Warren Buffett once said that derivatives are financial weapons of mass destruction. On many occasions, quite a few organisations have been subject to such self-inflicted financial calamities. JP Morgan Chase & Co, one of the largest banks in America, is the latest addition to the list. It is believed that the bank lost US$ 2 bn over hedging some tricky derivative transactions. The exact detail of how the losses materialised and why no steps were taken to curb the same at the initial stage is not yet public.
It is believed that the bank undertook a hedge against an exposure to high quality loans. And then in order to improve the first hedge took more economic exposure in derivative transactions. However, as the hedge failed to materialise, losses started mounting on the bank. True, that the pain from leveraged bets is far worse than plain vanilla cash instruments. However, what comes in as a surprise is the explanation given to such losses. The bank's chief executive is of the view that these losses were a result of sloppiness and poor judgment. So, were the bank's executives unaware of the potential drawbacks of having back to back levered trades?
The said example also raises concerns over the risk management practices followed by the banks. While it is believed that the derivate bets were within the spirit of the Volcker Rule, its raises doubts over the applicability of the law (yet to be enforced). It may be noted that the Volcker rule prevents banks from speculating in their own deposits. And here, JP Morgan hedged the existing loan position. So, there was no violation on technical terms per se. But violation or no violation it is the outcome that matters. And the fact is that the company has lost US$ 2 bn in derivative trade.
This loss as well as the ones incurred in the past by various other banks signifies that there is strong need to have well-defined risk management system in place. Tough regulations will prevent the financial institutions from undertaking such transactions that are harmful to the depositors. It may be noted that huge losses in US sub-prime mortgage debt incurred by the financial institutions were also a result of reckless speculation and weak risk management practices. If the global banks are not to take a lesson from the same, we might see a flashback of 2008 soon.