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JPMorgan Was Warned About Lax Risk Controls

A small group of shareholder advocates delivered an urgent message to top executives at JPMorgan Chase more than a year ago: the bank’s risk controls needed to be improved.

JP Morgan Chase
CNBC.com
JP Morgan Chase

JPMorgan officials dismissed the warning from the CtW Investment Group, the advocates, who also cautioned bank officials that the company had fallen behind the risk-management practices of its peers.

Now, after disclosing a $2 billion trading loss at JPMorganin May and watching the bank’s market value drop by more than $25 billion, those officials are expected to follow one of the group’s recommendations, strengthening the board panel that oversees risk.

Still, that will not address weaknesses that critics say undermined the power of the bank’s chief risk officer. According to two former traders at the chief investment office and outside specialists, the chief risk officer was not focused on the huge credit market bets the chief investment office made that eventually went bad.

What is more, in some cases, the chief risk officer did not review large trades by the chief investment office or properly set position limits, the former traders said.

“They got a bit too comfortable and seemed to ignore the chief investment office,” said one of the former bankers, who insisted on anonymity because the loss is under investigation by a host of regulators.

JPMorgan officials insist there was no structural flaw in risk management or setting position limits. “The chief risk officer has direct authority for the risk management of the entire firm, including oversight of the chief investment office,” said Kristin Lemkau, a spokeswoman for the bank.

But the critics maintain that having successfully navigated the financial crisis in 2008, JPMorgan’s risk officers became complacent about the danger posed by the chief investment office’s increasingly aggressive bets. In addition, while the office was profitable throughout the financial crisis, the chief risk officer was focused on problems elsewhere, including the bank’s money-losing mortgage business.

That complacency also caused JPMorgan Chase to lose ground, even as large rivals overhauled their risk management operations as a result of the crisis. The JPMorgan executives charged with judging risk were paid significantly less than their counterparts at other banks.

“There’s no doubt that there was a sense of overconfidence there,” said Michael Greenberger, a professor of law at the University of Maryland and a former regulator with the United States Commodity Futures Trading Commission.

The $2 billion loss does not threaten the overall health of JPMorgan Chase, which is still expected to report a substantial profit for the second quarter. But it is an embarrassing stumble for the bank, the nation’s biggest financial institution, and has emboldened regulators in Washington who are in the last stages of writing new rules for the entire industry.

It has also refocused attention on internal risk controls across the banking sector, despite the changes that have been made since the financial crisis.

“There have been increased efforts to improve risk controls,” Mr. Greenberger said. “But it wouldn’t surprise me if three or four months from now, there is another explosion somewhere else.”

Jamie Dimon, the bank’s chief executive, has acknowledged the trades were “sloppy” and “stupid,” but JPMorgan officials insist that nothing was fundamentally wrong with the risk-management structure or the ability of the chief risk officer to head off trades that endangered the bank.

While Mr. Dimon earned a reputation as a keen judge of risk, especially in the financial crisis, JPMorgan’s own chief risk officer earned less than some of his peers at rival financial giants. At Citigroup , for example, the chief risk officer, Brian Leach, earned $9 million in 2011, making him that company’s fourth-highest paid executive. At JPMorgan, Barry Zubrow, the chief risk officer until January and now in charge of corporate and regulatory affairs, was not among the top tier in compensation, and his pay is not disclosed. By contrast, Ina Drew, the executive who led the chief investment office, was near the top.

Ms. Drew, who has been blamed for the debacle and resigned last month, earned roughly $14 million in 2011, making her the fourth-highest paid executive at the bank. Nor was Mr. Zubrow among the highest-paid executives at JPMorgan in 2010, when Ms. Drew earned more than $15 million. At Bank of America that year, the chief risk officer Bruce R. Thompson was the highest-paid executive, making $11.4 million.

Compensation is more than a matter of ego for risk officers, said Dave Gibbons, a managing director at Promontory Financial Group, a consulting firm that works with banks. “The chief risk officer needs to be high enough in the organization to command stature, and the C.R.O.’s compensation needs to complement that stature,” Mr. Gibbons said. “The position should be equal to the CEO’s other direct reports. It doesn’t work to try to control the risk behavior of business leaders from a subordinate position, organizationally or culturally.”

The trading loss has also focused attention on how corporate boards handle the issue of companywide risk, said William Patterson, executive director of the CtW Investment Group, which represents union pension funds. Mr. Patterson delivered the initial warning to JPMorgan executives at a meeting in April 2011 that included James Crown, a board member, and Mr. Zubrow.

“We have been deeply concerned about whether the board is effectively monitoring risk appetite and setting up internal controls,” Mr. Patterson said in an interview last week. Specifically, Mr. Patterson told the executives that the three-person board panel that was responsible for monitoring overall risk-taking lacked sufficient familiarity with the more technical aspects of finance and banking.

One of the three members, Ellen V. Futter, is the president of the American Museum of Natural History, and a former president of Barnard College. Another, Mr. Crown, is a real estate heir who runs his family’s investment firm.

That lack of risk expertisemade it hard for the board’s risk committee to question the information provided by senior bank officials as the chief investment office’s bets were growing, said Cliff Rossi, a former senior risk officer at Citigroup who is now on the finance faculty at the University of Maryland’s Robert H. Smith School of Business.

“You need a board with sufficient knowledge so they have the ability to ask tough questions,” Mr. Rossi said. “It’s sort of like being a good detective.”

At Bank of America, the board’s risk committee includes Susan S. Bies, a former Federal Reserve Board governor, and Frank P. Bramble, a longtime banker.

In a letter to JPMorgan officials in April 2011, shortly before the meeting at JPMorgan, Mr. Patterson noted the improvements in board-level risk management undertaken by other big banks. “JPMorgan’s board significantly trails its peers in these efforts,” he wrote, “having taken very few visible steps to enhance its oversight of risk or recruit new director talent since the financial crisis.”

Now, in the wake of the trading loss, JPMorgan is expected to change the composition of its risk committee by adding current board members with more relevant experience, possibly including Timothy P. Flynn, the former chairman of the accounting giant KPMG.

Another problem, Mr. Patterson said, is that JPMorgan’s board has been too deferential to top executives, including Mr. Zubrow and Mr. Dimon.

JPMorgan had an “old-fashioned model of governance where the board picks the best chief executive and then takes a back seat,” Mr. Patterson said.

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