JP Morgan's Athena, basis risk and mis-selling

The week on Risk.net, January 13–19, 2017

JP MORGAN to commercialise front-office risk system, Athena

FRTB will spark rise in basis risk, firms warned

GOLDMAN MIS-SELLING FINE tops 2016 op risk losses

COMMENTARY: Mis-selling and mortgages

It is no real surprise that, looking back at 2016, the operational risk loss data is dominated by a few massive fines and compensation payments.

The tail of the loss distribution dominates operational risk far more than any other kind of risk – that is one of the reasons why modelling operational risk has proved so intractable. And, certainly since the crisis, most of these extreme losses have fallen into the same Basel category – 'clients, products and business practices', which might better be described as 'crime, deceit and dishonesty'.

Mis-selling, tax evasion and market-rigging do not happen by accident, they don't simply appear silently overnight in a bank's offices like mould in a poorly ventilated bathroom; they are the result of conscious human decisions to deceive and defraud.

Another problem, also exemplified in the list of losses from 2016, is the time lag between event and payment. More than a decade passed before US mortgage lender Household International was finally brought to book for predatory lending and accounting misstatements, during which time it was acquired by HSBC, which finally paid out a $1.58 billion settlement on its subsidiary's behalf in June. 

Seventeen years is abnormally long, but many of the other conduct losses also represent cases that have taken many years to close. (The same will doubtless continue to be true: JP Morgan made headlines this week as it paid out $55 million on charges that it overcharged black and Hispanic mortgage borrowers between 2006 and 2009.)

But the root causes of these losses are frustratingly difficult to observe and quantify compared with the causes of, say, a sudden rise in loan default rates or a swing in commodity prices – another reason why modelling operational risk is so difficult. The UK Financial Conduct Authority quietly abandoned its own review of banking culture at the end of 2015, in the face of political pressure, and no other project of similar scope has arisen to replace it; the Senior Managers Regime may be the envy of other regulators, but without an industry-wide review of banking culture it will be difficult to work out whether it is having any effect.

Investors could, however, be stepping up to fill the gap left by regulatory inaction. Growing interest in environmental, social and governance (ESG) issues is leading to a wave of new research aimed at turning this infamously 'squishy' data into hard investment recommendations. Much of this is aimed at neglected areas of risk, such as the potential for losses related to environmental pollution. But some is relevant to the culture and conduct question within operational risk – the focus on ESG is justified by asking "whether a company that has good health and safety practices is more productive, or whether a company with a high number of fatalities has higher litigation expenses".

Oversight of corporate culture – at banks and elsewhere – could be brought in by the back door: not imposed by regulators after the fact, but by investor pressure and market discipline in real time.

 

STAT OF THE WEEK

After a slow start, client clearing of single-name CDSs began to take off in the US last year. Ice cleared $190 billion of single-name CDSs for buy-side clients in 2016, compared with $33 billion the previous year. However, that still accounts for only a tiny fraction of the overall market for single-name CDSs – derivatives users traded more than $3 trillion of these contracts in the first half of 2016, according to the Bank for International Settlements.

 

QUOTE OF THE WEEK

"The moment the variation margin rules hit in March, counterparties including smaller domestic banks will face a pricing shock that will put pressure on any relationships they might have with the European Union or US, and increase demand for inter-Asian trades" Paul Landless, Clifford Chance

 

ALSO THIS WEEK

Hidden benefits of the Fed's model validation push
Incidents such as the London Whale losses show an overhaul of model validation should be welcomed, not maligned

Giancarlo to overhaul Sef rules if given CFTC reins
Acting chairman says all methods of execution should be permitted on Sefs

Questions remain after EC publishes position limits rules
Market participants raise concerns about extraterritoriality and hedge exemptions, while regulators are tipped to struggle

LCH to clear single-name CDSs for US clients
Paris-based CDSClear already in discussions to onboard its first US FCM

VM rules may spark Asian migration away from EU/US banks
Six-month transition could make inter-Asian trades cheaper, but only if liquidity is sufficient

Fresh Priips objections reignite timing fears
Supervisors' concerns could delay adoption and put pressure on implementation timeline

Basel set to decide on capital relief for accounting changes
Phase-in to IFRS 9 and Cecl needed to avert "a dramatic overnight drop in regulatory capital", say auditors

US dealers face trading lockout from small Japanese banks
Lack of substituted compliance for Japan's small bank margin rules causing concern

Further reading

• Commodities

Questions remain after EC publishes position limits rules

• 19 Jan 2017

• Commodities

EU commodities regulation: outlook for 2017

• 13 Jan 2017

• Markets

LSE-backed Libor replacement faces data wrangle

• 12 Jan 2017

• Asset management

Buy-siders weigh virtues of P2P repo

• 12 Jan 2017