JP Morgan Chase 2006 Annual Report Download - page 60

MANAGEMENT’S DISCUSSION AND ANALYSIS
JPMorgan Chase & Co.
58 JPMorgan Chase & Co. / 2006 Annual Report
portfolios are adjusted to ensure that capital is consistent with external bench-
marks, such as subordination levels on market transactions or capital held at rep-
resentative monoline competitors, where appropriate.
Market risk capital
The Firm calculates market risk capital guided by the principle that capital
should reflect the risk of loss in the value of portfolios and financial instruments
caused by adverse movements in market variables, such as interest and foreign
exchange rates, credit spreads, securities prices and commodities prices. Daily
Value-at-Risk (“VAR”), monthly stress-test results and other factors are used to
determine appropriate capital levels. The Firm allocates market risk capital to
each business segment according to a formula that weights that segment’s VAR
and stress-test exposures. See Market risk management on pages 77–80 of this
Annual Report for more information about these market risk measures.
Operational risk capital
Capital is allocated to the lines of business for operational risk using a risk-based
capital allocation methodology which estimates operational risk on a bottom-up
basis. The operational risk capital model is based upon actual losses and potential
scenario-based stress losses, with adjustments to the capital calculation to reflect
changes in the quality of the control environment or the use of risk-transfer prod-
ucts. The Firm believes the model is consistent with the new Basel II Framework
and expects to propose it eventually for qualification under the advanced meas-
urement approach for operational risk.
Private equity risk capital
Capital is allocated to privately- and publicly-held securities, third-party fund
investments and commitments in the Private Equity portfolio to cover the potential
loss associated with a decline in equity markets and related asset devaluations.
Regulatory capital
The Firm’s federal banking regulator, the Federal Reserve Board, establishes capi-
tal requirements, including well-capitalized standards for the consolidated finan-
cial holding company. The Office of the Comptroller of the Currency (“OCC”)
establishes similar capital requirements and standards for the Firm’s national
banks, including JPMorgan Chase Bank, N.A. and Chase Bank USA, N.A.
On December 14, 2006, the federal banking regulatory agencies announced
an interim decision that SFAS 158 will not impact regulatory capital. Until fur-
ther guidance is issued, any amounts included in Accumulated other compre-
hensive income (loss) within Stockholders’ equity related to the adoption of
SFAS 158 will be excluded from regulatory capital. For further discussion of
SFAS 158, refer to Note 7 on pages 100–105 of this Annual Report.
In the first quarter of 2006, the federal banking regulatory agencies issued a
final rule that provides regulatory capital relief for certain cash-collateralized,
securities-borrowed transactions. The final rule, which became effective
February 22, 2006, also broadens the types of transactions qualifying for reg-
ulatory capital relief under the interim rule. Adoption of the rule did not have
a material effect on the Firm’s capital ratios.
On March 1, 2005, the Federal Reserve Board issued a final rule, which
became effective April 11, 2005, that continues the inclusion of trust pre-
ferred capital debt securities in Tier 1 capital, subject to stricter quantitative
limits and revised qualitative standards, and broadens the definition of
restricted core capital elements. The rule provides for a five-year transition
period. As an internationally active bank holding company, JPMorgan Chase
is subject to the rule’s limitation on restricted core capital elements, including
trust preferred capital debt securities, to 15% of total core capital elements,
net of goodwill less any associated deferred tax liability. At December 31,
2006, JPMorgan Chase’s restricted core capital elements were 15.1% of total
core capital elements.
The following tables show that JPMorgan Chase maintained a well-capitalized
position based upon Tier1and Total capital ratios at December 31,2006 and 2005.
Capital ratios Well-capitalized
December 31, 2006 2005 ratios
Tier 1 capital ratio 8.7% 8.5% 6.0%
Total capital ratio 12.3 12.0 10.0
Tier 1 leverage ratio 6.2 6.3 NA
Total stockholders’ equity to assets 8.6 8.9 NA
Risk-based capital components and assets
December 31, (in millions) 2006 2005
Total Tier 1 capital $ 81,055 $ 72,474
Total Tier 2 capital 34,210 29,963
Total capital $ 115,265 $ 102,437
Risk-weighted assets $ 935,909 $ 850,643
Total adjusted average assets 1,308,699 1,152,546
Tier 1 capital was $81.1 billion at December 31, 2006, compared with $72.5
billion at December 31, 2005, an increase of $8.6 billion. The increase was
due primarily to net income of $14.4 billion, net issuances of common stock
under the Firm’s employee stock based compensation plans of $3.8 billion and
$873 million of additional qualifying trust preferred capital debt securities.
Partially offsetting these increases were changes in stockholders’ equity net of
Accumulated other comprehensive income (loss) due to dividends declared of
$4.9 billion, common share repurchases of $3.9 billion, the redemption of pre-
ferred stock of $139 million, a $1.2 billion increase in the deduction for good-
will and other nonqualifying intangibles and a $563 million reduction in quali-
fying minority interests. Additional information regarding the Firm’s capital
ratios and the federal regulatory capital standards to which it is subject is pre-
sented in Note 26 on pages 129–130 of this Annual Report.
Basel II
The Basel Committee on Banking Supervision published the new Basel II
Framework in 2004 in an effort to update the original international bank capital
accord (“Basel I”), which has been in effect since 1988. The goal of the Basel II
Framework is to make regulatory capital more risk-sensitive, and promote
enhanced risk management practices among large, internationally active bank-
ing organizations.
U.S. banking regulators are in the process of incorporating the Basel II Framework
into the existing risk-based capital requirements. JPMorgan Chase will be
required to implement advanced measurement techniques in the U.S., commenc-
ing in 2009, by employing internal estimates of certain key risk drivers to derive
capital requirements. Prior to its implementation of the new Basel II Framework,
JPMorgan Chase will be required to demonstrate to its U.S. bank supervisors that
its internal criteria meet the relevant supervisory standards. JPMorgan Chase
expects to be in compliance within the established timelines with all relevant
Basel II rules. During 2007 and 2008, the Firm will adopt Basel II rules in certain
non-U.S. jurisdictions, as required.
Dividends
The Firm’s common stock dividend policy reflects JPMorgan Chase’s earnings out-
look, desired dividend payout ratios, need to maintain an adequate capital level
and alternative investment opportunities. In 2006, JPMorgan Chase declared
quarterly cash dividends on its common stock of $0.34 per share. The Firm con-
tinues to target a dividend payout ratio of 30-40% of net income over time.