JP Morgan Chase 2008 Annual Report Download - page 117

JPMorgan Chase & Co./ 2008 Annual Report 115
measure. In the Firm’s view, including these items in VaR produces a
more complete perspective of the Firm’s risk profile for items with
market risk that can impact the income statement. The Consumer
Lending VaR includes the Firm’s mortgage pipeline and warehouse
loans, MSRs and all related hedges.
The revised VaR measure continues to exclude the DVA taken on
derivative and structured liabilities to reflect the credit quality of the
Firm. It also excludes certain nontrading activity such as Private
Equity, principal investing (e.g., mezzanine financing, tax-oriented
investments, etc.) and Corporate balance sheet and capital manage-
ment positions, as well as longer-term corporate investments.
Corporate positions are managed through the Firm’s earnings-at-risk
and other cash flow monitoring processes rather than by using a VaR
measure. Nontrading principal investing activities and Private Equity
positions are managed using stress and scenario analyses.
Changing to the 95% confidence interval caused the average VaR to
drop by $85 million in the third quarter when the new measure was
implemented. Under the 95% confidence interval, the Firm would
expect to incur daily losses greater than those predicted by VaR esti-
mates about twelve times a year.
The following table provides information about the sensitivity of DVA
to a one basis point increase in JPMorgan Chase’s credit spreads. The
sensitivity of DVA at December 31, 2008, represents the Firm (includ-
ing Bear Stearns), while the sensitivity of DVA for December 31,
2007, represents heritage JPMorgan Chase only.
Debit Valuation Adjustment Sensitivity
1 Basis Point Increase in
(in millions) JPMorgan Chase Credit Spread
December 31, 2008 $ 32
December 31, 2007 $ 38
Loss advisories and drawdowns
Loss advisories and drawdowns are tools used to highlight to senior
management trading losses above certain levels and initiate discus-
sion of remedies.
Economic value stress testing
While VaR reflects the risk of loss due to adverse changes in normal
markets, stress testing captures the Firm’s exposure to unlikely but
plausible events in abnormal markets. The Firm conducts economic
value stress tests for both its trading and nontrading activities at
least every two weeks using multiple scenarios that assume credit
spreads widen significantly, equity prices decline and interest rates
rise in the major currencies. Additional scenarios focus on the risks
predominant in individual business segments and include scenarios
that focus on the potential for adverse moves in complex portfolios.
Periodically, scenarios are reviewed and updated to reflect changes in
the Firm’s risk profile and economic events. Along with VaR, stress
testing is important in measuring and controlling risk. Stress testing
enhances the understanding of the Firm’s risk profile and loss poten-
tial, and stress losses are monitored against limits. Stress testing is
also utilized in one-off approvals and cross-business risk measure-
ment, as well as an input to economic capital allocation. Stress-test
results, trends and explanations are provided at least every two
weeks to the Firm’s senior management and to the lines of business
to help them better measure and manage risks and understand
event risk-sensitive positions.
Earnings-at-risk stress testing
The VaR and stress-test measures described above illustrate the total
economic sensitivity of the Firm’s balance sheet to changes in market
variables. The effect of interest rate exposure on reported net income
is also important. Interest rate risk exposure in the Firm’s core non-
trading business activities (i.e., asset/liability management positions)
results from on- and off-balance sheet positions and can occur due
to a variety of factors, including:
• Differences in the timing among the maturity or repricing of
assets, liabilities and off-balance sheet instruments. For example,
if liabilities reprice quicker than assets and funding interest rates
are declining, earnings will increase initially.
• Differences in the amounts of assets, liabilities and off-balance
sheet instruments that are repricing at the same time. For exam-
ple, if more deposit liabilities are repricing than assets when gen-
eral interest rates are declining, earnings will increase initially.
• Differences in the amounts by which short-term and long-term
market interest rates change. For example, changes in the slope
of the yield curve because the Firm has the ability to lend at
long-term fixed rates and borrow at variable or short-term fixed
rates. Based upon these scenarios, the Firm’s earnings would be
affected negatively by a sudden and unanticipated increase in
short-term rates paid on its liabilities (e.g., deposits) without a
corresponding increase in long-term rates received on its assets
(e.g., loans). Conversely, higher long-term rates received on
assets generally are beneficial to earnings, particularly when the
increase is not accompanied by rising short-term rates paid on
liabilities.
• The impact of changes in the maturity of various assets, liabilities
or off-balance sheet instruments as interest rates change. For
example, if more borrowers than forecasted pay down higher rate
loan balances when general interest rates are declining, earnings
may decrease initially.
The Firm manages interest rate exposure related to its assets and lia-
bilities on a consolidated, corporate-wide basis. Business units trans-
fer their interest rate risk to Treasury through a transfer-pricing sys-
tem, which takes into account the elements of interest rate exposure
that can be risk-managed in financial markets. These elements
include asset and liability balances and contractual rates of interest,
contractual principal payment schedules, expected prepayment expe-
rience, interest rate reset dates and maturities, rate indices used for
re-pricing, and any interest rate ceilings or floors for adjustable rate
products. All transfer-pricing assumptions are dynamically reviewed.
The Firm conducts simulations of changes in net interest income
from its nontrading activities under a variety of interest rate scenar-
ios. Earnings-at-risk tests measure the potential change in the Firm’s
net interest income, and the corresponding impact to the Firm’s pre-