Country risk is the risk that a sovereign event or action alters the value or terms of contractual obligations of obligors, counterparties and issuers, or adversely impacts markets related to a country. The Firm has a comprehensive country risk management framework for assessing country risks, determining risk tolerance, and measuring and monitoring direct country exposures in the Firm. The Country Risk Management group is responsible for
developing guidelines and policy for managing country risk in both emerging and developed countries. The Country Risk Management group actively monitors the various portfolios giving rise to country risk to ensure the Firm’s country risk exposures are diversified and that exposure levels are appropriate given the Firm’s strategy and risk tolerance relative to a country.
Country risk organization
The Country Risk Management group is an independent risk management function which works in close partnership with other risk functions to identify and monitor country risk within the Firm. The Firmwide Risk Executive for Country Risk reports to the Firm’s CRO.
Country Risk Management is responsible for the following functions:
• Developing guidelines and policies consistent with a comprehensive country risk framework
• Assigning sovereign ratings and assessing country risks
• Measuring and monitoring country risk exposure and stress across the Firm
• Managing country limits and reporting trends and limit breaches to senior management
• Developing surveillance tools for early identification of potential country risk concerns
• Providing country risk scenario analysis Country risk identification and measurement
The Firm is exposed to country risk through its lending, investing, and market-making activities, whether cross-border or locally funded. Country exposure includes activity with both government and private-sector entities in a country. Under the Firm’s internal country risk management approach, country exposure is reported based on the country where the majority of the assets of the obligor, counterparty, issuer or guarantor are located or where the majority of its revenue is derived, which may be different than the domicile (legal residence) or country of
incorporation of the obligor, counterparty, issuer or guarantor. Country exposures are generally measured by considering the Firm’s risk to an immediate default of the counterparty or obligor, with zero recovery. Assumptions are sometimes required in determining the measurement and allocation of country exposure, particularly in the case of certain tranched credit derivatives. Different
measurement approaches or assumptions would affect the amount of reported country exposure.
Under the Firm’s internal country risk measurement framework:
• Lending exposures are measured at the total committed amount (funded and unfunded), net of the allowance for credit losses and cash and marketable securities collateral received
• Securities financing exposures are measured at their receivable balance, net of collateral received
• Debt and equity securities are measured at the fair value of all positions, including both long and short positions
• Counterparty exposure on derivative receivables,
including credit derivative receivables, is measured at the derivative’s fair value, net of the fair value of the related collateral
• Credit derivatives protection purchased and sold is reported based on the underlying reference entity and is measured at the notional amount of protection purchased or sold, net of the fair value of the recognized derivative receivable or payable. Credit derivatives protection purchased and sold in the Firm’s market-making activities is presented on a net basis, as such activities often result in selling and purchasing protection related to the same underlying reference entity; this reflects the manner in which the Firm manages these exposures
The Firm also has indirect exposures to country risk (for example, related to the collateral received on securities financing receivables or related to client clearing activities).
These indirect exposures are managed in the normal course of business through the Firm’s credit, market, and
operational risk governance, rather than through Country Risk Management.
The Firm’s internal country risk reporting differs from the reporting provided under FFIEC bank regulatory
requirements as there are significant differences in reporting methodology. For further information on the FFIEC’s reporting methodology, see Cross-border outstandings on page 357 of the 2013 Form 10-K.
Management’s discussion and analysis
150 JPMorgan Chase & Co./2013 Annual Report
Country risk stress testing
The country risk stress framework aims to identify potential losses arising from a country crisis by capturing the impact of large asset price movements in a country based on market shocks combined with counterparty specific
assumptions. Country Risk Management periodically defines and runs ad hoc stress scenarios for individual countries in response to specific market events and sector performance concerns.
Country risk monitoring and control
The Country Risk Management Group establishes guidelines for sovereign ratings reviews and limit management.
Country stress and nominal exposures are measured under a comprehensive country limit framework. Country ratings and limits activity are actively monitored and reported on a regular basis. Country limit requirements are reviewed and approved by senior management as often as necessary, but at least annually. In addition, the Country Risk Management group uses surveillance tools for early identification of potential country risk concerns, such as signaling models and ratings indicators.
Country risk reporting
The following table presents the Firm’s top 20 exposures by country (excluding the U.S.). The selection of countries is based solely on the Firm’s largest total exposures by country, based on the Firm’s internal country risk
management approach, and does not represent the Firm’s view of any actual or potentially adverse credit conditions.
Top 20 country exposures
December 31, 2013 (in billions) Lending(a)
Trading and investing(b)(c) Other(d)
Total exposure
United Kingdom $ 34.4 $ 43.5 $ 1.4 $ 79.3
Germany 13.0 29.1 0.2 42.3
Netherlands 5.3 25.5 2.6 33.4
France 13.9 17.0 — 30.9
Switzerland 19.9 1.7 0.6 22.2
Canada 13.8 5.4 0.2 19.4
Australia 7.4 11.3 — 18.7
China 11.1 3.9 0.7 15.7
Brazil 5.7 5.6 — 11.3
India 6.8 3.8 0.1 10.7
Hong Kong 3.8 3.5 1.7 9.0
Korea 4.8 2.9 — 7.7
Italy 3.4 4.0 — 7.4
Singapore 3.4 2.0 1.3 6.7
Mexico 2.3 4.4 — 6.7
Japan 3.9 2.6 — 6.5
Sweden 1.8 4.0 0.1 5.9
Russia 4.7 0.7 — 5.4
Spain 3.2 1.3 — 4.5
Malaysia 2.4 1.5 0.6 4.5
(a) Lending includes loans and accrued interest receivable, net of collateral and the allowance for loan losses, deposits with banks, acceptances, other monetary assets, issued letters of credit net of participations, and undrawn commitments to extend credit. Excludes intra-day and operating exposures, such as from settlement and clearing activities.
(b) Includes market-making inventory, securities held in AFS accounts and hedging.
(c) Includes single-name and index and tranched credit derivatives for which one or more of the underlying reference entities is in a country listed in the above table.
(d) Includes capital invested in local entities and physical commodity inventory.
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Selected European exposure
Notwithstanding the economic and fiscal situation in Europe showing signs of stabilization, with Spain and Ireland exiting their bail out programs and some encouraging progress on financial reform, the Firm continues to closely monitor its exposures in Spain, Italy, Ireland, Portugal and Greece. Management believes its exposure to these five countries is modest relative to the Firm’s aggregate exposures. The Firm continues to conduct business and support client activity in these countries and, therefore, the Firm’s aggregate net exposures and sector distribution may vary over time. In addition, the net exposures may be affected by changes in market conditions, including the effects of interest rates and credit spreads on market valuations.
The following table presents the Firm’s direct exposure to Spain, Italy, Ireland, Portugal and Greece at December 31, 2013, as measured under the Firm’s internal country risk management approach. For individual exposures, corporate clients represent approximately 93% of the Firm’s non-sovereign exposure in these five countries, and substantially all of the remaining 7% of the non-sovereign exposure is to the banking sector.
December 31, 2013 Lending net of
Allowance(a) AFS securities Trading(b)
Derivative collateral(c)
Portfolio
hedging(d) Total exposure (in billions)
Spain
Sovereign $ — $ 0.5 $ (0.2) $ — $ (0.2) $ 0.1
Non-sovereign 3.2 — 3.3 (1.9) (0.2) 4.4
Total Spain exposure $ 3.2 $ 0.5 $ 3.1 $ (1.9) $ (0.4) $ 4.5
Italy
Sovereign $ — $ — $ 8.0 $ (1.0) $ (4.3) $ 2.7
Non-sovereign 3.4 — 3.0 (1.1) (0.6) 4.7
Total Italy exposure $ 3.4 $ — $ 11.0 $ (2.1) $ (4.9) $ 7.4
Ireland
Sovereign $ — $ — $ — $ — $ (0.1) $ (0.1)
Non-sovereign 0.2 — 0.5 (0.1) — 0.6
Total Ireland exposure $ 0.2 $ — $ 0.5 $ (0.1) $ (0.1) $ 0.5
Portugal
Sovereign $ — $ — $ 0.1 $ — $ — $ 0.1
Non-sovereign 0.5 — 0.9 (0.4) (0.1) 0.9
Total Portugal exposure $ 0.5 $ — $ 1.0 $ (0.4) $ (0.1) $ 1.0
Greece
Sovereign $ — $ — $ 0.1 $ — $ — $ 0.1
Non-sovereign 0.1 — 0.5 (0.5) — 0.1
Total Greece exposure $ 0.1 $ — $ 0.6 $ (0.5) $ — $ 0.2
Total exposure $ 7.4 $ 0.5 $ 16.2 $ (5.0) $ (5.5) $ 13.6
(a) Lending includes loans and accrued interest receivable, deposits with banks, acceptances, other monetary assets, issued letters of credit net of participations, and undrawn commitments to extend credit. Excludes intra-day and operating exposures, such as from settlement and clearing activities.
Amounts are presented net of the allowance for credit losses of $100 million (Spain), $43 million (Italy), $6 million (Ireland), $19 million (Portugal), and
$13 million (Greece) specifically attributable to these countries. Includes $3.0 billion of unfunded lending exposure at December 31, 2013. These exposures consist typically of committed, but unused corporate credit agreements, with market-based lending terms and covenants.
(b) Primarily includes: $13.9 billion of counterparty exposure on derivative and securities financings, $1.6 billion of issuer exposure on debt and equity securities. Securities financings of approximately $25.2 billion were collateralized with approximately $27.5 billion of cash and marketable securities as of December 31, 2013.
(c) Includes cash and marketable securities pledged to the Firm, of which approximately 95% of the collateral was cash at December 31, 2013.
(d) Reflects net protection purchased through the Firm’s credit portfolio management activities, which are managed separately from its market-making activities. Predominantly includes single-name CDS and also includes index credit derivatives and short bond positions.
Management’s discussion and analysis
152 JPMorgan Chase & Co./2013 Annual Report
Effect of credit derivatives on selected European exposures
Country exposures in the Selected European exposure table above have been reduced by purchasing protection through single name, index, and tranched credit derivatives. The following table presents the effect of purchased and sold credit derivatives on the trading and portfolio hedging activities in the Selected European exposure table.
December 31, 2013 Trading Portfolio hedging
(in billions) Purchased Sold Net Purchased Sold Net
Spain $ (92.5) $ 92.3 $ (0.2) $ (7.8) $ 7.4 $ (0.4)
Italy (139.7) 140.9 1.2 (23.6) 18.7 (4.9)
Ireland (7.2) 7.1 (0.1) (0.7) 0.6 (0.1)
Portugal (32.9) 33.2 0.3 (2.8) 2.7 (0.1)
Greece (7.7) 7.7 — (0.7) 0.7 —
Total $ (280.0) $ 281.2 $ 1.2 $ (35.6) $ 30.1 $ (5.5)
Under the Firm’s internal country risk management approach, credit derivatives are generally reported based on the country where the majority of the assets of the reference entity are located. Exposures are measured assuming that all of the reference entities in a particular country default simultaneously with zero recovery. For example, single-name and index credit derivatives are measured at the notional amount, net of the fair value of the derivative receivable or payable. Exposures for index credit derivatives, which may include several underlying reference entities, are determined by evaluating the relevant country for each of the reference entities underlying the named index, and allocating the applicable amount of the notional and fair value of the index credit derivative to each of the relevant countries. Tranched credit derivatives are measured at the modeled change in value of the derivative assuming the simultaneous default of all underlying reference entities in a specific country; this approach considers the tranched nature of the derivative (i.e., that some tranches are subordinate to others) and the Firm’s own position in the structure.
The “Total” line in the table above represents the simple sum of the individual countries. Changes in the Firm’s methodology or assumptions would produce different results.
The credit derivatives reflected in the “Portfolio hedging”
column are predominantly single-name CDS used in the Firm’s credit portfolio management activities, which are intended to mitigate the credit risk associated with traditional lending activities and derivative counterparty
exposure. The effectiveness of the Firm’s CDS protection as a hedge of the Firm’s exposures may vary depending upon a number of factors, including the maturity of the Firm’s CDS protection, the named reference entity, and the contractual terms of the CDS. For further information about credit derivatives see Credit derivatives on pages 137–138, and Note 6 on pages 220–233 of this Annual Report.
The Firm’s net presentation of purchased and sold credit derivatives reflects the manner in which this exposure is managed, and reflects, in the Firm’s view, the substantial mitigation of market and counterparty credit risk in its credit derivative activities. Market risk is substantially mitigated because market-making activities, and to a lesser extent, hedging activities, often result in selling and purchasing protection related to the same underlying reference entity. For example, for each of the five named countries as of December 31, 2013, the protection sold by the Firm was more than 94% offset by protection
purchased on the identical reference entity.
In addition, counterparty credit risk has also been
substantially mitigated by the master netting and collateral agreements in place for these credit derivatives. As of December 31, 2013, 100% of the purchased protection presented in the table above is purchased under contracts that require posting of cash collateral; 88% is purchased from investment-grade counterparties domiciled outside of the selected European countries; and 68% of the protection purchased offsets protection sold on the identical reference entity, with the identical counterparty subject to a master netting agreement.
JPMorgan Chase & Co./2013 Annual Report 153
MODEL RISK MANAGEMENT
Model risk
The Firm uses models, for many purposes, but primarily for the measurement, monitoring and management of risk positions. Valuation models are employed by the Firm to value certain financial instruments which cannot otherwise be valued using quoted prices. These valuation models may also be employed as inputs to risk management models, including VaR and economic stress models. The Firm also makes use of models for a number of other purposes, including the calculation of regulatory capital requirements and estimating the allowance for credit losses.
Models are owned by various functions within the Firm based on the specific purposes of such models. For
example, VaR models and certain regulatory capital models are owned by the line-of-business aligned risk management functions. Owners of models are responsible for the development, implementation and testing of their models, as well as referral of models to the Model Risk function (within the Model Risk and Development unit) for review and approval. Once models have been approved, model owners are responsible for the maintenance of a robust operating environment and must monitor and evaluate the performance of the models on an ongoing basis. Model owners may seek to enhance models in response to changes in the portfolios and for changes in product and market developments, as well as to capture improvements in available modeling techniques and systems capabilities.
The Model Risk function is part of the Firm’s Model Risk and Development unit, which in turn reports to the Chief Risk Officer. The Model Risk function is independent of the model owners and reviews and approves a wide range of models, including risk management, valuation and certain
regulatory capital models used by the Firm.
Models are tiered based on an internal standard according to their complexity, the exposure associated with the model and the Firm’s reliance on the model. This tiering is subject to the approval of the Model Risk function. A model review conducted by the Model Risk function considers the model’s
suitability for the specific uses to which it will be put. The factors considered in reviewing a model include whether the model accurately reflects the characteristics of the product and its significant risks, the selection and reliability of model inputs, consistency with models for similar products, the appropriateness of any model-related adjustments, and sensitivity to input parameters and assumptions that cannot be observed from the market. When reviewing a model, the Model Risk function analyzes and challenges the model methodology and the reasonableness of model assumptions and may perform or require additional testing, including back-testing of model outcomes. Model reviews are approved by the appropriate level of management within the Model Risk function based on the relevant tier of the model.
Under the Firm’s model risk policy, new models, as well as material changes to existing models, are reviewed and approved by the Model Risk function prior to
implementation in the operating environment.
In the event that the Model Risk function does not approve a model, the model owner is required to remediate the model within a time period agreed upon with the Model Risk function. The model owner is also required to resubmit the model for review to the Model Risk function and to take appropriate actions to mitigate the model risk if it is to be used in the interim. These actions will depend on the model and may include, for example, limitation of trading activity.
The Firm may also implement other appropriate risk measurement tools to augment the model that is subject to remediation.
Exceptions to the Firm’s model risk policy may be granted by the head of the Model Risk function to allow a model to be used prior to review or approval.
For a summary of valuations based on models, see Critical Accounting Estimates Used by the Firm on pages 176–177 and Note 3 on pages 195–215 of this Annual Report.
Management’s discussion and analysis
154 JPMorgan Chase & Co./2013 Annual Report