At first glance, the image below may seem to be nothing but a jumble of lines and three-letter acronyms with no discernible meaning.
Despite this mess, the image actually represents just how complicated international banking has become, with so many linkages between so many countries and institutions that it is pretty much impossible to wrap one's head around and understand.
If you're an investor in a huge, global bank like JPMorgan Chase (NYSE:JPM), this is a scary reality. Interconnectivity can create huge risks for the company's profitability, especially in areas like fixed income, currencies, and commodities (FICC) trading.
Managing risk -- or creating it?
FICC trading, which makes up just under 4% of JPMorgan's revenues, looks to mitigate risks for banks and clients. However, what banks like JPMorgan underestimate -- and what the above chart shows -- is that FICC trading in and of itself has the potential to drastically increase risks, where it's nearly impossible to have any level of risk management over such a complicated web of global banking activity.
This type of trading originally began as a hedging strategy for both the bank and its clients but it eventually developed into a profit center, as banks strayed from lending into riskier activities.
However, 2013 saw a slight reversal of this trend; FICC trading revenue dropped by 21% year-over-year to $3.76 billion. And yet despite such a substantial fall, the value of all derivatives contracts to the value of total assets remained just under 3%. A decline in income without a corresponding drop in the proportion of the company's portfolio invested through FICC is an encouraging sign for short-term growth. It supports the theory that this was just a bad year for trading brought on by a weak global economy. As conditions improve worldwide, the bulls believe that FICC revenue will increase accordingly.
But should trading be so central to bank's business model?
Now that's a significantly harder question to answer. At a recent conference hosted by the Institute for New Economic Thinking, Richard Bookstaber from the Office of Financial Research within the Treasury Department gave a speech on interbank connectivity and how to assess risk. (Mr. Bookstaber's comments in no way reflect the official view of the Treasury Department)
Bookstaber makes the point that our existing models for understanding how banks will react in a crisis are based on a false premise of how economics works. In these models the market is treated as static, meaning that trades made by one bank have no effect on the decisions made at other banks -- a proposition we already know to be untrue It's a framework that completely ignores everything we know about human psychology and herding behavior, but more importantly it undervalues how interconnected global finance really is.
According to Bookstaber, we need to change how we think about risk. All actions have consequences, and those consequences also have consequences. Imagine a scenario where JPMorgan holds reserves of crude oil. Simultaneously, a large hedge fund is heavily invested in both oil and, say, foreign currency swaps. One of the bets goes bad and the hedge fund's cash reserves start drying up, so they sell some oil to cover the losses. A sudden bump in the supply of crude oil, eagerly unloaded by the hedge fund, would depress the price of a commodity that had nothing to do with the initial event. As a result, JPMorgan's bottom line would suffer, hurting its shareholders!
It's a mild example, but one that highlights the simple lesson that because not all risk can be accounted for, it's best to err on the side of caution. I prefer to see banks like JPMorgan profit from activities like commercial lending and advisory services, where the pitfalls are more visible. Globalization has made our financial system so complex that it's near impossible to retrace how and when a trading loss can happen (ahem, the London Whale). So with the financial crisis still in the rearview mirror, my instinct is that the downward spiral in FICC revenues may be the best thing for JPMorgan's long-term health and prosperity.