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

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

NAMEDERIVATIVES

FOR TRADE

(Notional) $KDERIVATIVES

NOT FOR TRADE

(Notional) $KTOTAL DERIVATIVES

(Notional) $KJPMORGAN CHASE BANK NA63,650,436,0006,735,675,00070,386,111,000CITIBANK NATIONAL ASSN48,584,581,0003,127,381,00051,711,962,000BANK OF AMERICA NA40,110,943,3706,229,087,19146,340,030,561GOLDMAN SACHS BANK USA42,270,359,000483,791,00042,754,150,000HSBC BANK USA NATIONAL ASSN3,777,639,035624,804,0164,402,443,051WELLS FARGO BANK NA3,085,841,000603,658,0003,689,499,000MORGAN STANLEY BANK NA2,543,674,00023,167,0002,566,841,000BANK OF NEW YORK MELLON1,324,329,00048,569,0001,372,898,000STATE STREET BANK&TRUST CO912,454,3456,075,991918,530,336PNC BANK NATIONAL ASSN144,085,198245,974,999390,060,197SUNTRUST BANK212,838,95354,670,445267,509,398NORTHERN TRUST CO236,579,7516,063,973242,643,724REGIONS BANK126,481,77723,191,409149,673,186U S BANK NATIONAL ASSN69,801,43742,854,555112,655,992KEYBANK NATIONAL ASSN67,703,02916,040,05283,743,081FIFTH THIRD BANK46,571,16922,149,57168,720,740BRANCH BANKING&TRUST CO23,132,30345,959,89469,092,197UNION BANK NATIONAL ASSN40,620,25110,150,02050,770,271RBS CITIZENS NATIONAL ASSN29,700,3537,884,81537,585,168BOKF NATIONAL ASSN26,262,68791,00026,353,687CAPITAL ONE NATIONAL ASSN16,312,13212,524,82128,836,953BMO HARRIS BANK NA22,921,4364,375,73927,297,175HUNTINGTON NATIONAL BANK16,632,2809,623,04026,255,320DEUTSCHE BANK TR CO AMERICAS22,350,000022,350,000COMERICA BANK13,346,6222,384,14815,730,770COMPASS BANK13,950,5912,307,86116,258,452FIRST TENNESSEE BANK NA12,575,6547,009,78919,585,443MANUFACTURERS&TRADERS TR CO15,476,7451,987,07917,463,824BANK OF THE WEST9,671,2875,306,73714,978,024FLAGSTAR BANK FSB12,541,13368,95412,610,087WEBSTER BANK NATIONAL ASSN7,557,676812,9048,370,580CITIZENS BANK OF PA5,909,0441,659,9807,569,024PRIVATEBANK&TRUST CO6,529,482426,0696,955,551ASSOCIATED BANK NA3,393,9151,140,4874,534,402FIRST NIAGARA BANK NA2,414,5511,942,2474,356,798ONEWEST BANK FSB21,0004,188,1514,209,151ZIONS FIRST NATIONAL BANK2,533,2971,007,3833,540,680FIRSTMERIT BANK NA2,498,353248,0332,746,386FROST NATIONAL BANK1,315,80090,9681,406,768SYNOVUS BANK1,420,627337,8031,758,430RABOBANK NATIONAL ASSN1,289,000141,0001,430,000SILICON VALLEY BANK1,086,802281,0651,367,867FIRST NB OF PENNSYLVANIA1,398,12416,2821,414,406MORGAN STANLEY PRIVATE BK NA580,857436,1981,017,055FIRST REPUBLIC BANK602,163364,780966,943AMEGY BANK NATIONAL ASSN575,434129,561704,995CALIFORNIA BANK&TRUST271,851418,713690,564BANK OF HAWAII538,673147,407686,080COMMERCE BANK73,942557,407631,349WHITNEY BANK616,5240616,524ING BANK FSB4,226445,031449,257STATE FARM BANK FSB215,1710215,171SIGNATURE BANK70,000070,000

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

NAMEFAIR VALUE

ENVELOPE

OF TRADED BOOK

Reported $KDERIVATIVE DESK

OPERATING

LEVERAGE

MULTIPLIER

ComputedIMPLIED

FAIR VALUE OF

NOT FOR TRADE

PORTION

Computed $KJPMORGAN CHASE BANK NA153,680,000458.014,706,574CITIBANK NATIONAL ASSN111,839,000462.46,763,680BANK OF AMERICA NA45,531,2461,017.86,120,369GOLDMAN SACHS BANK USA32,116,0001,331.2363,413HSBC BANK USA NATIONAL ASSN15,133,688290.92,147,805WELLS FARGO BANK NA44,542,00082.87,287,747MORGAN STANLEY BANK NA169,00015,188.41,525BANK OF NEW YORK MELLON9,186,000149.5324,973STATE STREET BANK&TRUST CO7,400,437124.148,953PNC BANK NATIONAL ASSN1,958,763199.11,235,211SUNTRUST BANK2,155,245124.1440,464NORTHERN TRUST CO1,253,612193.631,329REGIONS BANK988,166151.5153,113U S BANK NATIONAL ASSN1,558,40972.3592,822KEYBANK NATIONAL ASSN1,466,13057.1280,821FIFTH THIRD BANK2,026,47333.9653,158BRANCH BANKING&TRUST CO1,403,77349.2933,785UNION BANK NATIONAL ASSN1,944,32926.1388,711RBS CITIZENS NATIONAL ASSN1,829,38220.5383,777BOKF NATIONAL ASSN355,22274.21,227CAPITAL ONE NATIONAL ASSN716,55340.2311,222BMO HARRIS BANK NA952,92028.6152,753HUNTINGTON NATIONAL BANK518,19650.7189,928DEUTSCHE BANK TR CO AMERICAS1,755,00012.70COMERICA BANK863,14018.2130,817COMPASS BANK1,137,55014.3161,473FIRST TENNESSEE BANK NA263,98174.294,481MANUFACTURERS&TRADERS TR CO825,00121.293,871BANK OF THE WEST804,38818.6284,996FLAGSTAR BANK FSB83,122151.7455WEBSTER BANK NATIONAL ASSN85,17998.38,272CITIZENS BANK OF PA388,15219.585,127PRIVATEBANK&TRUST CO197,91435.112,123ASSOCIATED BANK NA144,10531.536,245FIRST NIAGARA BANK NA117,87337.052,547ONEWEST BANK FSB20320,734.7202ZIONS FIRST NATIONAL BANK152,28623.343,328FIRSTMERIT BANK NA116,95923.510,563FROST NATIONAL BANK150,7599.39,749SYNOVUS BANK152,09211.629,218RABOBANK NATIONAL ASSN70,00020.46,902SILICON VALLEY BANK21,52163.64,422FIRST NB OF PENNSYLVANIA97,90614.41,127MORGAN STANLEY PRIVATE BK NA1397,316.960FIRST REPUBLIC BANK27,20135.510,262AMEGY BANK NATIONAL ASSN30,21423.35,553CALIFORNIA BANK&TRUST9,42673.35,715BANK OF HAWAII66,92310.314,379COMMERCE BANK2,182289.31,926WHITNEY BANK25,92223.80ING BANK FSB2220,420.822STATE FARM BANK FSB1514,344.70SIGNATURE BANK115608.70

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

NAMETOTAL ASSETS, $KESTIMATED

BALANCE SHEET

VALUE OF

DE-LEVERED

DERIVATIVES, $KPERCENT OF

TOTAL ASSETS, %JPMORGAN CHASE BANK NA1,842,735,000168,386,5749.1CITIBANK NATIONAL ASSN1,312,764,000118,602,6809.0BANK OF AMERICA NA1,448,261,69551,651,6153.6GOLDMAN SACHS BANK USA101,927,00032,479,41331.9HSBC BANK USA NATIONAL ASSN206,808,95817,281,4938.4WELLS FARGO BANK NA1,181,817,00051,829,7474.4MORGAN STANLEY BANK NA67,651,000170,5250.3BANK OF NEW YORK MELLON229,715,0009,510,9734.1STATE STREET BANK&TRUST CO183,994,2047,449,3904.0PNC BANK NATIONAL ASSN287,766,1973,193,9741.1SUNTRUST BANK172,289,3302,595,7091.5NORTHERN TRUST CO91,340,9131,284,9411.4REGIONS BANK124,712,9871,141,2790.9U S BANK NATIONAL ASSN330,227,4262,151,2310.7KEYBANK NATIONAL ASSN84,838,8581,746,9512.1FIFTH THIRD BANK114,402,1702,679,6312.3BRANCH BANKING&TRUST CO169,026,1162,337,5581.4UNION BANK NATIONAL ASSN91,575,6842,333,0402.5RBS CITIZENS NATIONAL ASSN106,242,3732,213,1592.1BOKF NATIONAL ASSN25,733,983356,4491.4CAPITAL ONE NATIONAL ASSN133,000,0291,027,7750.8BMO HARRIS BANK NA94,826,4101,105,6731.2HUNTINGTON NATIONAL BANK55,584,664708,1241.3DEUTSCHE BANK TR CO AMERICAS39,839,0001,755,0004.4COMERICA BANK62,503,279993,9571.6COMPASS BANK65,360,5521,299,0232.0FIRST TENNESSEE BANK NA25,439,984358,4621.4MANUFACTURERS&TRADERS TR CO78,221,757918,8721.2BANK OF THE WEST62,342,8651,089,3841.7FLAGSTAR BANK FSB14,030,79883,5770.6WEBSTER BANK NATIONAL ASSN19,109,50893,4510.5CITIZENS BANK OF PA33,062,054473,2791.4PRIVATEBANK&TRUST CO12,587,678210,0371.7ASSOCIATED BANK NA21,617,331180,3500.8FIRST NIAGARA BANK NA35,463,055170,4200.5ONEWEST BANK FSB25,009,8404050.0ZIONS FIRST NATIONAL BANK17,179,085195,6141.1FIRSTMERIT BANK NA14,646,838127,5220.9FROST NATIONAL BANK20,472,031160,5080.8SYNOVUS BANK26,796,938181,3100.7RABOBANK NATIONAL ASSN11,646,00076,9020.7SILICON VALLEY BANK19,608,40625,9430.1FIRST NB OF PENNSYLVANIA11,525,96999,0330.9MORGAN STANLEY PRIVATE BK NA12,069,5551990.0FIRST REPUBLIC BANK29,718,98737,4630.1AMEGY BANK NATIONAL ASSN12,005,46235,7670.3CALIFORNIA BANK&TRUST10,933,12615,1410.1BANK OF HAWAII13,760,75381,3020.6COMMERCE BANK20,370,1704,1080.0WHITNEY BANK12,813,70025,9220.2ING BANK FSB95,828,916440.0STATE FARM BANK FSB14,455,112150.0SIGNATURE BANK15,280,3671150.0

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.