JP Morgan Chase 2003 Annual Report Download - page 54

M anagement’s discussion and analysis
J.P. M organ Chase & Co.
52 J.P. Morgan Chase & Co. / 2003 Annual Report
To measure commercial credit risk, the Firm estimates the likelihood
of obligor or counterparty default; the amount of exposure should
the obligor or the counterparty default; and the loss severity given a
default event. Based on these factors and related market-based
inputs, the Firm estimates both expected and unexpected losses for
each segment of the portfolio. Expected losses are statistically-based
estimates of credit losses over time, anticipated as a result of obligor
or counterparty default. They are used to set risk-adjusted credit loss
provisions. How ever, expected credit losses are not the sole indica-
tors of risk. If losses w ere entirely predictable, the expected loss rate
could be factored into pricing and covered as a normal and recurring
cost of doing business. Unexpected losses represent the potential
volatility of actual losses relative to the expected level of losses and
are the basis for the Firm’s credit risk capital-allocation process.
In 2003, the Firm significantly modified its approach to commer-
cial credit risk management to further enhance risk management
discipline, improve returns and liquidity and use capital more effi-
ciently. Three primary initiatives w ere launched during the year:
improved single-name and industry concentration management,
through a revised threshold and limit structure; a revised capital
methodology; and increased portfolio management activity utiliz-
ing credit derivatives and loan sales. The Firm manages capital
and exposure concentrations by obligor, risk rating, industry and
geography. The Firm has reduced by one-half the number of
clients w hose credit exposure exceeded the narrow est definition
of concentration limits during 2003, through focused client plan-
ning and portfolio management activities.
A comprehensive review of the Firm’s wholesale credit risk
management infrastructure w as completed in 2003. As a result,
the Firm has commenced a multi-year initiative to reengineer
specific components of the credit risk infrastructure, including
creation of a simpler infrastructure w ith more standardized
hardw are and softw are platforms. The goal of the initiative is
to enhance the Firm’s ability to provide immediate and accurate
risk and exposure information; actively manage credit risk in the
residual portfolio; support client relationships; manage more
quickly the allocation of economic capital; and support compli-
ance with Basel II initiatives.
Consumer
Consumer credit risks are monitored at the aggregate CFS level
and within each line of business (mortgages, credit cards, auto-
mobile finance, small business and consumer banking).
Consumer credit risk management uses sophisticated portfolio
modeling, credit scoring and decision-support tools to project
credit risks and establish underw riting standards. Risk parameters
are established in the early stages of product development, and
the cost of credit risk is an integral part of product pricing and
evaluating profit dynamics. Losses generated by consumer loans
are more predictable than for commercial loans, but are subject to
cyclical and seasonal factors. The frequency of loss is higher on
consumer loans than on corporate loans but the severity of losses is
typically lower and more manageable, depending on w hether loans
are secured or not. In addition, common measures of credit quality
derived from historical loss experience can be used to predict
consumer losses. Likew ise, underwriting principles and philoso-
phies are common among lenders focusing on borrowers of
similar credit quality. For these reasons, Consumer Credit Risk
M anagement focuses on trends and concentrations at the portfo-
lio level, w here problems can be remedied through changes in
underw riting policies and adherence to portfolio guidelines.
Consumer Credit Risk M anagement also monitors key risk attrib-
utes, including borrow er credit quality, loan performance (as meas-
ured by delinquency) and losses (expected versus actual). The
monthly and quarterly analysis of trends around these attributes is
monitored against business expectations and industry benchmarks.
Capit al allocation f or credit risk
Unexpected credit losses drive the allocation of credit risk capital
by portfolio segment.
In the commercial portfolio, capital allocations are differentiated
by risk rating, loss severity, maturity, correlations and assumed
exposure at default. In 2003, the Firm revised its methodology for
the assessment of credit risk capital allocated to the commercial
credit portfolio, more closely aligning capital w ith current market
conditions. Specifically, the new approach employs estimates of
default likelihood that are derived from current market parame-
ters and is intended to capture the impact of both defaults and
declines in market value due to credit deterioration. This approach
is intended to reflect more accurately current risk conditions, as
w ell as to enhance the management of commercial credit risk by
encouraging the utilization of the grow ing market in credit deriva-
tives and secondary market loan sales. See the Capital manage-
ment section on pages 46–47 of this Annual Report.
Within the consumer businesses, capital allocations are differen-
tiated by product and product segment. For the consumer port-
folio, consumer products are placed into categories w ith
homogenous credit characteristics, from w hich default rates and
charge-offs can be estimated. Credit risk capital is allocated
based on the unexpected loss inherent in those categories.
Commercial and consumer credit portfolio
JPM organ Chase’s total credit exposure (which includes $34.9
billion of securitized credit cards) w as $730.9 billion at
December 31, 2003, a 2% increase from year-end 2002. The
increase reflected a change in the portfolio’s composition: a
$41.5 billion increase in consumer exposure, partially offset by
a $30.2 billion decrease in commercial exposure.
M anaged consumer loans increased by $15.7 billion, primarily
resulting from higher levels of residential mortgage and automo-
bile originations, while lending-related commitments increased
by $25.8 billion, primarily in the home finance and credit card
businesses.
Commercial exposure decreased by 7% to $382.7 billion as of
year-end 2003, the result of an $8.5 billion decrease in loans and
a $22.4 billion decrease in lending-related commitments. The
decrease in loans outstanding reflected w eaker demand, as w ell
as the Firm’s ongoing credit management activities, including
$5.2 billion in loan and commitment sales. This w as partially offset