J.P. Morgan Models Get Regulatory Spotlight

By JULIE STEINBERG And DAN FITZPATRICK

Regulators have stepped up scrutiny of J.P. Morgan Chase & Co.'s internal controls by asking the bank to demonstrate that its risk models are designed and working properly, according to people close to the situation.

The Office of the Comptroller of the Currency, the bank's primary regulator, has requested reviews of models that measure the possible effects of everything from trading losses to interest-rate moves, the people said. A change in one of these models contributed to losses in the bank's Chief Investment Office, a once-obscure unit that manages $370 billion in excess cash. The change effectively increased the amount of risk traders were allowed to take.

J.P. Morgan's CIO unit was responsible for trading losses of more than $2 billion. Total losses from the problematic positions are expected to be around $5 billion, but could go higher or lower. The bank, which is already out of the majority of the bad trades, is expected to provide an update on the losses when it reports second-quarter earnings on July 13.

The OCC has since April of last year required all banks it regulates to put together reviews and justifications of these types of models. It doesn't require banks to submit them unless they are specifically requested, as they have been in the case of J.P. Morgan. An OCC spokesman said the agency "routinely asks for additional documentation in the course of ongoing supervision at the banks it oversees."

The OCC demand underscores the heightened scrutiny J.P. Morgan now faces from a number of overseers as it tries to recover from mistakes that have stained the reputation of Chief Executive James Dimon. The bank currently is producing documents for eight agencies conducting probes into the losses.

A bank spokesman said the company already has acknowledged the multiple requests from regulators. "There is a lot of scrutiny and that's appropriate," he said. "We are cooperating fully."

The OCC is aiming to make sure that J.P. Morgan's reporting is "robust enough that we can actually see what's going on in the institution," said Thomas Curry, Comptroller of the Currency, in an interview. "That appears to have been an area of potential weakness."

The OCC can order a bank to retire a model if it is deemed ineffective. If a bank fails to manage its model risk in accordance with OCC instructions, that may trigger enforcement action.

Financial crises "tend to result in an abrupt shift and tightening of regulatory scrutiny," says Cliff Rossi, a finance professor at the University of Maryland Robert H. Smith School of Business. "The OCC is getting a lot of grief from Congress. Their natural response is, 'we will comb through every model you have and you will give a complete validation of this.'"

Banks have long had sophisticated systems to predict how much risk is being taken in various businesses. Models are used to determine everything from potential trading and loan losses to what underwriting guidelines should be for credit card borrowers. Scrutinizing all of those models is "a daunting task," for the regulators, Mr. Rossi said. "It's a tall order."

One J.P. Morgan model under scrutiny is a measure known as "Value at Risk", which provides an estimate of how much could be lost on average in a single trading day. The firm pioneered this model in the early 1990s.

A change in that model for the Chief Investment Office masked the risk the group took in the early part of 2012. It was approved by an internal model-review group composed of 50 to 70 quantitative researchers and modelers. Mr. Dimon didn't need to sign off on the change, but he was copied on an email describing the new model, said a person close to the bank.

Mr. Dimon acknowledged this month to the Senate Banking Committee that the change in the model "did effectively increase the amount of risk that this unit was able to take."

The Securities and Exchange Commission is exploring whether the bank misled investors when it didn't disclose that change in its April earnings release. Companies aren't required to disclose such changes, SEC Chairman Mary Schapiro said last week, but the agency's rules require companies to "speak truthfully and completely."

—Victoria McGrane contributed to this article.

Write to Julie Steinberg at julie.steinberg@dowjones.com and Dan Fitzpatrick at dan.fitzpatrick@wsj.com

A version of this article appeared June 29, 2012, on page C1 in the U.S. edition of The Wall Street Journal, with the headline: J.P. Morgan Models Get Regulatory Spotlight.