THE BLOG

On Sensitivity to Market Risk, Susceptibility and Vulnerability

06/29/2012 06:05 pm ET | Updated Aug 29, 2012

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.