London Whale Research Articles

The London Whale Scandal under new Scrutiny: A Critical Appraisal of the Concept of Retro-causality

This paper aims to extend the purview of the retro-causality concept, by exploring a complex and under-researched financial accounting scandal, namely the London Whale, a group of traders that operated on account of the London subsidiary of JPMorgan Chase & Co in 2012. We specify the conceptual articulation underlying the discourse on the scandal, between the intentions, the actions and the temporality in which the events have taken place. We then elaborate upon philosophers Elizabeth Anscombe and Donald Davidson. We show the limitations of rationalization as a causal deterministic explanation of actions in light of a methodical review of the JPMorgan Chase Task Force Report in 2013. We put forward the idea that the scandal features flows of awareness, reminiscent of Bergson's duration. The articulation between intentions, actions and causes is performed, by mobilizing quantum macroeconomic theory developed by the economist Bernard Schmitt. We show the relevance of retro-causality for central debates in contemporary accounting (e.g. fair value accounting and the efficient market hypothesis). Our empirical study abundantly draws on Ludwig Wittgenstein's language games, and retro-causality insights borrowed from quantum physics. Our results confirm our theoretical intuitions: there is a common thread and guiding reflection throughout the accounting scandal, namely the idea that the future might influence the past, under certain assumptions. Finally, some groundbreaking consequences are derived for the accounting profession regarding the global crisis in 2008.

Commentary—A Dimon in the Rough: Apologetic Crisis Management at JPMorgan Chase

When companies are caught in a crisis, the need to deliver a defense in order to salvage their damaged reputation is an ongoing challenge. Drawing from actional legitimacy and apologia theory, this article examines corporate use of crisis communication through a case study surrounding Jamie Dimon, CEO at JPMorgan Chase. Dimon found himself in a crisis from 2012 to 2013 when a so-called “London Whale” made a series of trades that cost the company $6 billion U. S. Dollars, and raised serious questions over Dimon’s judgment and ability to lead JPMorgan Chase. In particular, we argue that the restoration of actional legitimacy centers around strategies of mortification, (corrective) action, justification, and authorization.

Bank Capital and Loan Liquidity

We expand the bank liquidity creation concept from its current focus on bank portfolios to include providing liquidity to secondary markets for financial assets. We test opposing theories of the effects of bank capital on secondary market liquidity of syndicated loans. We find that higher bank capital significantly increases secondary market loan liquidity, consistent with risk absorption theory. The data also support the loan riskiness and bank balance sheet quality channels behind this theory. We use the exogenous capital shock from the 2012 JPMorgan Chase ‘London Whale’ incident to help establish causality. Our findings have important research and policy implications.

A factor-model approach for correlation scenarios and correlation stress testing

Abstract In 2012, JPMorgan accumulated a USD 6.2 billion loss on a credit derivatives portfolio, the so-called “London Whale”, partly as a consequence of de-correlations of non-perfectly correlated positions that were supposed to hedge each other. Motivated by this case, we devise a factor model for correlations that allows for scenario-based stress testing of correlations. We derive a number of analytical results related to a portfolio of homogeneous assets. Using the concept of Mahalanobis distance, we show how to identify adverse scenarios of correlation risk. In addition, we demonstrate how correlation and volatility stress tests can be combined. As an example, we apply the factor-model approach to the “London Whale” portfolio and determine the value-at-risk impact from correlation changes. Since our findings are particularly relevant for large portfolios, where even small correlation changes can have a large impact, a further application would be to stress test portfolios of central counterparties, which are of systemically relevant size.

Whale Watching on the Trading Floor: Organizational Misbehaviour, Collusive Rogue Trading, and Corporate Culture Deficits in the Investment Banking Industry

Recent history reveals a series of rogue traders, jeopardizing their employer’s assets and reputation. There have been instances of unauthorized acting in concert between traders, their supervisors, and/or firm’s decision makers and executives, resulting in collusive rogue trading. We explore organizational misbehaviour theory and explain three major collusive rogue trading events at National Australia Bank, JPMorgan with its London Whale, and the interest reference rate manipulation/LIBOR scandal through a descriptive model of organizational/structural, individual, and group forces. Our model draws conclusions on how banks can set up behavioural risk management and internal control frame-works to mitigate potential collusive rogue trading.

Why cultures fail: The power and risk of Groupthink

Why do terrible things happen under the watch of good leaders? Why do very smart, dedicated, well-meaning leaders make horrific mistakes? Can these problems be foreseen? How and why do these problems happen? How is it that a robust system of checks and balances designed to prevent these situations fails? Are these problems likely to happen again? In this paper, the power and risk of Groupthink is explored by examining two cases (London Whale and Sales Practices) at JPMorgan Chase and Wells Fargo. Through specific examples, the paper demonstrates that what happened at these organisations can happen in any company.

FSMA and Third Party Rights: Victory for FCA in Supreme Court

This article analyses the judgment of the Supreme Court in Financial Conduct Authority (Appellant) v Macris (Respondent) [2017] UKSC 19. The Financial Conduct Authority (FCA) emerged triumphant in this appeal and the outcome has altered the fortunes of persons regulated by the City watchdog. Reversing the Court of Appeal’s judgment, the Supreme Court held by majority that Mr Achilles Macris (M) had not been identified in the Final Notice given to JP Morgan Chase (JPMC). Accordingly, any “third party rights” under section 393 of the Financial Services and Markets Act 2000 (FSMA) were not engaged because the notice did not identify M when interpreted by information readily available in the public domain. Lord Sumption found the analogy with the law of defamation to be unhelpful. Lord Mance said that this was “a difficult case” and Lord Neuberger said it was “difficult to resolve” the meaning of the word “identifies” in section 393(1)(a) despite the provision being a “good example” of Parliament’s enactment of generally lucid statutory language. In 2012, the Synthetic Credit Portfolio (SCP) operated by JPMC had lost $6.2bn because of the rogue “London Whale” trades. Because of the notorious losses the Final Notice entailed a financial penalty or “conduct costs” of £137.6m. Between 2012-2016 the world’s twenty foremost international banks paid a total of £264bn in conduct costs of which JPMC’s share was £33.64bn. As the head of the Chief Investment Office, which managed excess deposits including the portfolio comprising the SCP’s traded credit instruments, M’s functions as JPMC’s employee were “controlled functions” under section 59 of FSMA. The losses were linked to high risk trading tactics, feeble management and failing to react to information alerting JPMC to the SCP’s problems. The appeal, explained Lord Sumption, turned on the meaning of “identifies” and on the meaning of the notice to which that word is being applied. His Lordship judged that “a person is identified in a notice under section 393 if he is identified by name or by a synonym for him, such as his office or job title”. He said that it must be evident from the notice that the synonym could only apply to one person and he must be identifiable from information contained either in the notice or publicly available elsewhere. Lord Sumption explained that it is possible to turn to public information available elsewhere only where it enables the interpretation (as opposed to supplementation) of the notice’s language. The ratio of Macris was subsequently applied by the Court of Appeal in the case of FCA v Grout [2018] EWCA Civ 71 which concerned Julien Grout (G) who was one of four traders in the SCP managed by M. Putting the Supreme Court’s test into action, Longmore, Moylan and Newey LJJ held that the FCA’s notice did not identify G – who was foreign exchange trader – for the purposes section 393 of FSMA. The notice did not identify only one person, as required by the test set out in Macris by the Justices of the Supreme Court.

A Factor-Model Approach for Correlation Scenarios and Correlation Stress-Testing

In 2012, JPMorgan accumulated a USD 6.2 billion loss on a credit derivatives portfolio, the so-called London Whale, partly as a consequence of de-correlations of non-perfectly correlated positions that were supposed to hedge each other. Motivated by this case, we devise a factor model for correlations that allows for scenario-based stress testing of correlations. We derive a number of analytical results related to a portfolio of homogeneous assets. Using the concept of Mahalanobis distance, we show how to identify adverse scenarios of correlation risk. In addition, we demonstrate how correlation and volatility stress tests can be combined. As an example, we apply the factor-model approach to the London Whale portfolio and determine the value-at-risk impact from correlation changes. Since our findings are particularly relevant for large portfolios, where even small correlation changes can have a large impact, a further application would be to stress test portfolios of central counterparties, which are of systemically relevant size.

Delaware and Financial Risk

I argue that financial risk poses unique challenges that justify a differential application of corporate law oversight standards. The steps in my argument are as follows. First, I show how modern firms with significant exposure to financial risk are different in fundamental ways that matter crucially to the application of oversight standards. Second, I argue that, notwithstanding these differences, the major Delaware oversight cases were correctly decided, though the result might have been the opposite if complaints had been framed differently, with relevant and important facts. Third, I argue that the federal case involving the JPMorgan “London Whale” episode was wrongly decided. Unlike other scholars who have discussed director duties in the aftermath of the financial crisis, I am not arguing for any change in the oversight standards themselves. Instead, my argument is that Delaware law already provides ample support and justification for holding directors to a higher standard with respect to the oversight of financial risk. The complexities of financial risk pose unique challenges that the Delaware courts should take into account when assessing director oversight failures. Such an approach would not subject directors to unwarranted exposure for oversight failures, or have negative implications for business, and it would not change Delaware’s approach to cases that do not involve financial risk. The Delaware courts have demonstrated a capacity to respond to changes in the corporate contract, notably in Caremark itself, where Chancellor Allen recognized that the modern corporate practice of oversight had changed, and that the courts should change accordingly. Director oversight of financial risk is merely the most recent area in need of this kind of incremental judicial change. This chapter will appear in a forthcoming book, “The Corporate Contract in Changing Times,” co-edited by Professors Steven Davidoff Solomon and Randall Thomas.

Board to Death: How Busy Directors Could Cause the Next Financial Crisis

In the aftermath of the Great Recession, shareholders and regulators expect financial institution boards of directors to play an active role in risk management. To date, however, shareholders, policymakers, and academics have ignored a critical shortcoming: the directors of the United States’ largest financial institutions are too busy to fulfill their governance responsibilities. Many financial institution directors hold full-time executive positions, and most serve on the board of at least one other company. Although these outside commitments provide important learning and networking opportunities, they also contribute to cognitive overload and limit the time that directors spend assessing strategy and risk. This Article argues that overcommitted directors impair the governance of large financial institutions. These firms, by virtue of their complexity and systemic importance, require enhanced risk monitoring that busy directors are ill-equipped to provide. Nonetheless, the boards of many large financial institutions remain alarmingly overcommitted. Through a series of case studies — including Wells Fargo’s fraudulent accounts scandal and JPMorgan’s London Whale trades — this Article explores how busy directors inhibit oversight of management, increase the risk of firm failure, and could cause the next financial crisis. This Article proposes a series of reforms to alleviate director overcommitment and thereby enhance the stability of the financial system.

The Plight of Modern Markets: How Universal Banking Undermines Capital Markets

This paper explains the process of competitive deregulation that led both the US and the UK to embrace universal banking and to abandon the functional separation of financial activities that had long characterized their financial systems. The paper argues that some of the consequences of favouring universal banking over functional separation that were understood in the 1930s were rarely voiced in years preceding deregulation. The principal argument offered in favour of separation was that the commercial banking system, which is supported by a government ‘safety net’, needs to be protected from the risks inherent in investment banking. By contrast, this paper argues that functional separation played an important role in protecting capital markets from the banking system.Universal banking is associated historically with thinly traded stock markets, and this paper argues that universal banking promotes the formation of a small group of large dealer‐banks which dominate the financial system and whose interests are best served by trading on nonpublic over‐the‐counter (OTC) markets. The paper finds that just such a group played a key role in the growing importance of such OTC markets in the US over the past few decades.The paper then argues that the benefits of the greater liquidity that large universal banks can provide to capital markets are offset by the dangers they create when they err. Because mistakes at these large banks are often allowed to grow in size to match the size of the banks, they distort prices on financial markets and sometimes create systemic risk. Two recent examples are given: J.P. Morgan Chase Bank's ‘London whale’ fiasco and UBS, Merrill Lynch and Citibank's exposures to subprime mortgages.Finally, the paper explains that the Senate Report on the Glass–Steagall Act indicates that the Act was designed in part to limit commercial bank participation in the margin loan market, as this activity makes possible a feedback loop between increases in the money supply and increases in asset prices, which in turn can generate an asset price bubble in capital markets. The recent crisis has led modern researchers to rediscover the relationship between margin lending, feedback loops, and asset price bubbles that was well understood by at least some legislators in the 1930s. The paper argues that the recent crisis demonstrates that modern banking regulation needs to be informed by an understanding of the consequences that may arise when a financial system is dominated by universal banks.

The London Whale Scandal Under New Scrutiny - A Philosophical Analysis of the Idea of Retro-Causality

In this article, we focus on the dual philosophical and discursive dimension of the London Whale scandal, the nickname given to Bruno Iksil, the French trader employed by the London subsidiary of J.P Morgan Chase in 2012. We aim at specifying the conceptual articulation that underlies the discourse on the London Whale scandal, between the intentions, the actions and the temporality wherein the events have been inserted. We first elaborate upon the 1963 article by Donald Davidson titled 'actions, reasons and causes' in the Journal of Philosophy. We then show the limitations of the rationalization of actions as causal deterministic explanation in light of a methodical review of the US Senate Report Actors and of the Report of JPMorgan Chase & Co. Management Task Force. We put forward the idea that the London Whale scandal was in fact characterized by a flow of awareness reminiscent of the Bergsonian concept of duration. Finally, the conceptual articulation between intentions, actions and causes is performed by mobilizing the quantum theory of money developed by Bernard Schmitt, and redefining the events of the scandal as a quantum of time.

JPMorgan Chase London Whale G: Hedging versus Proprietary Trading

In December 2013, the primary United States financial regulatory agencies jointly adopted final rules to implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is often referred to as the “Volcker Rule”. Section 619 prohibits banks from engaging in activities considered to be particularly risky, including proprietary trading and owning hedge funds or private equity funds. Banking regulators designed the final rule against proprietary trading in part to prevent losses like the $6 billion London Whale loss that took place in 2012 at JPMorgan Chase. Given the controversial nature of the Volcker Rule, it is not surprising that the regulatory agencies received 18,000 comment letters, including a 67-page letter from JPMorgan Chase.

JPMorgan Chase London Whale D: Risk Management Practices

JPMorgan Chase (JPM) prided itself on having the best risk management practices in the financial industry, having survived the 2007-2009 financial crisis in better shape than many competitors. Chief Executive Officer Jamie Dimon often spoke of the bank’s “fortress balance sheet”. A keen focus on risk management is vital to JPM’s longevity, as is the case with all highly leveraged financial institutions. However, the JPM Task Force that investigated the $6 billion 2012 London Whale trading loss concluded that risk management practices at the bank’s Chief Investment Office (CIO), the unit in which the loss occurred, were given less scrutiny by senior management than those of the bank’s client-facing businesses, despite the fact that the Chief Investment Office managed $350 billion in assets, an amount almost double JPM’s total stockholders’ equity at December 31, 2011.

JPMorgan Chase London Whale C: Risk Limits, Metrics, and Models

Value at Risk (VaR) is one of the most commonly used ways to measure and monitor market risk. At JPMorgan Chase (JPM), very large derivative positions established by Bruno Iksil in the Synthetic Credit Portfolio (SCP) caused the bank’s Chief Investment Office (CIO) to exceed its VaR limit for four days in a row in January 2012. In response, the CIO changed to a new VaR model on January 30, which appeared to immediately reduce VaR by half. However, JPM soon discovered that this new VaR model had not been properly implemented and the bank went back to using the previous model. In addition, Iksil, other SCP staff, and their managers also disregarded several other risk metrics and limits during the first quarter of 2012. However, after JPM’s Chief Investment Officer learned on March 23 that Iksil and the SCP had breached the CIO’s mark-to-market Credit Spread Widening 10% risk limit the day before, she ordered trading of the SCP to be halted immediately.

JPMorgan Chase London Whale B: Derivatives Valuation

After consistently producing positive results through 2011, the JPMorgan Chase (JPM) traders who oversaw the bank’s Synthetic Credit Portfolio (SCP) grew alarmed by a consistent string of losses beginning in January 2012. (The SCP was maintained by JPM to help hedge default risk and was the source of the 2012 London Whale trading loss.) To minimize the losses reported to their superiors until such time that market prices hopefully turned in their favor, the SCP traders began valuing their largest derivative positions in a manner that was not consistent with Generally Accepted Accounting Principles (GAAP) and JPM policy. The fair values recorded by the SCP traders were reviewed by the Valuation Control Group, as required by banking regulators, and by JPM’s Controller, but neither review raised any objection. However, after the JPM Task Force that investigated the 2012 London Whale incident uncovered evidence that the SCP traders had not estimated fair values in good faith, the bank restated its 1st quarter 2012 earnings on July 13, reducing consolidated total net revenue by $660 million (2.5%), which in turn reduced after-tax net income by $459 million (8.5%).

JPMorgan Chase London Whale E: Supervisory Oversight

As a diversified financial service provider and the largest United States bank holding company, JPMorgan Chase (JPM) is supervised by multiple regulatory agencies. JPM’s commercial bank subsidiaries hold a national charter and therefore are regulated by the Office of the Comptroller of the Currency (OCC). Since the bank’s Chief Investment Office (CIO) invested the surplus deposits of JPM’s commercial bank units, the OCC was also CIO’s primary regulator. During the critical period from late January through March 2012, when CIO traders undertook the failed derivatives strategy that ultimately cost the bank $6 billion, JPM did not provide the OCC with required monthly reports that included CIO performance data and CIO’s internal reviews of the fair values assigned by traders to their derivative positions. However, OCC supervisors also failed to request the missing data, and thus found themselves surprised by the April 6 news stories unmasking the London Whale.

Dissecting the JPMorgan whale: a post-mortem

In many respects, the "London whale" scandal at JPMorgan Chase is similar to other "rogue trading" events, in that a group of traders took large, speculative positions in complex derivative securities that went wrong, resulting in over US$6 billion of trading losses to the firm. As in other rogue trading cases, there were desperate attempts to cover up the losses until they became too big to ignore and eventually had to be recognized in the financial accounts of the bank. However, the whale case, so-called because of the sheer size of the trading positions involved, differs in several important respects from other rogue trading cases, not least because the sheer size and riskiness of the positions were well-known to many executives within JPMorgan, a firm that prided itself on having advanced risk management capabilities and systems. The role of Model Risk in this scandal, while not the primary cause, is important in that at least part of the impetus to take huge positions was due to incorrect risk modeling. Various external and internal inquiries into the events have concluded that critical risk management processes in the bank broke down, not only in the Chief Investment Office, the division in which the losses occurred, but across the bank. In particular, deficiencies in the firm's Model Development and Approval processes allowed traders to trade while underestimating the risks that they were running. Under Basel II regulations, losses due to process failure are classified as operational risk losses and hence this case demonstrates a significant failure of operational risk management in JPMorgan. This paper dissects the whale scandal from an operational risk perspective using the late Professor Barry Turner's framework for analyzing organizational disasters. The paper also makes suggestions as to how model risk may be managed to prevent similar losses in future.

Do Credit Default Swaps Affect Lending Practices? Evidence from Syndicate Structures and the London Whale Incident

This paper tests the monitoring concentration hypothesis that loan participants can transfer monitoring incentives back to lead arrangers by purchasing credit default swaps (CDSs) from lead arrangers with the capacity to sell such contracts. Monitoring concentration appears to play a significant role in reducing lead arrangers’ loan allocation, expanding syndicate size resulting in larger loans for borrowers, and increasing the usage of covenants. Other loan CDS dealers participating in the same syndicates dilutes the role of CDS in monitoring concentration because these dealers can also sell CDSs to non-dealer participants. The evidence is further supported by two robustness tests — the analysis of traditional term loans and the London Whale incident. Among the three types of loan facilities, traditional term loans have the highest likelihood that CDSs are purchased by the participant lenders because banks tend to keep these loans on their balance sheets. On the other hand, institutional term loans, which are arranged with the intention to be securitized or sold to institutional investors, are less likely to have CDS protections purchased by original participant lenders. In contrast to term loans, revolvers are lines of credit, i.e., the amount of loans may not be drawn. Therefore, participant lenders also have less need to purchase CDS protections. The above main findings are driven by traditional term loans. However, there are spillover effects to revolvers that are in the same loan packages with traditional term loans. The London Whale incident, which caused JP Morgan more than $6 billion trading losses in the CDS market, presents a unique opportunity to examine the effect of CDS on lending practices. During the event quarter, there is a clear shift of lending activities from CDS selling banks to non-CDS selling banks. In addition, arranger allocation increases and syndicate size reduces among CDS selling banks relative to non-CDS selling banks. The fact that not only the lending practices of JP Morgan but also those of other CDS selling banks are affected suggests a general mistrust of using CDS protections, which in term affects the loan syndicate structures of CDS selling banks. However, the effect is transitory and reversed during the following quarter. Overall, the findings indicate that financial innovations, such as CDSs, can profoundly impact banking practices.

The Plight of Modern Markets: How Universal Banking Undermines Capital Markets

This paper explains the process of competitive deregulation that led both the U.S. and the U.K. to embrace universal banking and to abandon the functional separation of financial activities that had long characterized their financial systems. The paper argues that some of the consequences of favoring universal banking over functional separation that were understood in the 1930s were rarely voiced in years preceding deregulation. The principal argument offered in favor of separation was that the commercial banking system, which is supported by a government “safety net,” needs to be protected from the risks inherent in investment banking. By contrast, this paper argues that functional separation played an important role in protecting capital markets from the banking system.Universal banking is associated historically with thinly traded stock markets, and this paper argues that universal banking promotes the formation of a small group of large dealer-banks which dominate the financial system and whose interests are best served by trading on non-public over-the-counter markets. The paper finds that just such a group played a key role in the growing importance of such over-the-counter markets in the U.S. over the past few decades.The paper then argues that the benefits of the greater liquidity that large universal banks can provide to capital markets are offset by the dangers they create when they err. Because mistakes at these large banks are often allowed to grow in size to match the size of the banks, they distort prices on financial markets and sometimes create systemic risk. Two recent examples are given: J.P. Morgan Chase Bank’s “London whale” fiasco and UBS, Merrill Lynch and Citibank’s exposures to subprime mortgages.Finally, the paper explains that the Senate Report on the Glass Steagall Act indicates that the Act was designed in part to limit commercial bank participation in the margin loan market, as this activity makes possible a feedback loop between increases in the money supply and increases in asset prices, which in turn can generate an asset price bubble in capital markets. The recent crisis has led modern researchers to rediscover the relationship between margin lending, feedback loops, and asset price bubbles that was well understood by at least some legislators in the 1930s. The paper argues that the recent crisis demonstrates that modern banking regulation needs to be informed by an understanding of the consequences that may arise when a financial system is dominated by universal banks.