Analysis: JPMorgan and other banks tinker with risk models

Mon Mar 18, 2013 1:40am EDT
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By David Henry and Lauren Tara LaCapra

NEW YORK (Reuters) - In 2011, senior executives at JPMorgan Chase & Co told one of the bank's trading and hedging groups to scale back its riskier positions as new regulations would make these bets much more expensive to maintain.

The group, called the Chief Investment Office (CIO), was asked to cut risk-weighted assets, a key measurement that regulators use when assessing a bank's stability and how much capital it needs to hold, according to a U.S. Senate subcommittee report on Thursday.

In December 2011, the CIO came up with a plan to change its risk models. It estimated that by calculating risk differently, the bank could reduce its risk-weighted assets by $7 billion - more than half the targeted amount - without having to actually sell the securities.

The CIO famously went on to lose more than $6 billion last year from bad credit derivatives bets that came to be known as the "London whale" trades. One of the main reasons the losses grew so large, according to Senate investigators, were the changes that JPMorgan made to its risk models.

A JPMorgan spokesman declined to comment. The largest U.S. bank has acknowledged mistakes but said senior management acted in good faith and never had any intent to mislead anyone.

Investors say they fear that JPMorgan is not alone in tinkering with risk models to meet tougher capital requirements laid out in new regulations known as Basel III.

Global banks are spending hundreds of millions of dollars to install elaborate computer models to measure risk and make sure they are adequately capitalized. Under Basel III, banks can shrink their risk-weighted assets - and boost profits - if they can build a model to prove the bond or loan is not so risky.

While banks can use these models legitimately, they can also be tweaked to try to game the system, said Adam Compton, a portfolio manager at Atlanta-based hedge fund GMT Capital Corp.   Continued...

A sign stands in front of the JPMorgan Chase & Co bank headquarters building in New York, March 15, 2013. REUTERS/Lucas Jackson