Fed regulators in hot seat over JPMorgan loss

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JPMorgan's $2 billion-plus trading loss raises serious questions about whether the New York Federal Reserve and other regulators were asleep at the wheel or whether it is asking too much of them to keep up with the financial engineering conducted by complex institutions with diverse, global operations.

The discussion may have migrated from too big to fail to too big to manage and too big to regulate.

Though the Fed - JPMorgan's primary regulator - is not supposed to prevent banks from losing money, and JPMorgan remains stable, the shock loss rattled confidence in the financial sector.

It also raises questions about how attuned regulators were to the botched derivatives trade.

The Fed ramped up the number of staff embedded at JPMorgan Chase & Co since the financial crisis, when the bank grew through its takeovers of much of the failed Bear Stearns and Washington Mutual.

But so far it is unclear whether any of these regulators detected something high-risk and untoward going on in JPMorgan's Chief Investment Office in New York or in London.

The Fed has declined to comment on when it knew there was a problem or whether it played any role in alerting the bank. It will likely take some time to sort things out.

The U.S. central bank certainly cannot say it wasn't told that there were huge positions being built up by JPMorgan.

Reports by the Wall Street Journal and Bloomberg in early April let everyone know that a JPMorgan trader, dubbed the 'London Whale,' was playing a dominant role in certain markets.

"Such banks have become too large and complex for management to control what is going on," former IMF chief economist and MIT professor Simon Johnson wrote on Friday.

"The regulators also have no idea about what is going on. Attempts to oversee these banks in a sophisticated and nuanced way are not working."

The timing of the announcement on Thursday was awkward for the Fed.

Just hours earlier, Fed chairman Ben Bernanke told a banking conference that, despite some remaining weaknesses, the stress tests carried out by the U.S. central bank showed large banks were well on the road to recovery from the turmoil of 2007-2009.

A week earlier, Governor Daniel Tarullo, the Fed's point person on regulation, praised U.S. banks for surpassing expectations as they geared up for higher capital and liquidity standards under Basel III.

"It makes everyone look bad," said a banking lawyer, who spoke on condition of anonymity. "How could anyone have allowed the 'whale' to make a $10 billion dollar bet? Why didn't the systems pick it up?''

The debacle may once again force the Fed, which is still trying to repair its reputation after the 2007-2009 financial crisis, to do damage control, possibly by strengthening its scrutiny of investment banking.

'NEVER AGAIN'

"Dodd-Frank was supposed to be the 'never again' moment for regulators after missing the 2008 crisis," Terry Haines of Potomac Research Group said of the financial-reform legislation, which gave the central bank even greater oversight powers.

"Now, regulators again missed a significant event - and again, regulators will double down on regulatory fixes to cover their own failures."

Damon Silvers, an associate general counsel for the AFL-CIO labor federation who sat on an oversight panel for the 2008 TARP bailout of US banks, said the Fed should apply firmer rules to ensure capital adequacy rather than rely on models.

The Fed has so far decided not to comment publicly on the JPMorgan case.

It may well remain silent until more details about the trade are known before deciding whether any changes are needed to its supervision of Wall Street.

The Fed may also want to ensure JPMorgan and other banks adjust the way they manage derivatives-trading risks.

Fed regulators are gathering and analyzing more facts about JPMorgan's trade, said a person close to the situation.

The Federal Reserve Bank of New York had been aware of the trading loss before Thursday's announcement and is monitoring the situation, a second source, who also spoke on condition of anonymity, said on Friday.

"This should be a positive political story in that JPMorgan suffered a big loss without any disruption to the bank or its lending operations," said Jaret Seiberg, a senior policy analyst at Guggenheim Partners. "In other words, the system worked."

When the Fed put JPMorgan through its annual stress test earlier this year, it determined that the bank could safely weather a storm far worse than the $2 billion in losses it has so far reported and still have enough capital to remain solvent.

The Fed focused on capital and liquidity in these tests, not on managing individual trades that could lead to big, private losses.

It is unclear when Fed regulators became aware of the risky trade, nor is it clear what, if anything, they advised the bank to do about it.

Adding to a growing chorus of criticism, Democratic Senate candidate Elizabeth Warren called for JPMorgan chief executive Jamie Dimon to resign from the New York Fed's board of directors.

JPMorgan's shares plunged 9.3 per cent on Friday, shedding $15 billion in market value and leading a broad decline in the financial sector.