[ by Melanie Gretchen ]

JPMorgan's report last week on how it lost more than $6 billion from trading in 2012 details how excessive complexity and poor oversight still threaten many parts of the financial system -- more than four years after the failure of Lehman Brothers.  Dealbook calls it "required reading for policy makers and financial executives."

The subject of the report is the bank’s trading of complex derivatives known as credit default swaps that are similar to the instruments that forced the government to bail out the American International Group in 2008. At JPMorgan, the nation’s largest bank and one of many that received government aid during the crisis, these investments did not threaten the institution’s survival as they did with A.I.G. But they caused losses large enough to dent the bank’s reputation for managing risk well, and cost its top executive, Jamie Dimon, a 50 percent reduction in his 2012 pay.

The report, which was prepared by JPMorgan executives, is not exhaustive: it does not explain, for instance, how an early loss estimate of $2 billion eventually grew to $6 billion. But it provides important insights into why the losses took the bank and regulators by surprise. The main reason is that they were not paying attention to a small group of traders working for the bank’s chief investment unit, which was supposed to be hedging, or protecting against future losses.

In fact, far from mitigating the bank’s risk, the London-based traders amassed a large, complex financial portfolio in the misguided hope that doing so would help the bank avoid a relatively modest loss of about $100 million, according to the report. As they dug themselves into a deeper and deeper hole, the risks they were taking were either kept from or ignored by senior managers and bank supervisors.

But not everybody was oblivious. Investors at other banks and hedge funds who were trading with JPMorgan noticed and took advantage of the situation. They even dubbed the group’s principal trader the “London Whale” because he took a very large position in the market.

The report’s findings suggest that some of the riskiest trading would have been either prohibited or at least better monitored had regulators finished drafting regulations about derivatives and short-term trading by banks that are required under the Dodd-Frank financial reform law.

But the far bigger lesson from this report is that senior bank officials and regulators need to be more vigilant than they have been in overseeing potentially risky activity wherever it may be taking place. The report found that even as the London group, which makes trades for JPMorgan itself, engaged in more complex transactions and took on more risk, its activities were more lightly monitored than the trading by other divisions, like JPMorgan’s investment bank, which provides financial services and advice to corporations and others.

The board of JPMorgan did the right thing in making this report public so that investors, depositors and the general public can better understand what happened. Last week, federal banking regulators ordered JPMorgan to improve its risk management systems and told its board to report on its progress. Given the nature of risk, we will probably not know how well these measures are working until the next crisis.

[Dealbook, 1/19/13]