By Occupy the SEC
Jamie Dimon’s plan to enfeeble the Dodd-Frank reforms, specifically the Volcker rule, has blown up spectacularly. Apparently JPM was so confident that their interpretation of the hedging exemption would prevail, that they got ahead of themselves and operated as if this loophople were in effect. But then things went horribly wrong for them. And the losses are even more damaging since the blowup is the result of activity the law was meant to curtail. Double trouble now for JPM, since it’s inconceivable that the hedging exemption they designed will make it into the final rulemaking. If it does survive, then we’ve got bigger issues with our regulators than we imagined.
In today’s New York Times, James Wyatt provides an under the radar view of how laws are gutted when the regulators involved in rule-making are heavily lobbied by the regulated. One objective of Occupy the SEC was to inject a non industry perspective in this process as a counterweight to the overwhelming industry influence. By looking for loopholes we intended to shed light on the self-serving interests of the bankers and the vulnerability of the regulators to concerted industry pressure. Wyatt describes the lobbying efforts:
Several visits over months by the bank’s well-connected chief executive, Jamie Dimon, and his top aides were aimed at persuading regulators to create a loophole in the law, known as the Volcker Rule. The rule was designed by Congress to limit the very kind of proprietary trading that JPMorgan was seeking.
“JPMorgan was the one that made the strongest arguments to allow hedging, and specifically to allow this type of portfolio hedging,” said a former Treasury official who was present during the Dodd-Frank debates.
Portfolio hedging is at the heart of the London Whale debacle.
The loophole is known as portfolio hedging, a strategy that essentially allows banks to view an investment portfolio as a whole and take actions to offset the risks of the entire portfolio. That contrasts with the traditional definition of hedging, which matches an individual security or trading position with an inversely related investment — so when one goes up, the other goes down.
Portfolio hedging “is a license to do pretty much anything,” Mr. Levin said. He and Senator Jeff Merkley, an Oregon Democrat who worked on the law with Mr.Levin, sent a letter to regulators in February, making clear that hedging on that scale was not their intention.
“There is no statutory basis to support the proposed portfolio hedging language,” they wrote, “nor is there anything in the legislative history to suggest that it should be allowed.”
We were extremely concerned about this loophole and argued against it in our comment letter to the regulators.
We are alarmed by the focus on .“portfolio hedging.” throughout the risk-mitigating hedging exemption. We interpret the intent of this exemption as relating to Delta One or central execution desks that have become ubiquitous across banking entities in recent years. Certainly these central hedging operations pose significant risks, as famously exemplified in the rogue trading scandal that caused a $2.3 billion loss in 2011.84 While it is clear that such practices necessitate increased oversight and significantly improved risk-management procedures, there are other instances of aggregated hedging that will be inappropriately included within .“portfolio hedging.” that require consideration. Even outside of central execution desks, many risks a recurrently managed on an aggregated basis, due to the numerous, and often compounding, proprietary portfolios that exist on every market making desk of every covered banking entity. With so many independent strategies at play, it is not uncommon for large exposures across a variety of assets to result when they are combined in the view of a manager. Management will often make use of a .“back book.” or .“management book.” for the dual purposes of conducting broad-line hedges against lumpy trading-desk exposures, and taking proprietary positions that fall outside of the mandate or risk-limits of an individual trader. While it is expected that such obvious proprietary exposures will diminish with the implementation of this Rule, we fail to understand the continued relevance of most management hedging operations once individual trading books pare their component exposures. We are troubled by the potential for such .“back books.” to become havens of prohibited proprietary activity after the implementation of this Rule.
A specific requirement that each type of exposure be designated as one that is hedged exclusively on an Individual or an Aggregate basis is essential. Risks should never be hedged on both an individual and aggregate basis, and most risk types are appropriately mitigated in only one of the categories. For instance, counterparty risk should always be (and in practice, typically always is) mitigated on a portfolio basis, and individual traders should not be able to make use of the hedging exemption by claiming mitigation of such a risk. These risks can be managed by a level of organization that is out of touch with the day-to-day operations of a trading desk. We propose that the Agencies consider requiring banking entities to create central .“Risk Management.” groups to perform aggregated hedges, to the extent that such groups are not already in place.
The broad allowance for aggregated hedging is troubling and its exemption is inconsistent with the intentions of this Rule. This rule mandates strict risk mitigation at a micro level, and should remove all Implicit or explicit allowances for the dangerous practice of management hedging. More generally, a banking entity.’s need for substantive aggregated hedging is indicative of a failure to appropriately mitigate risks at lower levels within an entity, and is therefore in violation of the spirit of the Rule. We acknowledge that the statute allows for aggregated hedging in Section 619(d)(1)(C),85 and we hope that the Agencies are prepared to be diligent in monitoring this activity closely to discourage abuses, which we see as a serious risk.
It’s way past time for ordinary citizens to have there voices heard in this process. We were encouraged that over 15,000 letters in support of a strong Volcker Rule were submitted to the regulators during the comment period. That was a clear signal that ordinary citizens want some checks on the power of the banks. Additionally , its encouraging that another 1,800 people petitioned the regulators to do the same.
Thanks to Jamie Dimon, perhaps the regulators will finally lend and ear to the clear message the citizens of this country are trying to get them to hear.