Dissecting the JPMorgan Whale: A Post-Mortem

Abstract

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.

Keywords: London Whale Scandal, Model Risk