In a recent panel discussion, Frank Partnoy, former investment banker and now a writer and finance law professor at the University of San Diego, called attention to the model used by the “London Whale” responsible for last year’s $6.2 billion in trading losses for JPMorgan Chase. Uncovered during the internal JPMorgan investigation, the model was central to a convoluted series of Excel spreadsheets at blame for the huge loss – it “operated through a series of Excel spreadsheets, which had to be completed manually, by a process of copying and pasting data from one spreadsheet to another.” It was during this investigation that a crucial error with the model was discovered: “After subtracting the old rate from the new rate, the spreadsheet divided by their sum instead of their average, as the modeler had intended. This error likely had the effect of muting volatility by a factor of two and of lowering the VaR.”
A cautionary tale for the middle market given we also have Excel playing a significant role in our financial statement consolidations and decision support analyses, particularly in environments that have dated and partially integrated financial statements. The London Whale “Tale” provides us with an early warning to upgrade and simplify these systems before a significant error goes undetected, only to be discovered when it’s too late.