1. notes, the economic problem that a

1.     
Introduction

 

Separation of ownership and organization control, a problem that
has bothered corporate world for a long period, has an utmost importance for
the survival of organizations. The separation of decision and risk-bearing
functions observed in large corporations, provides positive effects in part
because of the benefits of specialization of management and risk bearing but
also due to the separation of decision initiation and implementation from ratification
and monitoring of the decisions.

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The allocation of decision rights in an organization reflects a
trade-off between the costs of transferring relevant information and the costs
that occur when decision-making agents have different objectives than the
principal.

 

The aim of this paper is to identify and analyse rooted causes
behind JPMorgan dubbed “London Whale” scandal, which took place in 2012 and was
responsible for a loss around US$6.0 billion related to derivatives trades, and
whether or not dysfunctional decision rights allocation and poorly risk
management were prominent drivers to the debacle of such scandal.  

 

2.     
Allocating
Decision Rights

 

As Hayek (1945) notes, the economic problem that a society must
solve is how to secure the best use of resources. Hayek emphasizes that the
ultimate decision rights must rest with those who have information relevant to
making decisions, notably: circumstances, time and place.

 

According to Brickley, Smith and Zimmerman (2016), a common
characterization divides the decision-making process into four different steps:
(i) initiation, to develop contracts design and resource utilization proposal;
(ii) ratification, to pick up initiatives that will be implemented; (iii)
implementation, the execution process of chosen and ratified decisions, and
finally; (iv) monitoring, which can be described as decision-makers performance
and rewards measurements. Fama and Jensen (1983), refers to initiation and
implementation rights as decision management; and ratification and monitoring
functions are defined as decision control. Often, due to incentive problems,
employees do not bear the full wealth effects of their actions, thus granting
an employee decision management and decision control rights for the same
decision, probably will lead to dysfunctional behaviour (Brickley, Smith and
Zimmerman, 2016).

 

By delegating decision rights and determining power structure,
organizations usually make a trade-off between the agency costs arising from
conflicts of interest associated with decentralization, and the costs that
arise from poor information associated with centralization (Jensen and
Meckling, 1992). Moreover, an organization decision to concentrate management
and control information, it is also quite relevant on the risk management
perspective, once on this case it cannot be specialized risk bearing.

 

In summary, the allocation of decision rights is an important
issue on the contemporary business world. Management hierarchies and incentive
structures that encourage mutual monitoring are quite efficient ways of
monitoring decision making.

 

3.     
JP Morgan’s
London Whale Case

3.1  Overview

The so called “London Whale”, which
cost investment banking giant JPMorgan more than US$6 billion, was one of the
many scandals that has recently plagued Wall Street. Post 2008-2009 crisis Jamie Dimon,
JPMorgan chief executive, emerged as one of the most competent investment bank
CEO’s, and one of the few who ably steered his institution through the
subprime-mortgage crisis, (Matthews, 2013).

 

According to Bloomberg (2016), by
the beginning of 2012, JPMorgan trading desk in London accumulated outsized derivatives
positions in the market, implying in an estimated trading loss of US$2 billion by the outcry of the case in April 2012. Dubbed the “London
Whale”, due to the impressive volume of the transactions, this events with
derivatives trading caused the bank, so far, up to a US$6.2 billion loss. Furthermore,
despite the noticeable financial impact, maybe the main effect from these events
was to give rise to several investigations to examine the JPMorgan’s internal
controls and risk management policies.

 

3.2  Risk Management Failures

 

According to Santoro (2013), Value
at Risk, or VaR, is a quite popular risk-measurement tool that became popular
after the stock-market crash of 1987, once large and volatile banks portfolios
were requiring more sophisticated and accurate risk-control mechanisms. In
short, VaR is a metric that attempts to estimate the risk of loss on a
portfolio of assets, representing an estimate of the maximum expected loss over
a specified time period. Furthermore, VaR has the virtue of being simple: at
the end of each day, banks can estimate how much each of its individual
portfolios might lose ; being recognized as one of the best risk-measurement
tools available to banks and regulators.

 

Additionally, VaR also has a quite
important managerial role, enabling an efficient capital and thus, risk
allocation among traders. For instance, for two comparable performance, it is less
risky and preferable the one if lowest VaR. According to Dias (2010), by the
end of the 90’s, VaR had become widely accepted among banks, investors and
regulators authorities as a quite powerful risk management tool.

 

By the first quarter of 2012,
JPMorgan’s trades associated to the “London Whale” scandal exceeded the bank’s
risk indicators more than three hundred and thirty times, according to a U.S.
Senate subcommittee report. In short, the trades by that time, were ten times
riskier than what was allowed by the bank’s own guidelines and risk management
policies. For instance, in January 2012, JPMorgan VaR guidelines were exceeded
for four consecutive days (Santoro, 2013). 

 

According to Bloomberg (2016), once
the trading came to light, Dimon argued that they were flawed, complex and poorly monitored.
Yet, a myriad of risk management mistakes were committed, such as: limited accounting
management, poor internal control and flawed regulatory review. However, the
most remarkable aspect for this scandal was failures on the job design and
decision rights allocation among part of JPMorgan’s top management. The scandal
took place under the authority of JPMorgan Chief Investment Office (CIO), which
was commanded by Ina Drew, a quite experienced financial market executive with
direct report to bank CEO.

 

In January of 2012, just after
the improper trades began, JPMorgan started to use a recently designed VaR
model whose immediate effect was lowering by 50% risk exposure on the “London
Whale” trades. The bank eventually conceded that the new VaR standard was
seriously flawed, leading to even greater losses. According to Santoro (2013),
the outsized bets were enabled by the bank’s manipulation of its own financial
controls to reduce risk.

 

The failure to properly apply VaR
and other risk controls to “London Whale” trades was especially perplexing
because the experienced team in charge of JPMorgan Chief Investment Office,
which contributed with US$23 billion for JPMorgan earnings from 2007 through
2011 (The New Yorker, 2013). 

 

By January 2013, an JPMorgan
internal report argues that CIO executives were mostly responsible for flaws in
the application of VaR risk controls, however ultimately responsibility for the
financial loss belonged to the traders. Nevertheless, bank executives are not
the only ones to blame, regulators overseeing did not detect the risk
accumulating, which repeatedly breached risk limitations. Moreover, regulators did
not take any consideration by the time in which was set JPMorgan new VaR method
that, abruptly, watered down “London’s Whale” trades risk perception (Wall
Street Journal, (Zeissler and Metrick, 2014).

According to JPMorgan report (2013),
Dimon and the board of directors were duped. Relevant information was not sent
up the chain of command. Faulty information was transmitted, and information
access was limited for both senior management and the board. In line with
JPMorgan risk guidelines, CEO was supposed to receive a daily report about bank
VaR status. However, despite the apparently risk management culture, JPMorgan’s
trading positions in New York and London, the most profitable offices, were not
subject to standard risk analysis. For instance, trading days in London were
even lengthened according to time zone, hoping that the American market’s
closing prices would be kinder to London office profit and loss report (The New
Yorker, 2013).

 

It is quite evident the
dysfunctional on the assignment of decision-making process contributed to
JPMorgan trading scandal. From one hand there were market traders with great
incentive to focus on financial performance, without any relevant hierarchy
surveillance. Ultimately, implying in higher than acceptable level of risks,
lack of transparency and also trading activities that disagreed with JPMorgan
guidelines. On the other hand, top management, due to blurred areas on their
assigned mandate, performed a lower level of oversight engendered in
ineffective controls and weak risk management. Additionally, the approval of
the new VaR model was inadequate: lack of resources and oversight, limited scale
and scope and flawed implementation.  

 

According to Fama and
Jensen (1983) on complex
organizations, overcentralizing decision making is one of the biggest error
companies can make. Decision rights must be collocated with the relevant
information, and raising the level of decision-making authority thus requires
transferring information upward as well.

 

By January 2013, a detailed
JPMorgan report put out on how the bank has lost around US$6 billion on “London
Whale” case. The document stands out of how excessive complexity, poorly
designed decision assignments and poor oversight were the key drivers for such
scandal. According to the report, the main explanation why the scandal took
both the bank and regulators by surprise was that they were not paying enough
attention to a small group of London-based traders that were operating with a
misguided hope that thru a complex financial portfolio, they would prevent the
bank to avoid about US$100 million loss with derivative trades (The New York
Times, 2013). However, according to the report, ultimately results were higher
risk-taking willingness, which were deliberated ignored by JPMorgan top
management and bank industry supervisors.

 

Limited trading controls and
authority of top management executives in charge of risk, legal and compliance;
alongside with the lack of actions towards clearly assigning decision responsibilities
and effectively separating decision management and decision control of JPMorgan
trading activities were the core problem beneath the “London Whale” scandal.

 

3.3  Remedial Measures

 

After the outcry of the crisis, JPMorgan
has taken a broad range of remedial measures to respond to the lessons it has
learned from the events. According to JPMorgan report (2013), the main measures
were: (i) to put in place a new CIO leadership team; (ii) to enhance governance
within Chief Investment Office, by creating weekly and monthly committees,
which were responsible for understanding and managing risks arising from CIO
activities; (iii) to refocus CIO mandate on its core and traditional asset-liability
management, moving derivative trading to the Investment Bank; and, (iv) to revise
policies with respect to pricing, and to enhance CIO key business processes and
reports, such as the Global Daily Risk Report, providing management with a consolidated
and clear view of all risk positions.

 

Lastly, under the guidance of its
Chief Risk Officer, JPMorgan, mandated a risk assessment of each business line.
As part of this process, the bank conducted a spot check of significant drivers
of VaR standards; the appropriateness of the risks undertaken; policy,
response, and escalation process concerning limit breaches; the review of its
risk committee structure and mandate, among others.

 

4.     
Conclusion

 

It is not a single event that
brings about financial loss scandal, those events are usually the cumulative
results of many contributing factors: wrong decisions, poor allocation of
decision rights, faulty controls and oversight, not respecting limitations, as
well as conflicting interests and externalities, all contribute to bring about
a such events.

 

The lessons of the JPMorgan scandal
go beyond internal controls and risk management failures. The use of best corporate
governance practices and proper oversight, alongside with clear and
well-established mandate for bank executives, could have averted this crisis.

 

Therefore, a mismatch to implement and effective architecture
governance and to clearly allocate decision rights were embryonic factors on
the debacle of “London Whale” scandal.

 

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