JP Morgan Chase 2005 Annual Report Download - page 58

Management’s discussion and analysis
JPMorgan Chase & Co.
56 JPMorgan Chase & Co. /2005 Annual Report
Capital management
The Firm’s capital management framework is intended to ensure that there is
capital sufficient to support the underlying risks of the Firm’s business activities,
as measured by economic risk capital, and to maintain “well-capitalized”
status under regulatory requirements. In addition, the Firm holds capital above
these requirements in amounts deemed appropriate to achieve management’s
regulatory and debt rating objectives. The Firm’s capital framework is integrated
into the process of assigning equity to the lines of business.
Line of business equity
The Firm’s framework for allocating capital is based upon the following objectives:
• Integrate firmwide capital management activities with capital management
activities within each of the lines of business.
• Measure performance consistently across all lines of business.
• Provide comparability with peer firms for each of the lines of business.
Equity for a line of business represents the amount the Firm believes the busi-
ness would require if it were operating independently, incorporating sufficient
capital to address economic risk measures, regulatory capital requirements,
and capital levels for similarly rated peers. Return on equity is measured and
internal targets for expected returns are established as a key measure of a
business segment’s performance.
For performance management purposes, the Firm initiated a methodology at
the time of the Merger for allocating goodwill. Under this methodology, in the
last half of 2004 and all of 2005, goodwill from the Merger and from any
business acquisition by either heritage firm prior to the Merger was allocated
to Corporate, as was any associated equity. Therefore, 2005 line of business
equity is not comparable to equity assigned to the lines of business in prior
years. The increase in average common equity in the following table for 2005
was attributable primarily to the Merger.
(in billions) Yearly Average
Line of business equity 2005 2004(a)
Investment Bank $ 20.0 $ 17.3
Retail Financial Services 13.4 9.1
Card Services 11.8 7.6
Commercial Banking 3.4 2.1
Treasury & Securities Services 1.9 2.5
Asset & Wealth Management 2.4 3.9
Corporate(b) 52.6 33.1
Total common stockholders’ equity $ 105.5 $ 75.6
(a) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results.
(b) 2005 includes $43.5 billion of equity to offset goodwill and $9.1 billion of equity, primarily
related to Treasury, Private Equity and the Corporate Pension Plan.
Effective January 1, 2006, the Firm expects to refine its methodology for
allocating capital to the lines of business, and may continue to refine this
methodology. The revised methodology, among other things, considers for each
line of business goodwill associated with such line of business’ acquisitions
since the Merger. As a result of this refinement, Retail Financial Services, Card
Services, Commercial Banking,Treasury & Securities Services and Asset &
Wealth Management will have higher amounts of capital allocated in 2006,
while the amount of capital allocated to the Investment Bank will remain
unchanged. In management’s view, the revised methodology assigns responsi-
bility to the lines of business to generate returns on the amount of capital
supporting acquisition-related goodwill. As part of this refinement in the capital
allocation methodology, the Firm will assign to the Corporate segment an
amount of equity capital equal to the then-current book value of goodwill from
and prior to the Merger. In accordance with SFAS 142, the lines of business will
continue to perform the required goodwill impairment testing. For a further
discussion of goodwill and impairment testing, see Critical accounting estimates
and Note 15 on pages 81–83 and 114–116, respectively, of this Annual Report.
Economic risk capital
JPMorgan Chase assesses its capital adequacy relative to the underlying risks
of the Firm’s business activities, utilizing internal risk-assessment methodologies.
The Firm assigns economic capital based primarily upon five risk factors: credit
risk, market risk, operational risk and business risk for each business; and
private equity risk, principally for the Firm’s private equity business.
(in billions) Yearly Average
Economic risk capital 2005 2004(a)
Credit risk $ 22.6 $ 16.5
Market risk 9.8 7.5
Operational risk 5.5 4.5
Business risk 2.1 1.9
Private equity risk 3.8 4.5
Economic risk capital 43.8 34.9
Goodwill 43.5 25.9
Other(b) 18.2 14.8
Total common stockholders’ equity $ 105.5 $ 75.6
(a) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results.
(b) Additional capital required to meet internal debt and regulatory rating objectives.
Credit risk capital
Credit risk capital is estimated separately for the wholesale businesses
(Investment Bank, Commercial Banking, Treasury & Securities Services and
Asset & Wealth Management) and consumer businesses (Retail Financial
Services and Card Services).
Credit risk capital for the overall wholesale credit portfolio is defined in terms
of unexpected credit losses, both from defaults and declines in market value
due to credit deterioration, measured over a one-year period at a confidence
level consistent with the level of capitalization necessary to achieve a targeted
‘AA’ solvency standard. Unexpected losses are in excess of those for which
provisions for credit losses are maintained. In addition to maturity and corre-
lations, capital allocation is differentiated by several principal drivers of credit
risk: exposure at default (or loan equivalent amount), likelihood of default,
loss severity, and market credit spread.
• Loan equivalent amount for counterparty exposures in an over-the-counter
derivative transaction is represented by the expected positive exposure based
upon potential movements of underlying market rates. Loan equivalents
for unused revolving credit facilities represent the portion of an unused
commitment likely, based upon the Firm’s average portfolio historical
experience, to become outstanding in the event an obligor defaults.
• Default likelihood is based upon current market conditions for all publicly
traded names and investment banking clients, by referencing the growing
market in credit derivatives and secondary market loan sales. This method-
ology produces, in the Firm’s view, more active risk management by utilizing
a forward-looking measure of credit risk. This dynamic measure captures
current market conditions and will change with the credit cycle over time
impacting the level of credit risk capital. For privately-held firms in the
commercial banking portfolio, default likelihood is based upon longer term
averages over an entire credit cycle.