JP Morgan Chase 2005 Annual Report Download - page 59

JPMorgan Chase & Co. /2005 Annual Report 57
• Loss severity of exposure is based upon the Firm’s average historical
experience during workouts, with adjustments to account for collateral
or subordination.
• Market credit spreads are used in the evaluation of changes in exposure
value due to credit deterioration.
Credit risk capital for the consumer portfolio is intended to represent a capital
level sufficient to support an ‘AA’ rating, and its allocation is based upon product
and other relevant risk segmentation.Actual segment level default and severity
experience are used to estimate unexpected losses for a one-year horizon at a
confidence level equivalent to the ‘AA’ solvency standard. Statistical results for cer-
tain segments or portfolios are adjusted upward to ensure that capital is consistent
with external benchmarks, including subordination levels on market transactions
and capital held at representative monoline competitors, where appropriate.
Market risk capital
The Firm calculates market risk capital guided by the principle that capital
should reflect the risk of loss in the value of portfolios and financial instruments
caused by adverse movements in market variables, such as interest and foreign
exchange rates, credit spreads, securities prices and commodities prices. Daily
VAR, monthly stress-test results and other factors are used to determine
appropriate capital levels. The Firm allocates market risk capital to each
business segment according to a formula that weights that segment’s VAR
and stress test exposures. See Market risk management on pages 75–78 of
this Annual Report for more information about these market risk measures.
Operational risk capital
Capital is allocated to the lines of business for operational risk using a risk-based
capital allocation methodology which estimates operational risk on a bottom-up
basis. The operational risk capital model is based upon actual losses and potential
scenario-based stress losses, with adjustments to the capital calculation to reflect
changes in the quality of the control environment or the potential offset as a
result of the use of risk-transfer products. The Firm believes the model is consistent
with the new Basel II Framework and expects to propose it eventually for
qualification under the advanced measurement approach for operational risk.
Business risk capital
Business risk is defined as the risk associated with volatility in the Firm’s
earnings due to factors not captured by other parts of its economic-capital
framework. Such volatility can arise from ineffective design or execution of
business strategies, volatile economic or financial market activity, changing
client expectations and demands, and restructuring to adjust for changes in the
competitive environment. For business risk, capital is allocated to each business
based upon historical revenue volatility and measures of fixed and variable
expenses. Earnings volatility arising from other risk factors, such as credit,
market, or operational risk, is excluded from the measurement of business risk
capital, as those factors are captured under their respective risk capital models.
Private equity risk capital
Capital is allocated to privately- and publicly-held securities, third-party
fund investments and commitments in the Private Equity portfolio to cover
the potential loss associated with a decline in equity markets and related
asset devaluations.
Regulatory capital
The Firm’s federal banking regulator, the Federal Reserve Board (“FRB”),
establishes capital requirements, including well-capitalized standards for the
consolidated financial holding company. The Office of the Comptroller of the
Currency (“OCC”) establishes similar capital requirements and standards for
the Firm’s national banks, including JPMorgan Chase Bank and Chase Bank
USA, National Association.
The federal banking regulatory agencies issued a final rule that makes perma-
nent an interim rule issued in 2000 that provides regulatory capital relief for
certain cash-collateralized securities borrowed transactions, effective February
22, 2006. The final rule also broadens the types of transactions qualifying for
regulatory capital relief under the interim rule. Adoption of the rule is not
expected to have a material effect on the Firm’s capital ratios.
On March 1, 2005, the FRB issued a final rule, which became effective April 11,
2005, that continues the inclusion of trust preferred securities in Tier 1 capital,
subject to stricter quantitative limits and revised qualitative standards, and
broadens the definition of restricted core capital elements. The rule provides
for a five-year transition period. As an internationally active bank holding
company, JPMorgan Chase is subject to the rule’s limitation on restricted
core capital elements, including trust preferred securities, to 15% of total core
capital elements, net of goodwill less any associated deferred tax liability.
At December 31, 2005, JPMorgan Chase’s restricted core capital elements
were 16.5% of total core capital elements. JPMorgan Chase expects to be in
compliance with the 15% limit by the March 31, 2009, implementation date.
On July 20, 2004, the federal banking regulatory agencies issued a final rule that
excludes assets of asset-backed commercial paper programs that are consolidated
as a result of FIN 46R from risk-weighted assets for purposes of computing
Tier 1 and Total risk-based capital ratios. The final rule also requires that capital
be held against short-term liquidity facilities supporting asset-backed commercial
paper programs.The final rule became effective September 30, 2004. In addition,
both short- and long-term liquidity facilities are subject to certain asset quality
tests effective September 30, 2005. Adoption of the rule did not have a
material effect on the capital ratios of the Firm.
The following tables show that JPMorgan Chase maintained a well-capitalized
position based upon Tier1and Total capital ratios at December 31,2005 and 2004.
Capital ratios Well-capitalized
December 31, 2005 2004 ratios
Tier 1 capital ratio 8.5% 8.7% 6.0%
Total capital ratio 12.0 12.2 10.0
Tier 1 leverage ratio 6.3 6.2 NA
Total stockholders’ equity to assets 8.9 9.1 NA
Risk-based capital components and assets
December 31, (in millions) 2005 2004
Total Tier 1 capital $ 72,474 $ 68,621
Total Tier 2 capital 29,963 28,186
Total capital $ 102,437 $ 96,807
Risk-weighted assets $ 850,643 $ 791,373
Total adjusted average assets 1,152,546 1,102,456
Tier 1 capital was $72.5 billion at December 31, 2005, compared with
$68.6 billion at December 31, 2004, an increase of $3.9 billion. The increase
was due primarily to net income of $8.5 billion, net common stock issued under
employee plans of $1.9 billion, $1.3 billion of additional qualifying trust preferred
securities and a decline of $716 million in the deduction for nonqualifying
intangible assets as a result of amortization. Offsetting these increases were
dividends declared of $4.8 billion, common share repurchases of $3.4 billion,
an increase in the deduction for goodwill of $418 million and the redemption
of $200 million of preferred stock. Additional information regarding the Firm’s
capital ratios and the federal regulatory capital standards to which it is subject
is presented in Note 24 on pages 121–122 of this Annual Report.
Basel II
The Basel Committee on Banking Supervision published the new Basel II
Framework in 2004 in an effort to update the original international bank capital