[ By Howard Haykin ] Financial blogs can be so demanding on and unforgiving about the subjects of their postings.  Heard on the Street began with the standard question on everyone's mind:  Who knew what when? Journalist David Reilly thinks its corollary is also important:  Who didn't know what and why? Clues to both may lie in the circumstances surrounding an adjustment to a relatively esoteric gauge of risk within the bank's Chief Investment Office, which managed the losing trades.  Sometime in the Q1 of 2012, the investment office adjusted the model for measuring what is known as its "value at risk," or Var, according to the bank.

This measure looks to gauge the maximum potential daily loss for a firm, business unit or type of product.  There are plenty of flaws with this metric, which, for example, didn't help in the financial crisis.  But banks use it as a benchmark for assessing the performance of trades and as a way to spot brewing problems.  Ironically, the measure was created in the mid-1990s by J.P. Morgan.

Changes to Var Model. There typically has to be a very good reason to change a bank's model, so it's notable that JPMorgan changed the model at the beginning of the first quarter, and then in announcing the trading loss, said it was again changing the model - this time back to the original settings. The results were significant.  Having originally reported an average trading risk of $67 million for the investment office - or $2 million lower than the previous quarter - the Q1 measure ballooned to $129 million after the model was reverted to its original formula.  Obviously, that displayed a huge spike in the potential for loss within the investment office. Underlying Questions. Beyond the specifics of what exactly was adjusted within the model, the changes raise 2 far-broader questions:

• Why was it tinkered with?  Was it because someone thought the model was falsely showing a too-high level of risk for what was deemed to be a safe trade?  Or had the trade gone bad and someone didn't want the Var model to start alerting others to rising risk?  The latter would indicate the possibility of wrongdoing.
• Even if the change was made for a seemingly benign reason, who knew of and approved it among bank executives?  Notably, the investment office reporting directly to CEO Jamie Dimon?

If top management wasn't properly consulted, this might indicate a serious breakdown in internal controls and risk systems.  In addition, management and regulators may have been deprived of an early warning sign that something was going wrong. Unfortunately, few if any details have been furnished by JPMorgan about the trading losses and the bank doesn't plan on furnishing more until after the end of Q2 of 2012 - although, the information may be disclosed during one of the upcoming Congressional hearings - including Mr. Dimon's hearing, which is expected to happen anytime after mid-June. For Congress, questions about the bank's risk measures are particularly important. That is because issues around them also touch on the way banks manage capital and report risk to investors. Bank Generated Var Models. Because value-at-risk models help to determine how much capital banks hold against trading assets, it's important to understand that these are based on internally generated formulas.  This obvious conflict of interest comes with the increased risk that a bank which has an "incentive to game their model to lower their regulatory capital requirement" can, and may very well, do so.  That sentiment is expressed by former FDIC Chairman Sheila Bair.  And, regardless of the highly-regarded reputations of JPMorgan and its CEO Dimon, who's in a position to say that JPMorgan and/or its officers are above such deceptive actions. JPMorgan's experience is also a reminder that the risk measure varies among banks. Indeed, the Office of the Comptroller of the Currency, in a quarterly report on derivatives activity, "cautioned" that the risk gauge can mislead. The OCC said that J.P. Morgan, Goldman Sachs and Morgan Stanley calculate the measure with confidence there is a 95% chance that losses will be within the reading.  If the firms used a 99% confidence level like "Bank of America and Citigroup, their Var estimates would be meaningfully higher," the OCC said. In light of that, J.P. Morgan is a reminder for both banks and investors that attempts to measure risk, let alone tame it, are fraught with hazard. For further details, go to:   [WSJournal's Heard on the Street, 5/20/12].