The Office of Comptroller of the Currency [OCC] is demanding JPMorgan (JPM) take formal remedial actions to fix its risk control systems. OCC stands to be the primary regulator for JPM's deposit taking bank. The regulator can even levy a fine on America's largest bank. It began in May this year when the news about a huge trading loss at JPMorgan's Chief Investment Office in London hit the financial markets. The loss was reported at $2 billion, which later swelled to $6.2 billion at the end of the third quarter. This is latest in continuing issues JPM is facing after Bruno Iksil's outsized bets. Eight other regulatory bodies or related agencies are conducting investigations into the trades and the internal control systems of the bank.
JPM's Different Approach To Risk Management
While several investment banks failed during the financial meltdown, JPMorgan used a very different approach to risk management, which led the bank to survive the crisis with its stature not only intact but enhanced. This is why the CEO Jamie Dimon was widely acknowledged as the "ultimate chief risk officer of the bank." The CEO put so much importance on risk management that the formal head of the risk management function reported directly to him and was part of the executive team with continual access to the company's board of directors.
The risk management systems at JPM are different compared to the rest of the money center banks in the US. The risk management system assigns limits to groups of traders instead of limiting risks for every individual trader as is the standard. This allows individuals to take outsized positions resulting in huge losses like the one that occurred. However, the bank does not blame its risk management function for the loss. Yet analysts quickly declared the bank's loss an example of the failure of risk management.
Some issues of concern are that the bank's chief risk officer didn't have sufficient control over the CIO's risk officer. This meant that the CIO could manage its own risk without collaborating with the rest of the bank. Odd too, that the losses were discovered after the bank's value at risk model was changed. Weeks after the change in model,no one had an idea who approved the change in model or whether the change had been notified to the regulator. This is an example in itself of the deteriorating internal control systems at JPM. Since the episode, JPM has not taken concrete steps to improve its risk management or internal control systems.
MBS Repurchase Headwinds
The bank is faced with the challenge of higher net charge-offs as some of its mortgage loans soured during the third quarter. Incremental net charge-offs during the third quarter were $825 million, while net charge-offs totaled $1.4 billion. Home equity net charge-offs were $1.1 billion, compared with $581 million at the end of the same quarter of the prior year. In the near future, cost related to these is expected to increase.
At the end of the third quarter of this year, JPMorgan had a Basel III tier 1 common ratio of 8.4%, while Bank of America (BAC) and Citigroup (C) maintained tier 1 common ratios of 9% and 8.6%, respectively. JPM's 8.4% common ratio falls 10 basis points short of the regulatory requirement of 8.5%.
Compared to most of the other US money center banks, JPM trades at expensive valuations. JPM is trading at a 12% discount to its book value. In comparison, Goldman Sachs (GS), Citigroup and Bank of America are trading at 11%, 38% and 45% discount, respectively.
I am bearish on JPMorgan due to its expensive relative valuations and weakness in its internal control systems. Besides, the bank is facing increased headwinds from is sold MBS that it might need to repurchase.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.