The Scariest Thing Jamie Dimon Told the Senate Panel

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President and CEO of JPMorgan Chase Co. Jamie Dimon testifies before a Senate Banking Committee hearing on Capitol Hill June 13, 2012 in Washington, DC.

Much of the discussion about Jamie Dimon’s testimony has largely missed the point.

It’s true that the senators on the Banking Committee were humiliatingly deferential to the JPMorgan Chase chief executive. It’s true that Senators from both sides of the aisle seem to be attempting to score political points about Dodd-Frank, using Dimon as a prop for the usual D.C. partisan claptrap. It’s true there seem to have been prearranged ground rules that barred questions about the details of the trades that lost JPMorgan billions.

And, yes, it’s true that Dimon wore cufflinks with the presidential seal on them. (I’ve been investigating this one.)

But the most important thing Dimon said has been almost entirely ignored.

Dimon told the Senators that the multi-billion dollar losses at the bank stemmed from an attempt to adjust JPMorgan’s holdings because of changes in the way capital requirements work. Specifically, he said that the risk weighted assets of the CIO office were due to increase three hundred percent under Basel III.

"Under Basel I, the risk-weighted assets of these positions in the fourth quarter of 2011 were around $20 billion. Under Basel III, those [risk-weighted assets] were estimated to be around $60 billion. We thought this was an ineffective use of risk-weighted assets and our intent was to bring that down over time," Dimon said.

This echoed what he said in his prepared remarks:

“In December 2011, as part of a firmwide effort in anticipation of new Basel capital requirements, we instructed CIO to reduce risk-weighted assets and associated risk. To achieve this in the synthetic credit portfolio, the CIO could have simply reduced its existing positions; instead, starting in mid-January, it embarked on a complex strategy that entailed adding positions that it believed would offset the existing ones. This strategy, however, ended up creating a portfolio that was larger and ultimately resulted in even more complex and hard-to-manage risks.

This might need some translating for those of you who haven’t been keeping up with your required international capital accords reading.

Basel is the town in Switzerland where banking regulators and bankers from around the globe meet to decide on international standards for bank regulation. Basel I was the first body of rules decided on; Basel III is the latest. The U.S. is in the process of creating and implementing the Basel III rules.

(CNBC's Steve Liesman says Jamie Dimon "whiffed" on Volcker rule. But SIFMA head Tim Ryan says Steve's missing the point.)

The Basel III rules carry-over the concept of “risk weighting” from the prior set of rules. Under risk-weighting, the amount of capital a bank has to hold against an asset is determined by a formula agreed to by regulators. Not all assets are created equal in the eyes of regulators. Some are riskier and require more capital. Some are less risky and require less.

(As an aside: the last version of risk weighting helped nearly destroy the world because, as it turned out, regulators weren’t very good at predicting risk. They gave too little risk weight to highly rated mortgage securities and derivatives, which resulted in these being relatively cheaper for banks to finance, leaving the entire financial system far too exposed to people in sunny places paying their mortgages.)

Here’s how this works. If regulators require meet an 8 percent capital requirement, banks only have to hold the full 8 percent capital against assets that are given 100 percent risk weights. Assets considered safer are given reduced risk weights. So a bank only needs to have 4 percent capital against an asset with a 50 percent risk weight. You multiply the value of the asset times the capital requirement times the risk weight.

What Dimon revealed was that his bank’s chief investment office held assets whose risk weighting will undergo a massive shift under the new capital rules. What’s more, his bank’s reaction to this massive increase in capital requirements was not to increase the capital it holds but to shift away from exposure to the assets through the use of derivatives and hedging.

What makes this terrifying is that this kind of logic applies to every single bank in the world. They are all experiencing massive risk weighting shifts—and all attempting to grapple with them. Most are probably trying to be “smart” about this—which means not selling the assets directly or somehow raising more capital, but by hedging and buying derivatives.

In short, some version of the trade that broke the CIO office is going on in every major financial institution. And yet we’re acting like this is a problem for JPMorgan Chase alone.

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