JP Morgan Chase 2005 Annual Report Download - page 65

JPMorgan Chase & Co. /2005 Annual Report 63
Credit risk management
Credit risk is the risk of loss from obligor or counterparty default. The Firm
provides credit to customers of all sizes, from large corporate clients to loans
for the individual consumer. The Firm manages the risk/reward relationship of
each portfolio and discourages the retention of loan assets that do not generate
a positive return above the cost of risk-adjusted capital. The majority of the
Firm’s wholesale loan originations (primarily to IB clients) continues to be
distributed into the marketplace, with residual holds by the Firm averaging
less than 10%. Wholesale loans generated by CB and AWM are generally
retained on the balance sheet. With regard to the prime consumer credit
market, the Firm focuses on creating a portfolio that is diversified from both
a product and a geographical perspective. Within the prime mortgage business,
originated loans are retained on the balance sheet as well as selectively sold to
government agencies; the latter category is routinely classified as held-for-sale.
Credit risk organization
Credit risk management is overseen by the Chief Risk Officer, a member
of the Firm’s Operating Committee.The Firm’s credit risk management
governance structure consists of the following primary functions:
• establishes a comprehensive credit risk policy framework
• calculates Allowance for credit losses and ensures appropriate credit risk-
based capital management
• assigns and manages credit authorities to approve all credit exposure
• monitors and manages credit risk across all portfolio segments
• manages criticized exposures
Risk identification
The Firm is exposed to credit risk through lending (e.g., loans and lending-
related commitments), derivatives trading and capital markets activities.
The credit risk function works in partnership with the business segments in
identifying and aggregating exposure across all lines of business.
Risk measurement
To measure credit risk, the Firm employs several methodologies for estimating
the likelihood of obligor or counterparty default. Losses generated by consumer
loans are more predictable than wholesale losses, but are subject to cyclical
and seasonal factors. Although the frequency of loss is higher on consumer
loans than on wholesale loans, the severity of loss is typically lower and more
manageable. As a result of these differences, methodologies vary depending
on certain factors, including type of asset (e.g., consumer installment versus
wholesale loan), risk measurement parameters (e.g., delinquency status and
credit bureau score versus wholesale risk rating) and risk management and
collection processes (e.g., retail collection center versus centrally managed
workout groups). Credit risk measurement is based upon the amount of
exposure should the obligor or the counterparty default, the probability of
default and the loss severity given a default event. Based upon these factors
and related market-based inputs, the Firm estimates both probable and
unexpected losses for the wholesale and consumer portfolios. Probable losses,
reflected in the Provision for credit losses, are generally statistically-based
estimates of credit losses over time, anticipated as a result of obligor or coun-
terparty default. However, probable losses are not the sole indicators of risk.
If losses were entirely predictable, the probable loss rate could be factored
into pricing and covered as a normal and recurring cost of doing business.
Unexpected losses, reflected in the allocation of credit risk capital, represent
the potential volatility of actual losses relative to the probable level of losses.
(Refer to Capital management on pages 56–58 of this Annual Report for a
further discussion of the credit risk capital methodology.) Risk measurement
for the wholesale portfolio is assessed primarily on a risk-rated basis; for the
consumer portfolio, it is assessed primarily on a credit-scored basis.
Risk-rated exposure
For portfolios that are risk-rated, probable and unexpected loss calculations
are based upon estimates of probability of default and loss given default.
Probability of default is expected default calculated on an obligor basis. Loss
given default is an estimate of losses that are based upon collateral and
structural support for each credit facility. Calculations and assumptions are
based upon management information systems and methodologies which are
under continual review. Risk ratings are assigned and reviewed on an ongoing
basis by Credit Risk Management and revised, if needed, to reflect the borrowers’
current risk profiles and the related collateral and structural positions.
Credit-scored exposure
For credit-scored portfolios (generally held in RFS and CS), probable loss is
based upon a statistical analysis of inherent losses over discrete periods of
time. Probable losses are estimated using sophisticated portfolio modeling,
credit scoring and decision-support tools to project credit risks and establish
underwriting standards. In addition, common measures of credit quality derived
from historical loss experience are used to predict consumer losses. Other risk
characteristics evaluated include recent loss experience in the portfolios, changes
in origination sources, portfolio seasoning, loss severity and underlying credit
practices, including charge-off policies. These analyses are applied to the
Firm’s current portfolios in order to forecast delinquencies and severity of
losses, which determine the amount of probable losses. These factors and
analyses are updated on a quarterly basis.
Risk monitoring
The Firm has developed policies and practices that are designed to preserve
the independence and integrity of decision-making and ensure credit risks are
accurately assessed, properly approved, continually monitored and actively
managed at both the transaction and portfolio levels. The policy framework
establishes credit approval authorities, concentration limits, risk-rating
methodologies, portfolio-review parameters and problem-loan management.
Wholesale credit risk is continually monitored on both an aggregate portfolio
level and on an individual customer basis. For consumer credit risk, the key
focus items are trends and concentrations at the portfolio level, where potential
problems can be remedied through changes in underwriting policies and
portfolio guidelines. Consumer Credit Risk Management monitors trends
against business expectations and industry benchmarks. In order to meet
credit risk management objectives, the Firm seeks to maintain a risk profile
that is diverse in terms of borrower, product type, industry and geographic
concentration. Additional diversification of the Firm’s exposure is accomplished
through loan syndication and participations, loan sales, securitizations, credit
derivatives and other risk-reduction techniques.
Risk reporting
To enable monitoring of credit risk and decision-making, aggregate credit
exposure, credit metric forecasts, hold-limit exceptions and risk profile
changes are reported regularly to senior credit risk management. Detailed
portfolio reporting of industry, customer and geographic concentrations
occurs monthly, and the appropriateness of the allowance for credit losses is
reviewed by senior management at least on a quarterly basis. Through the
risk reporting and governance structure, credit risk trends and limit exceptions
are provided regularly to, and discussed with, the Operating Committee.
2005 Credit risk overview
The wholesale portfolio experienced continued credit strength during 2005.
Wholesale nonperforming loans were down by $582 million, or 37%, from
2004; net recoveries were $77 million compared with net charge-offs of