Media coverage of the staff in JPMorgan’s chief investment office turned up nuggets that ranged from the banal (credit derivatives trader Bruno Iksil has a penchant for wearing black jeans) to the comical (London head Achilles Macris had a picture of a missile on his apartment wall, in brave defiance of stereotypical assumptions about dealers).
One of the more interesting theories to circulate about the curious growth in the risk exposure associated with the management of a portfolio that is currently around $360 billion is that it is part of a plot by group chief executive Jamie Dimon to put further downward pressure on investment banking compensation at JPMorgan.
According to this theory, Dimon decided to allow a shift in the firm’s risk into the CIO because its staff members are compensated on meeting risk hedging goals as well as maximizing profits, and at lower overall levels than traders who take comparable positions within the investment bank.
Dimon certainly makes no bones about his desire to drive down the investment banking compensation ratio at the firm; unlike some of his peers he is in a strong enough position to follow through on his threats to cut the portion of revenues that his subordinates keep for themselves.
In each of his last two quarterly results conference calls Dimon has noted that he could have unleashed a compensation arms race, given that JPMorgan has been dramatically outperforming its rivals in revenue generation, but instead decided to hold down discretionary payouts.
Dimon has not received a public round of applause for his efforts from his fellow bank chief executives, but they might well be quietly grateful that JPMorgan has not taken advantage of its relative strength to poach more staff by increasing compensation.
Bank shareholders might also be expected to commend Dimon’s efforts on the cost-containment front, but they should be deeply wary of moves to increase the role of treasury or chief investment office functions in seeking to add a layer of profit to group risk-management trades.
JPMorgan is not alone in taking a proactive approach to group risk hedges. Barclays also generates big profits from the management of its risk, chiefly in the form of government bond and swap trades that are designed to take advantage of anomalies in the shape of interest rate curves while also serving as hedges.
As with JPMorgan, these trades have been a consistent source of profit in recent years; Barclays provides reasonable disclosure on the activity, even going as far as providing estimates on how much revenue it hopes to generate from the hedges in the coming year.
But this shift towards turbo-charged hedging activity by banks has obvious dangers. The chief risk is an overturning of market assumptions about future prices. Barclays is able to provide some guidance on the likely performance of its hedges because it can use forward curves to estimate future value and knows its balance-sheet needs. A sudden shift in forward interest rate curves is a far from improbable outcome, however. And a consistent failure to meet announced return-on-equity targets by Barclays and most of its rivals is bound to increase the pressure felt by senior managers to search for ways to boost returns by increasing risk.
The potential risks of prop-flow trading within investment banks are now reasonably well understood, given that upsets in positioning have been used so often to explain poor performance.
The dangers of prop-hedging are less well appreciated. These dangers could include aggressive collateral management decisions as well as actual positioning, given the growing importance of valuation and allocation assumptions relating to collateral.
The details of calculation of risk-weighted asset levels as a shift is made towards adoption of the Basle III capital regime are also a source of potential fudging, if only because big portfolio changes are being made on a very tight timeline.
There are more reasons to be concerned about hedging tactics at investment banks than simple worries that a black-jeans-wearing trader might be starting to go a little crazy in the further reaches of the credit derivatives markets.