS BANK	65,360,552	1,299,023	2.0
FIRST TENNESSEE BANK NA	25,439,984	358,462	1.4
MANUFACTURERS&TRADERS TR CO	78,221,757	918,872	1.2
BANK OF THE WEST	62,342,865	1,089,384	1.7
FLAGSTAR BANK FSB	14,030,798	83,577	0.6
WEBSTER BANK NATIONAL ASSN	19,109,508	93,451	0.5
CITIZENS BANK OF PA	33,062,054	473,279	1.4
PRIVATEBANK&TRUST CO	12,587,678	210,037	1.7
ASSOCIATED BANK NA	21,617,331	180,350	0.8
FIRST NIAGARA BANK NA	35,463,055	170,420	0.5
ONEWEST BANK FSB	25,009,840	405	0.0
ZIONS FIRST NATIONAL BANK	17,179,085	195,614	1.1
FIRSTMERIT BANK NA	14,646,838	127,522	0.9
FROST NATIONAL BANK	20,472,031	160,508	0.8
SYNOVUS BANK	26,796,938	181,310	0.7
RABOBANK NATIONAL ASSN	11,646,000	76,902	0.7
SILICON VALLEY BANK	19,608,406	25,943	0.1
FIRST NB OF PENNSYLVANIA	11,525,969	99,033	0.9
MORGAN STANLEY PRIVATE BK NA	12,069,555	199	0.0
FIRST REPUBLIC BANK	29,718,987	37,463	0.1
AMEGY BANK NATIONAL ASSN	12,005,462	35,767	0.3
CALIFORNIA BANK&TRUST	10,933,126	15,141	0.1
BANK OF HAWAII	13,760,753	81,302	0.6
COMMERCE BANK	20,370,170	4,108	0.0
WHITNEY BANK	12,813,700	25,922	0.2
ING BANK FSB	95,828,916	44	0.0
STATE FARM BANK FSB	14,455,112	15	0.0
SIGNATURE BANK	15,280,367	115	0.0

What reveals is a story of concentration risk. Of the fifty-three banks of this peer group, only four have derivatives as a proportion of their total assets exceeding five percent. One of them is JPMorgan Chase NA. Of the remaining three, Citibank NA is similarly sized. Goldman Sachs is its own unique investment banking model. HSBC Bank USA NA is a significantly smaller entity. Notable is that both Bank of America NA and Wells Fargo NA are the asset giants among a group that allocates between two to five percent of the portfolio to these instruments; the remaining banks in the noise indicating hedging as opposed to investment or market making purposes for this asset class. A possible exception might be those banks that reported near zero fair values.

So in context let's look again at JPMorgan Chase. It's definitely the biggest operation dwarfing every other. While the business was run on the higher end of the leverage spectrum, it was not the highest model in operation. In terms of tangible exposure to the balance sheet, it is or was the segment leader. The combination of the three factors is the signature of high susceptibility to event risk and high vulnerability to significant stress in the event that risk manifests. In the end it was a mistake to have ever believed that mass and reputaion were that much protection against this type of risk. It's a painful lesson to be sure and one that other banks should heed based purely an objective assessment of their own numbers in the context of these types of inconvenient truth benchmarks.

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Reprinted with permission. Copyright 2012 Institutional Risk Analytics. All Rights Reserved.

 

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Comments

[kallian publico]

10:40 AM on 07/02/2012

The only reason to make this hard to understand is to hide information not reveal it. As far as I know the only branch of science, knowledge and study that is deliberately "hard to understand" is nuclear physics. The reason it is hidden is because it is dangerous. Not just to the power balance of the world, but to the very existence of humanity and other forms of life.
Capital is fancy word for money. It is very simply money that is required to reduce risk. There is no beta that, as yet, has replaced money with some other form of internationally recognized "legal tender". Plutonium, oil, gold, DNA, market share, popularity none are as transposeable or transferable as money. The internet can not make this so. The vain ideas of economists cannot make this so, neither the fiat of desperate executives.
As long as the trust of the people resides in money, only their ignorance can uphold the deception. The deception being that money is no longer important in trade. When the deception is undermined only money can restore trust. Until the deception is over its flaws will continue to add to the debt of the people and not to its conspirators. As long as there are two economies, one for the conspirators and one for the rest of us wealth is no longer a sign of capital but an indicator of political influence. Do you understand what I mean? Does it matter?

[waltifarian]

06:20 PM on 06/30/2012

When an institution is backed by the taxpayer (FDIC) and it trades derivatives, its not a zero sum transaction. Because the counterparty knows there that a bailout is a strong possibility, and thus, while being made whole later might be hard, they can exploit that psychology all day long and let some subscriber down the road hold the bag of rocks. This fiction about derivatives to poisons alot of thinking and is exploited internally by lots snake oil salesman (sorry, I meant risk managers and qunats) at TBTF banks, but more importantly by folks like the London Whale. Its just not zero-sum when the taxpeyer is on the hook on only one side and everyone knows it.

[sobe123]

01:10 PM on 07/02/2012

Perfectly said. We are the chumps of the bankers.

[onitgoes]

01:57 PM on 06/30/2012

Good technichal analysis of what we all know intuitively...the whole system is a mammoth casino erected upon a foundation of sand, a giant house of cards that will inevitably come tumbling down. The only way to limit the collateral damage is through a strict separation of commercial and investment banking. Of course the high rollers will fight such a reform tooth and nail, because it would remove their public backstop, and they would thus have to exit the game.

[waltifarian]

06:10 PM on 06/30/2012

We said.

[mp905]

09:21 AM on 06/30/2012

My take away: these derivatives are the 'assets?' that keep bankers, regulators and the CEO of IRA awake at night. JPM Chase thought they knew what they were doing, but clearly didn't. They have a lot of exposure and a lot of risk, but Bank of America and Goldman Sachs are worse. If Jamie Dimon can screw up, so can they. And if they do, we are in for a repeat of 2008 with domino effects. But this time, instead of smallish players like Bears Stern, Lehman Brothers, Morgan Stanley, it's going to be the behemoths (JPM Chase, BofA, Goldman Sachs).

No wonder this poor guy is on a diet of Xanax. It's like being the guard in the room watching a drunk play with the nuclear launch button.

[For2ity]

02:38 PM on 06/30/2012

No, the nuclear launch button is actually two buttons separated by (I think) about eight fee,t so it takes two operators to do the deed once the president activates the "Football."

[ThatsTheTheWayItIs]

08:52 AM on 06/30/2012

A banks assets are its debt, loans that return interest. Banks are big because we have a lot of debt.
Debt is money loaned from rich people who have it to spare, to the rest of us who need it to live.

Wealth disparity causes debt. Debt increases wealth disparity as interest flows from poor to rich.

[For2ity]

02:49 PM on 06/30/2012

FACTS:
1. Assets are not debt; they are assets, such as "real" estate.
2. Ownership of assets is sold to those who accept others as "debtors."
3. Wealth disparity does not cause debt; people who borrow against their assets "cause" debt
4. "Interest" does not flow from poor to rich because the poor have no assets.

[Jeremy Bursac]

03:26 AM on 06/30/2012

So the article is saying JP Morgan Chase might wind up dashed on the black shoals?

[onitgoes]

09:13 AM on 06/30/2012

...or the moon might actually collide with Jamie Dimon's earth?!

[Jeremy Bursac]

02:20 PM on 06/30/2012

But you're not making a pun on options pricing models.

[Linda from Deerfield]

12:53 AM on 06/30/2012

JP Morgan's size is hard for me to fathom -- they are like an infection around here that I wouldn't want to go near. I wonder why the value of their overly many banking facilities does not seem to enter into review.