Risk Management Cycle Analysis Finance Essay

Risk is known as the probability or chance of loss, damage or hazard. Risk is related to every single entity in life. It is simply inevitable, and that serves as a significant motive for the development of various sophisticated techniques that help identify, quantify, manage and mitigate it. The risk management cycle contains complicated procedures and processes safeguarding firms of all shapes and sizes from the costs of destruction. This essay will effectively explain analyze, and evaluate JP Morgan's 2012 Two Billion dollar trade loss. The text will present each step of the bank's Risk Management Cycle, carefully illustrating where things went wrong while presenting their effective recovery plan and future Credit Risk Mitigation.

JP Morgan Chase Profile

J.P Morgan Chase is considered as United States' largest bank. The bank has more than 260,000 employees, $2.3 trillion in managed assets and more than $1.1 trillion deposits. Although today, the financial institution is in the recovery phase of an uncontrolled disastrous trading loss. (Remy Raisner, 2012)

Disastrous Trading Loss

JP Morgan was one of the banks that considerably managed and recovered from the 2008 financial crisis effectively. However recently, the bank experienced a massive and severe trading loss leaving them on shaky grounds. It is demonstrated that the major loss was concentrated in the Chief Investment Office totaling $5.8 billion dollars in the beginning of 2012. This illustrates the poor cash management in the first half of this year. The actual credit trades are still under investigation, it is obvious that the JP Morgan Chase suffers from large consequential reputational loss. The bank's Chief Executive Officer Jamie Dimon suffered great reputational loss due to his limited management and control of the situation. He has gained such a strong image over the last twenty five years for his impartial risk management of growth and volatility management that basically went down the drain. (Mike, 2012)

What Caused the Trading Loss?

There needs to be an accurate understanding of the situation to interpret whether the huge loss was as a result of the bank's failed risk management employees or what is expected of risk officer's duties.

Strategic management

There is an ongoing debate regarding the functions and credibility of the bank's risk management staff and managers.

Chief Executive Officer

JP Morgan's well respected CEO Dimon only knew about the multibillion trade loss through the wall street journal article months after the bank was trading and severely losing. (Denning, 2012) This demonstrates that the strategic management was poorly executed. How can a CEO of a firm not acknowledge the fact that risky trading activities are implemented that could suffer greatly from environmental and market changes? Given his reputation as a leading risk manager that helped JP Morgan recover efficiently and effectively after the financial crisis, he should have monitored and controlled the trading activities identifying and measuring their risk exposures.

Treasury Department

It was stated in a Wall Street Journal that during the period where the Chief Investment Office traded risky complex bonds resulting in more than five billion in losses, a treasurer was surprisingly absent! The person responsible for risk management was incompetent or inexperienced and was appointed in charge of the department as a result of internal connection.

Risk Management Department

Overall JP Morgan's management underestimates the severity and complexity of their risky decisions along with the substantial consequential losses. They simply classified the disaster as "executing hedges poorly and failing to monitor them properly" (Mike, 2012) There should have been recognition regarding the monitoring of such risky investments in order to prevent the severity of such losses from occurring. Given that the credit risks were identified and measured before the trading activities occurred; it is the management's responsibility to oversee the outcomes of their actions periodically. There should have been predictions and oversight of economic and market changes that would affect their positions so greatly.

Resolving the Problem

The management's attempt to solve the problem was very basic, simple and insufficient. They only dismiss traders like Ms. Drew and replacing her with similar traders with the same bonuses. Other than that, it is mentioned that various CIO executives left the organization after the loss occurred. This does not mean in any way that the losses will be compensated or prevented in the future. There should have been stricter controls on the employment of these traders in the first place. Competent traders and executives are crucial for a giant like JP Morgan especially when trading in risky activities like this one.

JP Morgan's Risk Management

It is stated in the bank's annual report that they have a wide range of processes and procedures to safeguard the bank's stakeholders and to ensure sufficient business conduct. The giant has a substantial amount of staff concentrated in audit, compliance and legal departments reaching 3,600 workers. "We know we won't always be perfect, but it won't be for lack of trying." (Chase, 2011)

Market Risk Management Cycle

The 2012 trading disaster highlights the inefficiencies in JP Morgan's market risk management. It is described as the risk of unexpected unfavorable change in market prices leading to negative values of a firm's financial instruments and portfolios. As defended in the Romney campaign, JP Morgan's loss is a result of market risk. (WASHINGTON, 2012) The bank's Chief Risk Officer is in charge of risk management. It is the main objective of controlling market risk is to decrease operational volatility, transparency of all market portfolios to senior managers, making efficient and effective decisions regarding investment returns. Senior Management and the Board of Directors are in charge of many market risk functions. They should create market risk strategy framework, approving and monitoring of limits, quantities and qualitative risk assessments like stress testing while of course measuring, monitoring and controlling the business's market risk.

Risk identification and classification

All business lines are responsible for identifying the various market risks in each unit. Usually market risks result from activities like Mortgage production, Private or Corporate Equity, IB and CIO. For the specific disaster discussed in this essay, the market risk has led to substantial losses in the Chief Investment Office.

Chief Investment Office Unit (CIO)

This department deals with managing the risk involved in the different activities that JP Morgan deals with, mainly working with structural risks. The market risk is related by measuring the net and structural exposures of the various activities. It is true that the multibillion dollar loss was concentrated in the CIO unit of the bank, however, the problem or incompetence is not illustrates in the risk identification phase. The problem arose in a later stage of the cycle.

Risk measurement

Risk measurement is the process of using techniques that illustrate a firm's risk exposure. JP Morgan utilizes several measures to get an accurate image of market risk through statistical and non- statistical measures.

Value-at-risk

The statistical risk measure is used by the bank to predict the probable loss exposure from negative market changes. Everyday this measure is calculated comprehensively as a part of risk management activities combining the majority of market risk factors. VaR is a significant technique that is stable across business. It allows the bank to compare and risk exposure to the monitoring limits set. This figure is then reported to senior management and used for capital and regulatory purposes. The problem with this technique is that it assumes that the historical data and values represent the immediate future's outcomes and distribution. The company sets a (95%) confidence level and losses are predicted to be more than the VaR value (5%). (Appendix1) According to the disaster that led to the multibillion dollar loss in 2012, it was said that the VaR measures were undervalued. "CIO risk limits were not sufficiently granular; and the approval and implementation during the first quarter of 2012 of the CIO VaR model related to the synthetic credit portfolio had been inadequate." (Chase, 2012)

VaR back-testing

The bank performs the back VaR back testing on a daily basis. June 30, 2012 illustrates that three days VaR values exceeded the actual values due to the CIO's synthetic credit portfolio which encountered adverse market fluctuations. The histogram in (Appendix 2) illustrates the CIO market risk losses at this date.

Economic-value stress testing

This technique illustrates the bank's exposure to unlikely but significant market changes. Scenarios are set that predict the maximum losses created by risk management valuations of macroeconomic events like financial crisis or disasters. They are updated on an ongoing basis reflecting the dynamic changes of markets. It is an efficient technique of controlling risk. They are also reported to senior management for transparency.

Non-statistical risk measures

Measures like interest rate basis and market values provide information about the bank's market risk exposure. They are integrated with the risk type and line of business for monitoring and controls.

Loss advisories and revenue drawdowns

These are techniques that illustrate losses up to a specified limit. This technique should have been monitored when the loss exposure to the CIO reached multibillion dollars. The senior management should have picked up on such figures.

Risk identification for large exposures

This is used to identify the losses from specific events like change in tax regulations or variety of market fluctuations. This allows the bank to adequately monitor the earning sensitivity.

Risk monitoring and control

Limits

JP Morgan controls market risk through the limits it sets like VaR and stress limits while incorporating non-statistical measures and profit /loss drawdowns mentioned above. These values reflect the firm's risk appetite, liquidity, market volatility and management. They are also in line with the business portfolios. In the disaster discussed, it is obvious that the limits set were not as accurate and were not monitored well by risk managers and the senior managers. There should have been stricter control and limits when dealing with complex CIO activities.

Model review

Models mentioned above are used for management and monitoring of risk. The valuation models are used for risk management models and for calculating capital and regulatory requirement. If the model reviews were monitored by the Chief Risk Officer in an effective manner, there would have been clear indications of the loss exposures. (Appendix, 2)

Risk reporting

The measures and models discussed above are supposed to be reported on a daily basis to senior management. Other measures like trends; profit/loss, stress testing and portfolio changes are reported on a weekly basis. (Chase, 2012) This seems hard to believe in which the senior management were oblivious of the losses and market changes that led to the loss. As mentioned several times the CEO only learned about the issue through the articles.

Effective Risk Management Strategy

JP Morgan Chase was always known for its outstanding risk management. However, this trading loss could have been a result of their overconfidence and lack of monitoring. A new framework is required to help executives classify risk based on their relation to strategy and controllability. Risk is divided into three categories preventable, strategy and external risks. (Mike, 2012)

Preventable Risks

They consist of internal risk elements in the bank. They could be controlled, eliminated and managed by ongoing monitoring operational practices, executive involvement in employee's decision, behaviors and activities. They are achieved through setting preventions, limits and norms. (Mikes, 2012)

Strategy Risks

This is the risk that JP Morgan takes voluntarily to make excessive returns. It was known for its smart risk taking activities. This type of risk is actually desirable as illustrated in the case. The CIO unit took significant risk to capture substantial gains. The bank's risk management system needs to be more effective in reducing the materialization of strategy risk. They should also build plans for occasions that cover losses where these events occur. (Mikes, 2012)

External risks

These are the risks that have affected the CIO unit activities the most. They are the risks that are out of the bank's control. The macroeconomic shifts that occurred affected the outcome of the investment and hedging goals intended. The approach needed to deal with external risk should be detailed and studied. There needs to be accurate detailed identification and mitigation of future activities. (Mikes, 2012)

Conclusions Recommendations

JP Morgan Chase went through a disastrous crunch in the first part of 2012. Their CIO synthetic credit portfolio aiming to hedge against the stressed credit environment did not perform as expected after 2011. Unfortunately, the complex derivative portfolio changes in size and characteristics and so lead to a substantial increase in risk association. Before June 30, 2012; the CIO synthetic portfolio lost $4.4 billion and $5.8 billion. The transfer of a segment of the portfolio to the IB led to the additional loss of $ 800 million and $1.7 billion. These conclusions are a result of the analysis and review of stress testing and simulated scenario techniques. (Chase, 2012) After examining the bank's strategic management and risk management cycle it is obvious that the disaster occurred as a result of overconfidence and lack of monitoring and reporting transparency. The senior management was not aware of the losses and defects that were occurring. Some of JP Morgan's executives were also described as being inexperienced. The CIO traders involved in the disaster have also stepped down or have been replaced. However, it is also suggested that this problem would have occurred with even flawless risk management. They could be due to the sudden changes in the market and sudden actions after April 10, 2012. It is demonstrated that the techniques used to measure and identify market risk are not the problem. JP Morgan utilizes efficient and sophisticated risk management techniques. The problem lies in the monitoring and reporting segment of the risk management cycle. If the CEO knew about the problem before reading the article, they could have managed the situation differently. In order to avoid future issues in miscommunication and risk monitoring JP Morgan Chase need to adapt or make use of a new framework that segments risk into preventable, strategy and external parts. By dividing them and setting risk management for each division they will be able to forecast and hedge against losses in a more effective manner. They have also taken measures after the disaster for the bank to recover its losses. (Appendix, 3)

Works Cited

Bianco, J., 2012. Understanding J.P. Morgan's Loss, And Why More Might Be Coming. [Online] Available at: https://www.ritholtz.com/blog/2012/05/understanding-j-p-morgans-loss-and-why-more-might-be-coming/ [Accessed 15 November 2012]. Chase, J. M., 2011. 2011 ANNUAL REPORT. [Online] Available at: https://files.shareholder.com/downloads/ONE/2169295553x0x556139/75b4bd59-02e7-4495-a84c-06e0b19d6990/JPMC_2011_annual_report_complete.pdf [Accessed 14 November 2012]. Chase, J. M., 2012. CORP Q2 2012. [Online] Available at: https://www.sec.gov/Archives/edgar/data/19617/000001961712000264/jpm-2012063010q.htm#s3B241053CD178D0FE04E57787E0ACC5A [Accessed 16 Novemebr 2012]. Denning, S., 2012. The Risky Risk Management Practices at JPMorgan Chase. Forbes, 18 May. DiSavino, C. P. a. S., 2012. Regulators cut JPMorgan's ability to trade power. [Online] Available at: https://www.reuters.com/article/2012/11/15/us-jpmorgan-ferc-powertrading-idUSBRE8AE08L20121115 [Accessed 19 November 2012]. JPM, W., 2012. JPMorgan And Wells Fargo Report Record Profits, Potential Long-Term Opportunities. [Online] Available at: https://seekingalpha.com/article/938381-jpmorgan-and-wells-fargo-report-record-profits-potential-long-term-opportunities [Accessed 16 Novemeber 2012]. Kopecki, D., 2012. JPMorgan Posts Trading Loss on 10 Days as Derivative Bet Unwinds. [Online] Available at: https://www.businessweek.com/news/2012-11-08/jpmorgan-posts-trading-loss-on-10-days-as-derivative-bet-unwinds [Accessed 10 November 2012]. Mike, R. K. a. A., 2012. JP Morgan's Loss: Bigger than "Risk Management". Harvard Business Review, 23 May. Mikes, R. S. K. a. A., 2012. Managing Risks: A New Framework. [Online] Available at: https://hbr.org/2012/06/managing-risks-a-new-framework/ar/1 [Accessed 16 Novemebr 2012]. Remy Raisner, C., 2012. Where Does JPMorgan Stand Now. Seeking Alpha, 8 November. SILVER-GREENBERG, J., 2012. JPMorgan Sues Boss of 'London Whale' in Trading Loss. [Online] Available at: https://dealbook.nytimes.com/2012/10/31/jpmorgan-sues-boss-of-london-whale/ [Accessed 10 November 2012]. WASHINGTON, 2012. Romney campaign defends JPMorgan loss as market risk. [Online] Available at: https://www.reuters.com/article/2012/05/15/us-usa-campaign-romney-jpmorgan-idUSBRE84E0NX20120515 [Accessed 14 November 2012].

Cite this page