JP Morgan Chase 2006 Annual Report Download - page 66

64 JPMorgan Chase & Co. / 2005 Annual Report
CREDIT RISK MANAGEMENT
Credit risk is the risk of loss from obligor or counterparty default. The Firm
provides credit (for example, through loans, lending-related commitments and
derivatives) to customers of all sizes, from large corporate clients to the indi-
vidual consumer. The Firm manages the risk/reward relationship of each credit
and discourages the retention of assets that do not generate a positive return
above the cost of risk-adjusted capital. The majority of the Firm’s wholesale
syndicated loan originations (primarily to IB clients) continues to be distributed
into the marketplace, with residual holds by the Firm averaging less than
10%. Wholesale loans generated by CB and AM are generally retained on the
balance sheet. With regard to the consumer credit market, the Firm focuses on
creating a portfolio that is diversified from both a product and a geographic
perspective. Within the mortgage business, originated loans are retained on the
balance sheet as well as securitized and sold selectively to U.S. government
agencies and U.S. government-sponsored enterprises; the latter category of
loans is routinely classified as held-for-sale.
Credit risk organization
Credit risk management is overseen by the Chief Risk Officer. The Firm’s credit
risk management governance consists of the following primary functions:
• establishing a comprehensive credit risk policy framework
• calculating the allowance for credit losses and ensuring appropriate credit
risk-based capital management
• assigning and managing credit authorities in connection with the approval
of all credit exposure
• monitoring and managing credit risk across all portfolio segments
• managing criticized exposures
Risk identification
The Firm is exposed to credit risk through lending and capital markets activi-
ties. Credit risk management works in partnership with the business segments
in identifying and aggregating exposures across all lines of business.
Risk measurement
To measure credit risk, the Firm employs several methodologies for estimating
the likelihood of obligor or counterparty default. Losses generated by consumer
loans are more predictable than wholesale losses, but are subject to cyclical
and seasonal factors. Although the frequency of loss is higher on consumer
loans than on wholesale loans, the severity of loss is typically lower and more
manageable on a portfolio basis. As a result of these differences, methodolo-
gies vary depending on certain factors, including type of asset (e.g., consumer
installment versus wholesale loan), risk measurement parameters (e.g., delin-
quency status and credit bureau score versus wholesale risk rating) and risk
management and collection processes (e.g., retail collection center versus
centrally managed workout groups). Credit risk measurement is based upon
the amount of exposure should the obligor or the counterparty default, the
probability of default and the loss severity given a default event. Based upon
these factors and related market-based inputs, the Firm estimates both prob-
able and unexpected losses for the wholesale and consumer portfolios.
Probable losses, reflected in the Provision for credit losses, primarily are based
upon statistical estimates of credit losses over time, anticipated as a result of
obligor or counterparty default. However, probable losses are not the sole
indicators of risk. If losses were entirely predictable, the probable loss rate
could be factored into pricing and covered as a normal and recurring cost of
doing business. Unexpected losses, reflected in the allocation of credit risk
capital, represent the potential volatility of actual losses relative to the proba-
ble level of losses. (Refer to Capital management on pages 57–59 of this
Annual Report for a further discussion of the credit risk capital methodology.)
Risk measurement for the wholesale portfolio is assessed primarily on a risk-
rated basis; for the consumer portfolio, it is assessed primarily on a credit-
scored basis.
Risk-rated exposure
For portfolios that are risk-rated, probable and unexpected loss calculations
are based upon estimates of probability of default and loss given default.
Probability of default is the expected default calculated on an obligor basis.
Loss given default is an estimate of losses that are based upon collateral and
structural support for each credit facility. Calculations and assumptions are
based upon management information systems and methodologies which are
under continual review. Risk ratings are assigned and reviewed on an ongoing
basis by Credit Risk Management and revised, if needed, to reflect the borrowers’
current risk profiles and the related collateral and structural positions.
Credit-scored exposure
For credit-scored portfolios (generally held in RFS and CS), probable loss is
based upon a statistical analysis of inherent losses over discrete periods of
time. Probable losses are estimated using sophisticated portfolio modeling,
credit scoring and decision-support tools to project credit risks and establish
underwriting standards. In addition, common measures of credit quality derived
from historical loss experience are used to predict consumer losses. Other risk
characteristics evaluated include recent loss experience in the portfolios, changes
in origination sources, portfolio seasoning, loss severity and underlying credit
practices, including charge-off policies. These analyses are applied to the
Firm’s current portfolios in order to forecast delinquencies and severity of
losses, which determine the amount of probable losses. These factors and
analyses are updated on a quarterly basis.
Risk monitoring
The Firm has developed policies and practices that are designed to preserve
the independence and integrity of decision-making and ensure credit risks are
assessed accurately, approved properly, monitored regularly and managed
actively at both the transaction and portfolio levels. The policy framework
establishes credit approval authorities, concentration limits, risk-rating
methodologies, portfolio-review parameters and guidelines for management
of distressed exposure. Wholesale credit risk is monitored regularly on both
an aggregate portfolio level and on an individual customer basis. For con-
sumer credit risk, the key focus items are trends and concentrations at the
portfolio level, where potential problems can be remedied through changes in
underwriting policies and portfolio guidelines. Consumer Credit Risk
Management monitors trends against business expectations and industry
benchmarks. In order to meet credit risk management objectives, the Firm
seeks to maintain a risk profile that is diverse in terms of borrower, product
type, industry and geographic concentration. Additional management of the
Firm’s exposure is accomplished through loan syndication and participations,
loan sales, securitizations, credit derivatives, use of master netting agreements
and collateral and other risk-reduction techniques.
Risk reporting
To enable monitoring of credit risk and decision-making, aggregate credit
exposure, credit metric forecasts, hold-limit exceptions and risk profile
changes are reported regularly to senior credit risk management. Detailed
portfolio reporting of industry, customer and geographic concentrations
occurs monthly, and the appropriateness of the allowance for credit losses is
reviewed by senior management at least on a quarterly basis. Through the
risk reporting and governance structure, credit risk trends and limit exceptions
are provided regularly to, and discussed with, the Operating Committee.
MANAGEMENT’S DISCUSSION AND ANALYSIS
JPMorgan Chase & Co.