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First, regulatory capital optimization under the post-crisis rules was a critical motivation
The initial position was long protection to hedge against the naturally long credit position in the CIO bond portfolio […] The combination of capital optimisation and trying to add jump-to-default protection to the short credit spread position did not help.
What is interesting is that without the RWA motivation, this probably would not have happened.
You know, this really takes me back. Back, in particular, to RWCG, May 14 2012: Was JP Morgan’s Loss Caused By “VaR” & Fancy Risk Management Orthodoxy?
Was JP Morgan’s loss caused by the “VaR” approach to risk itself?
Or (more precisely), they had come up with a trade hedge package they kinda liked, and fed it into VaR to get an answer as to whether it ‘reduced risk’, and when it did, used that as a reason to justify the trade.
Either story though would point to the real culprit behind this loss being the methodology and mentality that treats VaR – and things like it – as a highly useful risk-management measure that senior management should focus a lot on and actively use in day to day management and trade selection.
Just to clarify, at the time I wrote that, although I didn’t say this for fear of scaring off even more readers, ‘things like VaR’ basically meant RWA. This can be seen from the fact that (by my recollection) the official regulator-approved formula for RWA is as follows:
RWA := [a VaR + another, somehow stupider VaR]*(some fixed number pulled out of a hat) + other black box stuff you can't possibly manage to and which is probably calculated incorrectly so all you can do is just kinda hope it all stays small, or alternatively, you could probably get it smaller by shutting down businesses
I think that’s about right anyway. I may have forgotten a factor of π somewhere in there. Anyway, the point is that I called all this stuff 100% correctly from the get-go, not that anyone realizes it. This leads to two concluding, conflicting thoughts:
1. Everyone should be reading me.
2. On the other hand, thank goodness they haven’t figured that out.
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