Blogs & Comment

JPMorgan and why derivatives may be ungovernable

Directors don't understand them and regulators are too conflicted.

The recent loss of $3 billion by JPMorgan Chase confirms what is now a governance reality: boards of directors do not understand derivatives and cannot control management’s use of them. The same may be said for regulators.

One job of boards is to identify risks and ensure a proper system of risk management. If you cannot do this, you should not be on a board. Of the over 300 interviews I have undertaken in my research, some with directors of large banks, only one director claimed to understand complex derivatives. How can directors assess internal controls when they do not understand the very instrument itself?

Other than Jamie Dimon, CEO of JPMorgan, not a single director on the bank’s board has any experience in banking (see the roster of directors here). University of Toronto professor John Hull, a derivatives expert, told me in an e-mail that “there is no question in my mind that a large financial institution should have on its board people (perhaps 2 or 3) who understand derivatives and other complex financial products.” Unless bank boards that oversee derivatives are prepared to have subject matter experts who can effectively question management and insist on proper risk controls, other governance or oversight structures are needed.

But regulators may not be any better. In the words of Warren Buffett, “Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” (See Warren Buffett on Derivatives.)

So what have we learned from the financial crisis of 2008? Banks are bigger than ever, with most American mortgages concentrated in only a handful of them, yet the risky bets and use of complex derivatives continues. Harvard law professor Elizabeth Warren last week called for a new version of the Glass Steagall Act to control speculation. Yet independent Senator Bernie Saunders pronounced that Wall Street “runs” the Senate, implying that any attempt at further regulation would be forestalled. Meanwhile, Mitt Romney has vowed to unwind Dodd-Frank on his first day as president. Look at the long list of political donations made by JPMorgan in 2011 here. And this is just one bank.

If derivatives are going to continue, two things need to happen: regulatory conflicts of interest need to be addressed and boards need to have directors with the expertise to oversee them.