JP Morgan Chase 2010 Annual Report Download - page 145

JPMorgan Chase & Co./2010 Annual Report 145
Economic value stress testing
While VaR reflects the risk of loss due to adverse changes in mar-
kets using recent historical market behavior as an indicator of
losses, stress testing captures the Firm’s exposure to unlikely but
plausible events in abnormal markets using multiple scenarios that
assume significant changes in credit spreads, equity prices, interest
rates, currency rates or commodity prices. Scenarios are updated
dynamically and may be redefined on an ongoing basis to reflect current
market conditions. Along with VaR, stress testing is important in meas-
uring and controlling risk; it enhances understanding of the Firm’s risk
profile and loss potential, as stress losses are monitored against limits.
Stress testing is also employed in cross-business risk management.
Stress-test results, trends and explanations based on current market risk
positions are reported to the Firm’s senior management and to the lines
of business to allow them to better understand event risk–sensitive
positions and manage risks with more transparency.
Nonstatistical risk measures
Nonstatistical risk measures as well as stress testing include sensitivi-
ties to variables used to value positions, such as credit spread sensi-
tivities, interest rate basis point values and market values. These
measures provide granular information on the Firm’s market risk
exposure. They are aggregated by line-of-business and by risk type,
and are used for tactical control and monitoring limits.
Loss advisories and revenue drawdowns
Loss advisories and net revenue drawdowns are tools used to
highlight trading losses above certain levels of risk tolerance. Net
revenue drawdown is defined as the decline in net revenue since
the year-to-date peak revenue level.
Risk identification for large exposures
Individuals who manage risk positions in IB are responsible for
identifying potential losses that could arise from specific, unusual
events, such as a potential change in tax legislation, or a particu-
lar combination of unusual market moves. This information is
aggregated centrally for IB. Trading businesses are responsible for
RIFLEs, thereby permitting the Firm to monitor further earnings
vulnerability not adequately covered by standard risk measures.
Earnings-at-risk stress testing
The VaR and stress-test measures described above illustrate the
total economic sensitivity of the Firm’s Consolidated Balance
Sheets to changes in market variables. The effect of interest rate
exposure on reported net income is also important. Interest rate
risk exposure in the Firm’s core nontrading business activities
(i.e., asset/liability management positions, including accrual loans
within IB and CIO) results from on– and off–balance sheet posi-
tions. ALCO establishes the Firm’s interest rate risk policies, sets
risk guidelines and limits and reviews the risk profile of the Firm.
Treasury, working in partnership with the lines of business, calcu-
lates the Firm’s interest rate risk profile weekly and reports to
senior management.
Interest rate risk for nontrading activities can occur due to a
variety of factors, including:
• Differences in the timing among the maturity or repricing
of assets, liabilities and off–balance sheet instruments. For
example, if liabilities reprice more quickly than assets and fund-
ing interest rates are declining, earnings will increase initially.
• Differences in the amounts of assets, liabilities and off–balance
sheet instruments that are repricing at the same time. For example,
if more deposit liabilities are repricing than assets when general
interest rates are declining, earnings will increase initially.
• Differences in the amounts by which short-term and long-term
market interest rates change (for example, changes in the
slope of the yield curve) because the Firm has the ability to
lend at long-term fixed rates and borrow at variable or short-
term fixed rates. Based on these scenarios, the Firm’s earnings
would be affected negatively by a sudden and unanticipated
increase in short-term rates paid on its liabilities (e.g., depos-
its) without a corresponding increase in long-term rates re-
ceived on its assets (e.g., loans). Conversely, higher long-term
rates received on assets generally are beneficial to earnings,
particularly when the increase is not accompanied by rising
short-term rates paid on liabilities.
• The impact of changes in the maturity of various assets, liabili-
ties or off–balance sheet instruments as interest rates change.
For example, if more borrowers than forecasted pay down
higher-rate loan balances when general interest rates are de-
clining, earnings may decrease initially.
The Firm manages interest rate exposure related to its assets and
liabilities on a consolidated, corporate-wide basis. Business units
transfer their interest rate risk to Treasury through a transfer-
pricing system, which takes into account the elements of interest
rate exposure that can be risk-managed in financial markets.
These elements include asset and liability balances and contrac-
tual rates of interest, contractual principal payment schedules,
expected prepayment experience, interest rate reset dates and
maturities, rate indices used for repricing, and any interest rate
ceilings or floors for adjustable rate products. All transfer-pricing
assumptions are dynamically reviewed.
The Firm conducts simulations of changes in net interest income
from its nontrading activities under a variety of interest rate
scenarios. Earnings-at-risk tests measure the potential change in
the Firm’s net interest income, and the corresponding impact to
the Firm’s pretax earnings, over the following 12 months. These
tests highlight exposures to various rate-sensitive factors, such as
the rates themselves (e.g., the prime lending rate), pricing strate-
gies 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.
Mortgage prepayment assumptions are based on current interest
rates compared with underlying contractual rates, the time since
origination, and other factors which are updated periodically based
on historical experience and forward market expectations. The
balance and pricing assumptions of deposits that have no stated
maturity are based on historical performance, the competitive
environment, customer behavior, and product mix.