Accounting Should Guide Volcker Rule on What Counts as a Hedge

Clarification: The second paragraph of this column uses the word "offset" in the vernacular sense. Gains on the sale of unrelated securities (the "assets" mentioned in the passage) mitigated the bottom-line impact of losses on the JPMorgan Chase chief investment office’s derivatives. But as stated later in the column, the derivative positions did not qualify for hedge accounting treatment, and so were not "offset" in the strict accounting definition.

Accountants hate to be ignored, but we're used to it.

Accounting standards allowed Jamie Dimon to offset seemingly sudden, multibillion-dollar mark-to-market declines (on trades which were supposedly designed to mitigate losses) with unrealized gains on the sale of $1 billion of unrelated assets. Unfortunately, the proposed Volcker Rule ignores accounting standards for derivatives and hedges when judging what constitutes bank proprietary trading.

Dodd-Frank's Volcker Rule restricts a Fed-supervised bank from engaging in proprietary trading. To receive an exemption for "permitted risk-mitigating hedging" activities, a bank would have to meet seven criteria – all seven, not just one – under the implementation rules proposed by the OCC, the Federal Reserve Board, SEC, and the FDIC.

Would the Volcker Rule have prohibited JPMorgan Chase's losing "whale" trades? According to the most recent quarterly and annual filings, JPMorgan's positions in credit default swaps did not qualify for hedge accounting treatment under accounting rules. I believe they should be considered proprietary trading on that basis alone. The Volcker Rule hasn't been finalized yet, but the implementation proposal, published in the Federal Register in November, describes an approach that does not consider hedge accounting rules for deciding which trades are proprietary. That leaves plenty of opportunity for banks to arbitrage the possibilities.

The blog Economics of Contempt explains that it's been misguided for pundits to use the rule's portfolio hedging criteria to argue that JPMorgan's trades would be allowed by Volcker. "Even if JPMorgan's failed trades qualified as portfolio hedges, they would still have to meet other, more stringent requirements in order to qualify for the Volcker Rule's hedging exemption."

The other, more stringent, requirements of the proposed rule include an internal compliance program, such as reasonably designed written policies and procedures, internal controls, and independent testing. The transaction under the hedging exemption must be constructed in compliance those written policies, procedures and internal controls. The proposed rules also require that any transaction expecting a hedging exemption be continuously reviewed, monitored and managed.

Dimon has admitted that the losing trades were "poorly constructed, poorly reviewed, poorly executed, and poorly monitored." If policies and procedures to cover these activities exist at JPMorgan, they surely weren't followed.

The proposed implementation of the Volcker Rule also requires that the transaction be designed to hedge one or more specific risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, basis risk, or similar risks, related to individual or aggregated positions.

Dimon has yet to identify the specific positions, or the portfolio that was hedged. Nor has he demonstrated that the hedging transaction that's losing billions was intended to be reducing risk in the aggregate, as measured by appropriate risk management tools. In fact, Dimon admitted that risk management tools like Value at Risk failed and that the trade was not designed to be profit-neutral.

"It was there to deliver a positive result in a quite stressed environment," Dimon said on the May 10 emergency conference call after the trading loss was disclosed, "and we feel we can do that and make some net income."

If a bank engages in dynamic hedging, or if it tries rebalancing a hedge position or positions according to a change in the portfolio or a change in the price, or other characteristic, of the individual or aggregated positions, the Volcker Rule exemption must be revisited, under the proposed implementation. The exemption remains only if the rebalanced hedge is consistent with appropriate risk management practices, otherwise meets the terms of the exemption, and does not include the potential for speculative profit.

If a hedging transaction creates a significant new risk exposure that is not hedged at the same time, it may walk and quack like prohibited proprietary trading. If the predicted performance of a hedge would result in the bank earning appreciably more profits than it stood to lose on the related position, the hedge is probably a duck – that is, a proprietary trade.

Compensation arrangements for traders performing risk-mitigating hedging activities should not reward proprietary risk-taking, according to the proposed rules. 

If a bank rewards traders for speculation in, and appreciation of, the market value of a covered financial position, rather than success in reducing risk, I hear "quack, quack." The bank is probably running a proprietary desk, not a hedging desk.  

I doubt any of the traders in JPMorgan's CIO weren't paid handsomely for profitable trading. The CIO added more than $100 million to bank profits in recent years. Ina Drew, the former head of the group, was reportedly one of the highest paid officials at JP Morgan.

The Volcker Rule, in its proposed form, falls short in my opinion, because it requires only that a transaction be "reasonably" correlated to the risks it is intended to hedge in order to qualify for the hedging exemption. Federal agencies did not propose that a transaction looking for the hedging exemption be highly correlated.

That contrasts with the accounting rules that require the hedge to be "highly effective" at offsetting the credit portfolio risks, for example, to qualify for hedge accounting. A transaction that is only tangentially related to the risks it supposedly mitigates may be prohibited proprietary trading, but a trade with a reasonable correlation would get the exemption.

Why didn't the agencies correlate the Volcker Rules to the accounting standards? The answer is found in a footnote to the Volcker Rule proposal. "Such standards are … designed for financial statement purposes, not to identify proprietary trading and [they] change often and are likely to change in the future."

Michael Klausner, a professor of business and law at Stanford University, says a principles-based approach may work better to regulate these activities.

"Whether we are talking about accounting rules or something else, the effort to implement the concepts underlying the Volcker Rule will inevitably be imperfect," he told me. "The activities it addresses are inherently complex and poorly suited to precise rules."

Volcker Rule or no, the accounting standards for derivatives and hedge accounting are here to stay. True, the rules are subject to judgment and manipulation. Mark-to-market rules for derivatives can bite you suddenly like a big dog suddenly broken loose from his chain; accounting rules can also give banks cookie jars to pull from when needed the most. But accounting rules already provide a framework for viewing the decisions around proprietary trading.

If the final Volcker Rule is not aligned with accounting rules for hedging, we'll relive this angst over "poorly constructed hedges" and unexpected hits on bank profits and capital again and again.

Francine McKenna writes the blog re: The Auditors, about the Big Four accounting firms. She worked in consulting, professional services, accounting and financial management for more than 25 years.