JP Morgan Chase 2006 Annual Report Download - page 59

JPMorgan Chase & Co. / 2006 Annual Report 57
CAPITAL MANAGEMENT
The Firm’s capital management framework is intended to ensure that there is
capital sufficient to support the underlying risks of the Firm’s business activi-
ties, as measured by economic risk capital, and to maintain “well-capitalized”
status under regulatory requirements. In addition, the Firm holds capital above
these requirements in amounts deemed appropriate to achieve management’s
regulatory and debt rating objectives. The process of assigning equity to the
lines of business is integrated into the Firm’s capital framework and is over-
seen by ALCO.
Line of business equity
The Firm’s framework for allocating capital is based upon the following objectives:
• integrate firmwide capital management activities with capital management
activities within each of the lines of business;
• measure performance consistently across all lines of business; and
• provide comparability with peer firms for each of the lines of business.
Equity for a line of business represents the amount the Firm believes the busi-
ness would require if it were operating independently, incorporating sufficient
capital to address economic risk measures, regulatory capital requirements and
capital levels for similarly rated peers. Return on equity is measured and internal
targets for expected returns are established as a key measure of a business seg-
ment’s performance.
Effective January 1, 2006, the Firm refined its methodology for allocating capital
to the lines of business. As a result of this refinement, RFS, CS, CB, TSS and AM
had higher amounts of capital allocated to them commencing in the first quarter
of 2006. The revised methodology considers for each line of business, among
other things, goodwill associated with such line of business’ acquisitions since the
Merger. In management’s view, the revised methodology assigns responsibility to
the lines of business to generate returns on the amount of capital supporting
acquisition-related goodwill. As part of this refinement in the capital allocation
methodology, the Firm assigned to the Corporate segment an amount of equity
capital equal to the then-current book value of goodwill from and prior to the
Merger. As prior periods have not been revised to reflect the new capital alloca-
tions, capital allocated to the respective lines of business for 2006 is not compara-
ble to prior periods; and certain business metrics, such as ROE, are not compara-
ble to the current presentation. The Firm may revise its equity capital-allocation
methodology again in the future.
In accordance with SFAS 142, the lines of business perform the required goodwill
impairment testing. For a further discussion of goodwill and impairment testing,
see Critical accounting estimates and Note 16 on pages 83–85 and 121–123,
respectively, of this Annual Report.
Line of business equity Yearly Average
(in billions) 2006 2005
Investment Bank $ 20.8 $ 20.0
Retail Financial Services 14.6 13.4
Card Services 14.1 11.8
Commercial Banking 5.7 3.4
Treasury & Securities Services 2.3 1.5
Asset Management 3.5 2.4
Corporate(a) 49.7 53.0
Total common stockholders’ equity $110.7 $105.5
(a) 2006 and 2005 include $41.7 billion and $43.1 billion, respectively, of equity to offset
goodwill and $8.0 billion and $9.9 billion, respectively, of equity, primarily related to
Treasury, Private Equity and the Corporate Pension Plan.
Economic risk capital
JPMorgan Chase assesses its capital adequacy relative to the risks underlying
the Firm’s business activities, utilizing internal risk-assessment methodologies.
The Firm assigns economic capital primarily based upon four risk factors:
credit risk, market risk, operational risk and private equity risk, principally for
the Firm’s private equity business.
Economic risk capital Yearly Average
(in billions) 2006 2005
Credit risk $ 22.1 $ 22.6
Market risk 9.9 9.8
Operational risk 5.7 5.5
Private equity risk 3.4 3.8
Economic risk capital 41.1 41.7
Goodwill 43.9 43.1
Other(a) 25.7 20.7(b)
Total common stockholders’ equity $ 110.7 $ 105.5
(a) Reflects additional capital required, in management’s view, to meet its regulatory and debt
rating objectives.
(b) Includes $2.1 billion of capital previously reported as business risk capital.
Credit risk capital
Credit risk capital is estimated separately for the wholesale businesses (IB,
CB, TSS and AM) and consumer businesses (RFS and CS).
Credit risk capital for the overall wholesale credit portfolio is defined in terms
of unexpected credit losses, both from defaults and declines in market value
due to credit deterioration, measured over a one-year period at a confidence
level consistent with the level of capitalization necessary to achieve a targeted
‘AA’ solvency standard. Unexpected losses are in excess of those for which
provisions for credit losses are maintained. In addition to maturity and corre-
lations, capital allocation is based upon several principal drivers of credit risk:
exposure at default (or loan-equivalent amount), likelihood of default, loss
severity and market credit spread.
• Loan-equivalent amount for counterparty exposure in an over-the-counter
derivative transaction is represented by the expected positive exposure based
upon potential movements of underlying market rates. The loan-equivalent
amount for unused revolving credit facilities represents the portion of the
unused commitment or other contingent exposure that is expected, based
upon average portfolio historical experience, to become outstanding in the
event of a default by an obligor.
• Default likelihood is based upon current market conditions for all
Investment Bank clients by referencing equity and credit derivatives mar-
kets, as well as certain other publicly traded entities that are not IB clients.
This methodology facilitates, in the Firm’s view, more active risk manage-
ment by utilizing a dynamic, forward-looking measure of credit. This meas-
ure changes with the credit cycle over time, impacting the level of credit
risk capital. For privately held firms and individuals in the Commercial Bank
and Asset Management, default likelihood is based upon longer-term aver-
ages through the credit cycles.
• Loss severity of exposure is based upon the Firm’s average historical
experience during workouts, with adjustments to account for collateral
or subordination.
Credit risk capital for the consumer portfolio is based upon product and other rel-
evant risk segmentation. Actual segment level default and severity experience are
used to estimate unexpected losses for a one-year horizon at a confidence level
equivalent to the ‘AA’ solvency standard. Statistical results for certain segments or