JP Morgan Chase 2010 Annual Report Download - page 104

Management’s discussion and analysis
104 JPMorgan Chase & Co./2010 Annual Report
tinue to adopt, based on various established timelines, Basel II rules
in certain non-U.S. jurisdictions, as required.
Basel III
In addition to the Basel II Framework, on December 16, 2010, the
Basel Committee issued the final version of the Capital Accord,
called “Basel III”, which included narrowing the definition of capi-
tal, increasing capital requirements for specific exposures, introduc-
ing short-term liquidity coverage and term funding standards, and
establishing an international leverage ratio. The Basel Committee
also announced higher capital ratio requirements under Basel III
which provide that the common equity requirement will be in-
creased to 7%, comprised of a minimum of 4.5% plus a 2.5%
capital conservation buffer.
In addition, the U.S. federal banking agencies have published for
public comment proposed risk-based capital floors pursuant to the
requirements of the Dodd-Frank Act to establish a permanent Basel
I floor under Basel II / Basel III capital calculations.
The Firm fully expects to be in compliance with the higher Basel III
capital standards when they become effective on January 1, 2019,
as well as additional Dodd-Frank Act capital requirements when
they are implemented. The Firm estimates that its Tier 1 common
ratio under Basel III rules (including the changes for calculating
capital on trading assets and securitizations) would be 7% as of
December 31, 2010. This estimate reflects the Firm’s current under-
standing of the Basel III rules and their application to its businesses
as currently conducted; accordingly, this estimate will evolve over
time as the Firm’s businesses change and as a result of further rule-
making on Basel III implementation from U.S. federal banking
agencies. The Firm also believes it may need to modify the current
liquidity profile of its assets and liabilities in response to the short-
term liquidity coverage and term funding standards contained in
Basel III. The Basel III revisions governing liquidity and capital
requirements are subject to prolonged observation and transition
periods. The observation period for the liquidity coverage ratio and
term funding standards begins in 2011, with implementation in
2015 and 2018, respectively. The transition period for banks to
meet the revised common equity requirement will begin in 2013,
with implementation on January 1, 2019. The Firm will continue to
monitor the ongoing rule-making process to assess both the timing
and the impact of Basel III on its businesses and financial condition.
Broker-dealer regulatory capital
JPMorgan Chase’s principal U.S. broker-dealer subsidiaries
are J.P. Morgan Securities LLC (“JPMorgan Securities”; formerly
J.P. Morgan Securities Inc.), and J.P. Morgan Clearing Corp.
(“JPMorgan Clearing”). JPMorgan Securities became a limited
liability company on September 1, 2010. JPMorgan Clearing is a
subsidiary of JPMorgan Securities and provides clearing and
settlement services. JPMorgan Securities and JPMorgan Clearing
are each subject to Rule 15c3-1 under the Securities Exchange
Act of 1934 (the “Net Capital Rule”). JPMorgan Securities and
JPMorgan Clearing are also registered as futures commission
merchants and subject to Rule 1.17 of the Commodity Futures
Trading Commission (“CFTC”).
JPMorgan Securities and JPMorgan Clearing have elected to compute
their minimum net capital requirements in accordance with the
“Alternative Net Capital Requirements” of the Net Capital Rule. At
December 31, 2010, JPMorgan Securities’ net capital, as defined by
the Net Capital Rule, was $6.9 billion, exceeding the minimum
requirement by $6.3 billion, and JPMorgan Clearing’s net capital was
$5.7 billion, exceeding the minimum requirement by $3.9 billion.
In addition to its minimum net capital requirement, JPMorgan
Securities is required to hold tentative net capital in excess of $1.0
billion and is also required to notify the Securities and Exchange
Commission (“SEC”) in the event that tentative net capital is less
than $5.0 billion, in accordance with the market and credit risk
standards of Appendix E of the Net Capital Rule. As of December
31, 2010, JPMorgan Securities had tentative net capital in excess of
the minimum and notification requirements.
Economic risk capital
JPMorgan Chase assesses its capital adequacy relative to the risks
underlying its business activities, using internal risk-assessment
methodologies. The Firm measures economic capital primarily
based on four risk factors: credit, market, operational and private
equity risk.
Economic risk capital
Yearly Average
Year ended December 31, (in billions)
20
10
200
9
Credit risk
$
49.7
$ 51.3
Market risk
15.1
15.4
Operational risk
7.
4
8.5
Private equity risk
6.2
4.7
Economic risk capital
78.4
79.9
Goodwill
48.
6
48.3
Other
(a)
34.5
17.7
Total common stockhol
d
ers’ equity
$
16
1.5
$ 145.9
(a) Reflects additional capital required, in the Firm’s view, to meet its regulatory
and debt rating objectives.
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 de-
fined in terms of unexpected credit losses, both from defaults and
from declines in the portfolio value due to credit deterioration
measured over a one-year period at a confidence level consistent
with an “AA” credit rating standard. Unexpected losses are losses
in excess of those for which allowances for credit losses are main-
tained. The capital methodology is based on several principal
drivers of credit risk: exposure at default (or loan-equivalent
amount), default likelihood, credit spreads, loss severity and portfo-
lio correlation.