JP Morgan Chase 2003 Annual Report Download - page 76

M anagement’s discussion and analysis
J.P. M organ Chase & Co.
74 J.P. Morgan Chase & Co. / 2003 Annual Report
Critical accounting estimates used by the Firm
scrutiny of the purpose and effect of its transactions from the
client’s point of view, with the goal that these transactions are
not used to mislead investors or others. The structure operates
at three levels: as part of every business’s transaction approval
process; through review by regional Policy Review Committees;
and through oversight by the Policy Review Office.
Business transaction approval
Primary responsibility for adherence to the policies and proce-
dures designed to address reputation risk lies w ith the business
units conducting the transactions in question. The Firm’s transac-
tion approval process requires review and sign-off from, among
others, internal legal/compliance, conflicts, tax and accounting
policy groups. Transactions involving an SPE established by the
Firm receive particular scrutiny and must comply w ith a Special-
Purpose Vehicle Policy, designed to ensure that every such entity
is properly approved, documented, monitored and controlled.
Regional policy review commit t ees
Business units are also required to submit to regional Policy Review
Committees proposed transactions that may heighten reputation
Private equity risk management
Risk management
JPM P employs processes for risk measurement and control of
private equity risk that are similar to those used for other busi-
nesses within the Firm. The processes are coordinated with the
Firm’s overall approach to market and concentration risk. Private
equity risk is initially monitored through the use of industry and
geographic limits. Additionally, to manage the pace of new
investments, a ceiling on the amount of annual private equity
investment activity has been established.
JPM P’s public equity holdings create a significant exposure to
general declines in the equity markets. To gauge that risk, VAR
and stress-test exposures are calculated in the same way as
they are for the Firm’s trading and nontrading portfolios. JPM P
management undertakes frequent review s of its public security
holdings as part of a disciplined approach to sales and hedging
issues. Hedging programs are limited but are considered w hen
practical and as circumstances dictate. Over time, the Firm may
change the nature and type of hedges it enters into, as w ell as
close hedging positions altogether.
Capital allocation for private equity risk
Internal capital is allocated to JPM P’s public equities portfolio
based on stress scenarios w hich reflect the potential loss inher-
ent in the portfolio in the event of a large equity market
decline. Capital is also allocated for liquidity risk, w hich results
from the contractual sales restrictions to w hich some holdings
are subject. For private equities, capital is allocated based on a
long-term equity market stress scenario that is consistent with
the investment time horizons associated with these holdings.
For these investments, additional capital is allocated against the
risk of an unexpectedly large number of w rite-offs or write-
dow ns. The Firm refined its methodology for measuring private
equity risk during the second quarter of 2003. It now assigns a
moderately higher amount of capital for the risk in the private
equity portfolio, most of w hich is assigned to JPM P.
risk – particularly a client’s motivation and its intended financial
disclosure of the transaction. The committees approve, reject or
require further clarification on or changes to the transactions.
The members of these committees are senior representatives of
the business and support units in the region. The committees
may escalate transaction review to the Policy Review Office.
Policy Review Office
The Policy Review Office is the most senior approval level for
client transactions involving reputation risk issues. The mandate
of the Office is to opine on specific transactions brought by the
Regional Committees and consider changes in policies or prac-
tices relating to reputation risk. The head of the office consults
w ith the Firm’s most senior executives on specific topics and pro-
vides regular updates. Aside from governance and guidance on
specific transactions, the objective of the policy review process is
to reinforce a culture, through a “ case study” approach, that
ensures that all employees, regardless of seniority, understand
the basic principles of reputation risk control and can recognize
and address issues as they arise.
The Firm’s accounting policies and use of estimates are integral
to understanding the reported results. The Firm’s most complex
accounting estimates require management’s judgment to ascer-
tain the valuation of assets and liabilities. The Firm has estab-
lished detailed policies and control procedures intended to
ensure valuation methods, including any judgments made as
part of such methods, are w ell controlled, independently
reviewed and applied consistently from period to period.
In addition, the policies and procedures are intended to ensure
that the process for changing methodologies occurs in an
appropriate manner. The Firm believes its estimates for deter-
mining the valuation of its assets and liabilities are appropriate.
The follow ing is a brief description of the Firm’s critical accounting
estimates involving significant management valuation judgments.