JP Morgan Chase 2006 Annual Report Download - page 64

MANAGEMENT’S DISCUSSION AND ANALYSIS
JPMorgan Chase & Co.
62 JPMorgan Chase & Co. / 2006 Annual Report
LIQUIDITY RISK MANAGEMENT
Liquidity risk arises from the general funding needs of the Firm’s activities and
in the management of its assets and liabilities. JPMorgan Chase’s liquidity
management framework is intended to maximize liquidity access and mini-
mize funding costs. Through active liquidity management the Firm seeks to
preserve stable, reliable and cost-effective sources of funding. This access
enables the Firm to replace maturing obligations when due and fund assets
at appropriate maturities and rates. To accomplish this, management uses a
variety of measures to mitigate liquidity and related risks, taking into consid-
eration market conditions, prevailing interest rates, liquidity needs and the
desired maturity profile of liabilities, among other factors.
The three primary measures of the Firm’s liquidity position include the following:
• Holding company short-term position: Holding company short-term
position measures the parent holding company’s ability to repay all obliga-
tions with a maturity of less than one year at a time when the ability of the
Firm’s subsidiaries to pay dividends to the parent company is constrained.
• Cash capital position: Cash capital position is a measure intended to
ensure the illiquid portion of the balance sheet can be funded by equity,
long-term debt, trust preferred capital debt securities and deposits the Firm
believes to be core.
• Basic surplus: Basic surplus measures the Bank’s ability to sustain a 90-
day stress event that is specific to the Firm where no new funding can be
raised to meet obligations as they come due.
Liquidity is managed so that, based upon the measures described above,
management believes there is sufficient surplus liquidity.
An extension of liquidity management is the Firm’s contingency funding plan.
The goal of the plan is to ensure appropriate liquidity during normal and
stress periods. The plan considers numerous temporary and long-term stress
scenarios where access to unsecured funding is severely limited or nonexist-
ent, taking into account both on– and off–balance sheet exposures, separate-
ly evaluating access to funds by the parent holding company, JPMorgan
Chase Bank, N.A. and Chase Bank USA, N.A.
Part of the Firm’s contingency funding plan is its ratings downgrade analysis.
For this analysis, the impact of numerous rating agency downgrade scenarios
are considered.
The various analytics used to manage the Firm’s liquidity and related risks rely
on management’s judgment regarding JPMorgan Chase’s ability to liquidate
assets or use assets as collateral for borrowings and take into account histori-
cal data on the funding of loan commitments (for example, commercial paper
back-up facilities), liquidity commitments to SPEs, commitments with rating
triggers and collateral posting requirements.
Governance
The Firm’s Asset-Liability Committee approves the Firm’s liquidity policy and
oversees the policy’s execution. Treasury is responsible for measuring, monitor-
ing, reporting and managing the Firm’s liquidity risk profile. Treasury formulates
the Firm’s liquidity targets and strategies; monitors the Firm’s on– and off–bal-
ance sheet liquidity obligations; maintains contingency planning, including rat-
ings downgrade stress testing; and identifies and measures internal and exter-
nal liquidity warning signals to permit early detection of liquidity issues.
Funding
Sources of funds
Consistent with its liquidity management policy, the Firm has raised funds at
the parent holding company sufficient to cover its obligations and those of
its nonbank subsidiaries that mature over the next 12 months.
As of December 31, 2006, the Firm’s liquidity position remained strong based
upon its liquidity metrics. JPMorgan Chase’s long-dated funding, including
core liabilities, exceeded illiquid assets, and the Firm believes its obligations
can be met even if access to funding is impaired.
The diversity of the Firm’s funding sources enhances financial flexibility and
limits dependence on any one source, thereby minimizing the cost of funds.
The deposits held by the RFS, CB, TSS and AM lines of business are generally a
stable and consistent source of funding for JPMorgan Chase Bank, N.A. As of
December 31, 2006, total deposits for the Firm were $639 billion. A significant
portion of the Firm’s deposits are retail deposits, which are less sensitive to
interest rate changes and therefore are considered more stable than market-
based (i.e., wholesale) deposits. In addition to these deposits, the Firm benefits
from substantial liability balances originated by RFS, CB, TSS and AM through
the normal course of business. These franchise-generated liability balances are
also a stable and consistent source of funding due to the nature of the busi-
nesses from which they are generated. For a further discussion of deposit and
liability balance trends, see Business Segment Results and Balance Sheet
Analysis on pages 36–52 and 55–56 , respectively, of this Annual Report.
Additional sources of funds include a variety of both short- and long-term
instruments, including federal funds purchased, commercial paper, bank notes,
long-term debt, and trust preferred capital debt securities. This funding is
managed centrally, using regional expertise and local market access, to ensure
active participation by the Firm in the global financial markets while main-
taining consistent global pricing. These markets serve as a cost-effective and
diversified source of funds and are a critical component of the Firm’s
liquidity management. Decisions concerning the timing and tenor of accessing
these markets are based upon relative costs, general market conditions,
prospective views of balance sheet growth and a targeted liquidity profile.
Finally, funding flexibility is provided by the Firm’s ability to access the repur-
chase and asset securitization markets. These markets are evaluated on an
ongoing basis to achieve an appropriate balance of secured and unsecured
funding. The ability to securitize loans, and the associated gains on those secu-
ritizations, are principally dependent upon the credit quality and yields of the
assets securitized and are generally not dependent upon the credit ratings of
the issuing entity. Transactions between the Firm and its securitization struc-
tures are reflected in JPMorgan Chase’s consolidated financial statements and
notes to the consolidated financial statements; these relationships include
retained interests in securitization trusts, liquidity facilities and derivative
transactions. For further details, see Off–balance sheet arrangements and
contractual cash obligations and Notes 14 and 29 on pages 59–60, 114–118
and 132–134, respectively, of this Annual Report.
The Board of Directors exercises its oversight of risk management, principally
through the Board’s Risk Policy Committee and Audit Committee. The Risk
Policy Committee oversees senior management risk-related responsibilities,
including reviewing management policies and performance against these poli-
cies and related benchmarks. The Audit Committee is responsible for oversight
of guidelines and policies that govern the process by which risk assessment
and management is undertaken. In addition, the Audit Committee reviews
with management the system of internal controls and financial reporting that
is relied upon to provide reasonable assurance of compliance with the Firm’s
operational risk management processes.