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Whale Trade Losses Highlight Regulation in City of London — Again

J.P. Morgan's now infamous whale loss is not the only major trading loss to have originated in London. What does this mean for U.K. regulation?

A London-based unit of J.P. Morgan has lost $3 billion or more in poorly judged credit derivatives trades, and with every week come more revelations about how and why a bank can have made such a mess. Is the fact that this happened in London merely incidental color or a key part of the story?

Britain’s capital has certainly had its fair share of extreme trading losses based on poorly constructed and foolishly risky positions since the City of London was deregulated by the Big Bang of 1986 — and arguably more.

The J.P. Morgan incident comes hot on the heels of the $2 billion hit in 2011 to UBS through equity-related trading by a single London-based individual, Kweku Adoboli. Credit derivatives losses chalked up by a London unit of American International Group played a crucial role in triggering the 2008 financial crisis.

Credit derivatives originated in London — thriving under the U.K.’s light-touch regulatory regime. Encouraged by the accommodating environment, investment banks turned London into the global center of several markets, including foreign exchange. The risks of losing money through spectacular errors became progressively greater, but so too did the rewards — both for the banks and the U.K. government, which raked in billions of pounds in tax. But the risks taken by the banks in the U.K. and U.S. in the search for yield turned out to be so much more dangerous than anyone had imagined, and as a consequence the two national governments were left spending billions of pounds in mopping up the pieces.

Will the British government, therefore, end its regime of light-touch regulation?

Up to a point. Government ministers accepted the 2011 recommendations of the Vickers Commission on Banking, which included ring-fencing retail divisions from investment banking arms and imposing more onerous bank capital requirements. The Financial Services Authority, which regulated the industry with a light hand during the buildup to the credit crunch, is being replaced by an avowedly more hands-on regime including the Bank of England and various new agencies.

However, the government is wary of returning to anything approaching the heavily regulated financial sector that existed in Britain before the reforms of the 1980s.

One reason is the strong laissez-faire strain in British politics that began in the administration of Margaret Thatcher (1979-''90), continued under later Conservative and Labour premiers, and has survived the credit crunch to find a strong ally in David Cameron, the present prime minister. A more interventionist style of government injected stability into the U.K. economy in the middle decades of the twentieth century, but in the 1970s this strategy ended in economic disaster and national humiliation. Intervention has a bad name in Britain, and politicians will not return to it.

The financial services industry is also immensely useful to the British economy — when it is not imploding of course. Fed by the rising tide of regulation, its share of the economy has grown from 2 percent of gross value added (a measure of output) in the 1950s to about 9 percent today. Without financial services’ £32 billion ($49.8 billion) trade surplus, the U.K.’s persistent trade deficit would be almost twice as high as it is.

Finally, financial services companies account for 12 percent of tax revenue, according to a study by PwC for the City of London Corporation.

Can regulation be made heavy enough to make trading errors such as J.P. Morgan’s considerably less likely, while still allowing financial services to earn so much money for the U.K. economy and exchequer?

It is difficult to say what action by U.K. or U.S. regulators would have prevented the specific case of the J.P. Morgan whale trade, because the bank has provided rather sketchy details of what happened. Moreover, an analysis of where regulators went wrong if at all is complicated further by a debate over whether U.K., or U.S., regulators were primarily responsible in this particular case.

However, speaking more generally about risky trades, many analysts’ reply to the question would be "probably not." They would argue that the only way of making the system much less risky, rather than merely a little less so, would be to impose truly draconian restrictions on what banks could invest in — banning investment in derivatives, for example, so that banks could only invest in the underlying assets. This would not only reduce the size of financial services in the economy — which may or may not be a bad thing — it might also distort the efficient allocation of capital to the economy as a whole, the process that drives economic growth.

What we know of the whale trade appears to confirm the fact that in their search for high returns, traders are brilliant at finding new high-risk investments in what looks the most unpromising territory. The trade was made by the bank’s Chief Investment Office — set up, according to J.P. Morgan, to reduce risk by managing the bank’s overall risk exposure. This hedging unit turned, however, into a moneymaking machine that contributed about 10 percent of the bank’s profits in the three years before the error — and would have to have taken considerable risks to achieve this. This suggests that even if they are only given a small amount of rope, traders can usually find a way of using it to lasso large profits based on high-risk strategies — and to hang themselves accidentally while pursuing these.

The solution to the conundrum of how to reduce huge trading errors that destabilize the financial system lies partly in more regulation — along the lines of what the U.K. is already set to implement. But what is probably more important, in the eyes of many analysts, is much better-quality day-to-day work by regulators. We do not yet know whether regulators in the U.K. or U.S. were caught napping or instead played any role in preventing the whale trade from becoming even more disastrous than it was, by pointing out that the bank had a dangerous exposure in a particular niche of credit derivatives that would be difficult to close quickly because of limited liquidity. What we do know is that financial regulators are finding it increasingly hard to keep up with the ever more complex trading strategies typified by the whale trade. To make inroads into this problem, regulators need to do a better job of retaining top talent and even poaching it from the banks. To do this, they need to be able to compete for people like Sally Dewar, the former head of risk at the FSA who now works in J.P. Morgan’s risk team. That means paying some of them enormous amounts of money.

Unfortunately, the notion of banker-level salaries for government employees might be the most controversial proposal of all amid all the ideas for reforming the financial sector. In January Stephen Hester, the chief executive of Royal Bank of Scotland — majority-owned by the U.K. government following its 2008 collapse — was forced by public opinion to forego a £1 million bonus despite his clear progress in sorting out the bank’s troubling loan book. It would be even harder for ministers to get away with ultra-high rewards for regulators whose successes were less measurable and visible than Hester’s.

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