Dimon's bank rules and liquidity qualms

Everyone should by now be used to Jamie Dimon, chairman of US bank JPMorgan Chase, railing against regulation. Still, when the head of the biggest US bank by assets says new rules contributed to a move in US Treasuries that should happen only once every 3bn years, perhaps we should listen.

In fact, the statistics suggest it was worse: the plunge in 10-year bond yields on October 15 was an eight standard deviation event (ie: very unlikely). Matthew Wittman, a trader at hedge fund Christofferson Robb, calculates that this should happen just once if bond trading started at the (real) Big Bang and the universe were to last 300 times as long as it has so far.

As Mr Dimon says, this suggests a problem with the statistics. Unfortunately, the statistics - or rather the false assumption that market returns follow a normal distribution - are still relied upon by lots of financial models. Of these, the two most important are the model to work out regulatory capital requirements, and the model used by investors for asset allocation.

Luckily, change is afoot. Bank rules are likely to change soon to take account of extreme events happening more frequently. Many investment models have been tweaked and, anyway, lots of investors start with a conclusion and fiddle with the inputs to get the answer they want.

No model can capture every risk, though. Plenty of hedge funds were wrongfooted when the Swiss central bank allowed the franc to strengthen in January. That move, says Mr Wittman, was a 300 standard deviation event. If a lottery picked an atom a trillion trillion trillion times a second since the universe started, picking a particular winning atom out of all those in the universe would still be less than a 30 standard deviation event.

The October bond move was big, but not unprecedented. The swing might have been exacerbated by lower liquidity because of regulations but, at heart, it was about panic among hedge funds as they rushed to exit a crowded trade. Investors should be worried about lower liquidity, as are regulators. But, on really bad days in the past, the market makers protected themselves by not answering the phone. Regulations give banks a new excuse for not taking risks they do not want.

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