JP Morgan Chase 2008 Annual Report Download - page 118

Management’s discussion and analysis
116 JPMorgan Chase & Co./ 2008 Annual Report
tax earnings, over the following 12 months. These tests highlight
exposures to various rate-sensitive factors, such as the rates them-
selves (e.g., the prime lending rate), pricing strategies on deposits,
optionality and changes in product mix. The tests include forecasted
balance sheet changes, such as asset sales and securitizations, as
well as prepayment and reinvestment behavior.
Immediate changes in interest rates present a limited view of risk,
and so a number of alternative scenarios are also reviewed. These
scenarios include the implied forward curve, nonparallel rate shifts
and severe interest rate shocks on selected key rates. These scenarios
are intended to provide a comprehensive view of JPMorgan Chase’s
earnings-at-risk over a wide range of outcomes.
JPMorgan Chase’s 12-month pretax earnings sensitivity profile as of
December 31, 2008 and 2007, is as follows.
Immediate change in rates
(in millions) +200bp +100bp -100bp -200bp
December 31, 2008 $ 336 $ 672 $ NM(a) $NM
(a)
December 31, 2007 $ (26) $ 55 $ (308) $ (664)
(a) Down 100 and 200 basis point parallel shocks result in a Fed Funds target rate of
zero, and negative three- and six-month Treasury rates. The earnings-at-risk results of
such a low probability scenario are not meaningful (“NM”).
The change in earnings-at-risk from December 31, 2007, results from
a higher level of AFS securities and lower market interest rates. The
benefit to the Firm of an increase in rates results from a widening of
deposit margins which are currently compressed due to very low
short-term interest rates. This benefit would be partially offset by the
effect of reduced mortgage prepayments. The impact to the Firm’s
pretax earnings of reduced mortgage prepayments would become
more pronounced under a +200 bp parallel shock.
Additionally, another sensitivity involving a steeper yield curve, with
long-term rates rising 100 basis points and short-term rates staying
at current levels, results in a 12-month pretax earnings benefit of
$740 million. The increase in earnings is due to reinvestment of
maturing assets at the higher long-term rates with funding costs
remaining unchanged.
Risk identification for large exposures (“RIFLE”)
Individuals who manage risk positions, particularly those that are
complex, are responsible for identifying potential losses that could
arise from specific, unusual events, such as a potential tax change,
and estimating the probabilities of losses arising from such events.
This information is entered into the Firm’s RIFLE database.
Management of trading businesses control RIFLE entries, thereby per-
mitting the Firm to monitor further earnings vulnerability not ade-
quately covered by standard risk measures.
Risk monitoring and control
Limits
Market risk is controlled primarily through a series of limits. Limits
reflect the Firm’s risk appetite in the context of the market environ-
ment and business strategy. In setting limits, the Firm takes into con-
sideration factors such as market volatility, product liquidity, business
trends and management experience.
Market risk management regularly reviews and updates risk limits.
Senior management, including the Firm’s Chief Executive Officer and
Chief Risk Officer, is responsible for reviewing and approving risk lim-
its at least once a year.
The Firm maintains different levels of limits. Corporate-level limits
include VaR and stress limits. Similarly, line-of-business limits include
VaR and stress limits and may be supplemented by loss advisories,
nonstatistical measurements and instrument authorities. Businesses
are responsible for adhering to established limits, against which
exposures are monitored and reported. Limit breaches are reported
in a timely manner to senior management, and the affected business
segment is required to reduce trading positions or consult with sen-
ior management on the appropriate action.
Qualitative review
The Market Risk Management group also performs periodic reviews
as necessary of both businesses and products with exposure to mar-
ket risk to assess the ability of the businesses to control their market
risk. Strategies, market conditions, product details and risk controls
are reviewed, and specific recommendations for improvements are
made to management.
Model review
Some of the Firm’s financial instruments cannot be valued based
upon quoted market prices but are instead valued using pricing mod-
els. Such models are used for management of risk positions, such as
reporting against limits, as well as for valuation. The Model Risk
Group, independent of the businesses and market risk management,
reviews the models the Firm uses and assesses model appropriate-
ness and consistency. The model reviews consider a number of fac-
tors about the model’s suitability for valuation and risk management
of a particular product, including whether it accurately reflects the
characteristics of the transaction and its significant risks, the suitabili-
ty and convergence properties of numerical algorithms, reliability of
data sources, consistency of the treatment with models for similar
products, and sensitivity to input parameters and assumptions that
cannot be priced from the market.
Reviews are conducted of new or changed models, as well as previ-
ously accepted models, to assess whether there have been any
changes in the product or market that may impact the model’s validity
and whether there are theoretical or competitive developments that
may require reassessment of the model’s adequacy. For a summary of
valuations based upon models, see Critical Accounting Estimates Used
by the Firm on pages 119–123 of this Annual Report.
Risk reporting
Nonstatistical exposures, value-at-risk, loss advisories and limit
excesses are reported daily for each trading and nontrading business.
Market risk exposure trends, value-at-risk trends, profit and loss
changes, and portfolio concentrations are reported weekly. Stress-
test results are reported at least every two weeks to business and
senior management.