What Is Systemic Risk? Does It Apply to Recent JP Morgan Losses?

JP Morgan recently disclosed that it suffered significant losses in a unit that traded complex financial instruments. Congress will be examining the JP Morgan trades and oversight by JP Morgan’s regulators. Two of the questions that policymakers might ask are could the JP Morgan losses or similar trades trigger another financial crisis and how would the Volcker Rule in the Dodd-Frank Act have applied to the JP Morgan trades? This report explains general systemic risk analysis. It evaluates recent JP Morgan trades in light of our understanding of sources of systemic risk. If the sizes of the losses remain small, it appears extremely unlikely that JP Morgan’s reported losses in its asset liabilities management unit could trigger a financial crisis or systemic event.

Systemic risk refers to the possibility that the financial system as a whole might become unstable, rather than the health of individual market participants. Stable financial systems do not transmit or magnify shocks to the broader economy. A firm, person, government, financial utility, or policy might create systemic risk if (1) its failure causes other failures in a domino effect; (2) news about its assets signals that others with similar assets may also be distressed, called contagion; (3) it contributes to fire sales during price declines; or (4) its absence prevents other firms from using an essential service, called critical functions.

There are a number of policy responses to systemic risk. Greater transparency can prevent uncertainty from magnifying panics and permit regulators to monitor the system as a whole. Lenders of last resort can prevent markets from becoming illiquid or healthy firms from being cut off from credit. Deposit guarantors can reduce the incentives for a firm’s counterparties to run. Prudential regulations and capital requirements can reduce the chance of firm failure and the costs of the failures that nonetheless occur. However, policies to address systemic risk can create risks of their own, such as moral hazard, in which firms that believe they will be rescued take additional risks.

Although the reported JP Morgan trading losses are too small to be a significant threat to current financial stability, they do illustrate a potential source of systemic risk. When large firms trade in markets with low volume, they may have trouble liquidating their positions without affecting market prices. Under these conditions, their losses may be much greater than their risk- management models anticipated, if the models assumed normal conditions.

Once formal rules are finalized, the Volcker Rule’s prohibition of proprietary trading would apply to JP Morgan. The applicability of the rule to the reported trades would depend upon the definition of a hedge. A hedge is a trade to offset the risks of another position, or exposure to a counterparty, or another existing risk. JP Morgan has argued that the trades were used to hedge another hedge and its general portfolio. It is not clear if regulators will agree in the future that such trades will be included in hedging for purposes of the Volcker Rule.