By Joseph Neu
The fallout from JP Morgan’s multibillion “hedging” losses will continue to reverberate for some time—all the more so because they underscore numerous trends that treasurers, and not just those at financial institutions, will be focused on. The obvious one is that it feeds the sense of eroding confidence in banks, even JP Morgan. This unfortunately is something that has yet to be fully restored post-crisis and explains why counterparty risk management is still job one for treasurers. Looking past this important item, here are three more.
FRESH ATTACKS ON HEDGING
Hedging is never really immune from attack on some front, but the JP Morgan losses stemming from activities labeled as hedges opens another one. At last month’s Bank Treasurers’ Peer Group Meeting, sponsored by UBS and facilitated by The NeuGroup, treasurers from the larger US regional banks in the group reported a surprising interest on the part of Fed regulators (even before the JP Morgan news broke) in hedges and hedge accounting.
One explanation for renewed regulatory interest is that hedging could be a potential loophole for banks to avoid Volcker Rule restrictions on proprietary trading. Regulators being asked to allow a hedging exemption obviously want to restrict it to actual hedging. The difference between hedging and risk taking, however, can be nuanced and may just come down to management intent. Whether the JP Morgan losses can be argued to be hedges or not, hedges will be subject to even more external scrutiny as a result.
Unfortunately for proponents of hedging, this additional scrutiny comes at a time when more treasurers (at least on the corporate side) are considering or already curbing hedging activities. On top of heightened volatility, out-of-whack correlations, higher costs due to bank regulations and OTC derivatives reforms, not to mention the administrative hassles of collateral and margin posting, this is just one more reason to curb treasurers’ hedging appetite.
Given that bank regulators will likely tie Volcker Rule exemptions to hedge accounting in some form, the trickle-down implication for corporates is that their exemptions will also be under renewed pressure to be tied to accounting rules. This will stymie another hedging trend: increased use of more economically viable hedges that do not qualify for hedge accounting. And, yes, portfolio or macro hedges have also been directly implicated by the JP Morgan losses.
RISK MODEL SCRUTINY
A significant part of the regulatory hell for bank treasurers these days is the need to validate all their models (including many spreadsheets) to regulators with extensive documentation, including what goes into them, how the models are used in decisions and, when decisions are not based on models, why qualitative judgement and not model analytics prevailed.
Given how bank models, risk models especially, failed to prevent the financial crisis this validation effort probably has merit. And similar compliance efforts are sure to eventually trickle down to corporates too.
Not lost in the implication that JP Morgan’s risk models proved faulty— even with the crisis lessons and added validation scrutiny— is that JP Morgan was the creator of RiskMetrics. RiskMetrics, of course, popularized VaR for use in most corporates. How far have most come in improving their risk models in the meantime?
INVESTMENT PORTFOLIO RISK
The third area of focus from the JP Morgan loss fallout is on the riskiness of assets held in the investment portfolio. Corporate treasurers, even more so than their bank peers, are encouraged not to take on risk in their excess cash investment portfolios that may impact EPS numbers. In today’s environment, it is difficult to define what is a “safe” investment and even more difficult to earn any return in the process.
Now, just when some treasurers have finally won over their Board to change investment policies to lower credit limits to allow investments in the lower-end of the investment-grade paper, with the justification that it is probably “safer” than that of higher-rated banks, JP Morgan’s “Chief Investment Officer” comes along and gives Boards a reason to reconsider. The irony is that this loss by what was thought to be one of the safest US banks may actually validate the corporates-are-safer thinking.