Management’s discussion and analysis
142 JPMorgan Chase & Co./2013 Annual Report
JPMorgan Chase & Co./2013 Annual Report 143
The following table summarizes by LOB the predominant business activities that give rise to market risks, and the market risk management tools utilized to manage those risks; CB is not presented in the table below as it does not give rise to significant market risk.
Risk identification and classification for business activities
LOB
Predominant business activities and related market risks
Positions included in Risk Management VaR
Positions included in other risk measures (Not included in Risk Management VaR)(a)(b)
CIB • Makes markets and services its clients’ activity in products across fixed income, foreign exchange, equities and commodities
• Market risk arising from market making and other derivatives activities which may lead to a potential decline in net income as a result of changes in market prices; e.g. rates and credit spreads
• Trading assets/liabilities - debt and equity instruments, and derivatives
• Certain securities purchased under resale agreements and securities borrowed
• Certain securities loaned or sold under repurchase agreements
• Structured notes, see Note 4 on pages 215-218 of this Annual Report
• Derivative CVA
• Hedges of the retained loan portfolio and CVA, classified as derivatives
• Principal investing activities
• Retained loan portfolio
• Deposits
CCB • Origination and servicing of mortgage loans
• Complex, non-linear interest rate risks, as well as basis risk
• Non-linear risk arises primarily from prepayment options embedded in mortgages and changes in the probability of newly originated mortgage commitments actually closing
• Basis risk results from differences in the relative movements of the rate indices underlying mortgage exposure and other interest rates
Mortgage Banking
• Mortgage pipeline loans, classified as derivatives
• Warehouse loans, classified as trading assets - debt instruments
• MSRs
• Hedges of the MSRs and loans, classified as derivatives
• Interest only securities, classified as trading assets and related hedges classified as derivatives
• Retained loan portfolio
• Deposits
Corporate/
Private equity
• Predominantly responsible for managing the Firm’s liquidity, funding, structural interest rate and foreign exchange risks arising from activities undertaken by the Firm’s four major reportable business segments, as well as executing the Firm’s capital plan
Treasury and CIO
• Primarily derivative positions measured at fair value through earnings, classified as derivatives
• Private Equity
• Investment securities portfolio and related hedges
• Deposits
• Long-term debt and related hedges
AM • Market risk arising from the Firm’s initial capital investments in products, such as mutual funds, which are managed by AM
• Hedges of seed capital investments, classified as derivatives
• Initial seed capital investments
• Capital invested alongside third-party investors, typically in privately distributed collective vehicles managed by AM (i.e., Co-Investments)
• Retained loan portfolio
• Deposits
(a) Additional market risk positions result from debit valuation adjustments (“DVA”) taken on structured notes and derivative liabilities to reflect the credit quality of the Firm. Neither DVA nor the additional market risk positions resulting from it are included in VaR.
(b) During the fourth quarter of 2013, the Firm implemented a funding valuation adjustment (“FVA”) framework in order to incorporate the impact of funding into its valuation estimates for OTC derivatives and structured notes. FVA gives rise to additional market risk positions, and is not currently included in VaR.
Effective in the first quarter of 2014, the FVA market risk exposure and its associated hedges will be included in CIB’s average VaR.
Management’s discussion and analysis
144 JPMorgan Chase & Co./2013 Annual Report
Value-at-risk
JPMorgan Chase utilizes VaR, a statistical risk measure, to estimate the potential loss from adverse market moves in a normal market environment consistent with the day-to-day risk decisions made by the lines of business.
The Firm has one overarching VaR model framework, Risk Management VaR, used for risk management purposes across the Firm, which utilizes historical simulation based on data for the previous 12 months. The framework’s approach assumes that historical changes in market values are representative of the distribution of potential outcomes in the immediate future. The Firm believes the use of Risk Management VaR provides a stable measure of VaR that closely aligns to the day-to-day risk management decisions made by the lines of business and provides necessary/
appropriate information to respond to risk events on a daily basis.
Risk Management VaR is calculated assuming a one-day holding period and an expected tail-loss methodology which approximates a 95% confidence level. This means that, assuming current changes in market values are consistent with the historical changes used in the simulation, the Firm would expect to incur VaR “band breaks,” defined as losses greater than that predicted by VaR estimates, not more than five times every 100 trading days. The number of VaR band breaks observed can differ from the statistically expected number of band breaks if the current level of market volatility is materially different from the level of market volatility during the twelve months of historical data used in the VaR calculation.
Underlying the overall VaR model framework are individual VaR models that simulate historical market returns for individual products and/or risk factors. To capture material market risks as part of the Firm’s risk management framework, comprehensive VaR model calculations are performed daily for businesses whose activities give rise to market risk. These VaR models are granular and incorporate numerous risk factors and inputs to simulate daily changes in market values over the historical period; inputs are selected based on the risk profile of each portfolio as sensitivities and historical time series used to generate daily market values may be different across product types or risk management systems. The VaR model results across all portfolios are aggregated at the Firm level.
Data sources used in VaR models may be the same as those used for financial statement valuations. However, in cases where market prices are not observable, or where proxies are used in VaR historical time series, the sources may differ. In addition, the daily market data used in VaR models may be different than the independent third-party data collected for VCG price testing in their monthly valuation process (see pages 196–200 of this Annual Report for further information on the Firm’s valuation process.) VaR model calculations require more timely (i.e., daily) data and a consistent source for valuation and therefore it is not
practical to use the data collected in the VCG monthly valuation process.
VaR provides a consistent framework to measure risk profiles and levels of diversification across product types and is used for aggregating risks across businesses and monitoring limits. These VaR results are reported to senior management, the Board of Directors and regulators.
Since VaR is based on historical data, it is an imperfect measure of market risk exposure and potential losses, and it is not used to estimate the impact of stressed market conditions or to manage any impact from potential stress events. In addition, based on their reliance on available historical data, limited time horizons, and other factors, VaR measures are inherently limited in their ability to measure certain risks and to predict losses, particularly those associated with market illiquidity and sudden or severe shifts in market conditions. As VaR cannot be used to determine future losses in the Firm’s market risk positions, the Firm considers other metrics, such as economic-value stress testing and other techniques, as described further below, to capture and manage its market risk positions under stressed scenarios.
For certain products, specific risk parameters are not captured in VaR due to the lack of inherent liquidity and availability of appropriate historical data. The Firm uses proxies to estimate the VaR for these and other products when daily time series are not available. It is likely that using an actual price-based time series for these products, if available, would affect the VaR results presented. The Firm uses alternative methods to capture and measure those risk parameters that are not otherwise captured in VaR, including economic-value stress testing, nonstatistical measures and risk identification for large exposures as described further below.
The Firm’s VaR model calculations are continuously evaluated and enhanced in response to changes in the composition of the Firm’s portfolios, changes in market conditions, improvements in the Firm’s modeling techniques and other factors. Such changes will also affect historical comparisons of VaR results. Model changes go through a review and approval process by the Model Review Group prior to implementation into the operating environment.
For further information, see Model risk on page 153 of this Annual Report.
Separately, the Firm calculates a daily aggregated VaR in accordance with regulatory rules (“Regulatory VaR”), which is used to derive the Firm’s regulatory VaR-based capital requirements under the Basel 2.5 Market Risk Rule (“Basel 2.5”). This Regulatory VaR model framework currently assumes a ten business-day holding period and an expected tail loss methodology which approximates a 99%
confidence level. Regulatory VaR is applied to “covered”
positions as defined by Basel 2.5, which may be different than the positions included in the Firm’s Risk Management VaR. For example, credit derivative hedges of accrual loans
JPMorgan Chase & Co./2013 Annual Report 145
are included in the Firm’s Risk Management VaR, while Regulatory VaR excludes these credit derivative hedges.
For additional information on Regulatory VaR and the other components of market risk regulatory capital (e.g. VaR-based measure, stressed VaR-VaR-based measure and the respective backtesting) for the Firm, see JPMorgan Chase’s
“Regulatory Capital Disclosures – Market Risk Pillar 3 Report” which are available on the Firm’s website (http://
investor.shareholder.com/jpmorganchase/basel.cfm) and Capital Management on pages 160–167 of this Annual Report.
The table below shows the results of the Firm’s Risk Management VaR measure using a 95% confidence level.
Total VaR
As of or for the year ended December 31, 2013 2012 At December 31,
(in millions) Avg. Min Max Avg. Min Max 2013 2012
CIB trading VaR by risk type
Fixed income $ 43 (a) $ 23 $ 62 $ 83 (a) $ 47 $ 131 $ 36 (a) $ 69 (a)
Foreign exchange 7 5 11 10 6 22 9 8
Equities 13 9 21 21 12 35 14 22
Commodities and other 14 11 18 15 11 27 13 15
Diversification benefit to CIB trading VaR (34)(b) NM (c) NM (c) (45)(b) NM (c) NM (c) (36)(b) (39)(b)
CIB trading VaR 43 21 66 84 50 128 36 75
Credit portfolio VaR 13 10 18 25 16 42 11 18
Diversification benefit to CIB VaR (9)(b) NM (c) NM (c) (13)(b) NM (c) NM (c) (5)(b) (9)(b)
CIB VaR 47 (a)(e) 25 74 96 (a)(e) 58 142 42 (a)(e) 84 (a)(e)
Mortgage Banking VaR 12 4 24 17 8 43 5 24
Treasury and CIO VaR (f) 6 (a) 3 14 92 (d) 5 (d) 196 (d) 4 6
Asset Management VaR 4 2 5 2 — (g) 5 3 2
Diversification benefit to other VaR (8)(b) NM (c) NM (c) (10)(b) NM (c) NM (c) (5)(b) (7)(b)
Other VaR 14 6 28 101 18 204 7 25
Diversification benefit to CIB and other VaR (9)(b) NM (c) NM (c) (45)(b) NM (c) NM (c) (5)(b) (11)(b)
Total VaR $ 52 $ 29 $ 87 $ 152 $ 93 $ 254 $ 44 $ 98
(a) On July 2, 2012, CIO transferred its synthetic credit portfolio, other than a portion aggregating approximately $12 billion notional, to CIB; CIO’s retained portfolio was effectively closed out during the three months ended September 30, 2012.
(b) Average portfolio VaR and period-end portfolio VaR were less than the sum of the VaR of the components described above, which is due to portfolio diversification. The diversification effect reflects the fact that risks are not perfectly correlated.
(c) Designated as not meaningful (“NM”), because the minimum and maximum may occur on different days for distinct risk components, and hence it is not meaningful to compute a portfolio-diversification effect.
(d) The Firm restated its 2012 first quarter financial statements regarding the CIO synthetic credit portfolio. The CIO VaR amounts for 2012 were not recalculated to reflect the restatement.
(e) Effective in the fourth quarter of 2012, CIB’s VaR includes the VaR of the former reportable business segments, Investment Bank and Treasury & Securities Services (“TSS”), which were combined to form the CIB business segment as a result of the reorganization of the Firm’s business segments. TSS VaR was not material and was previously classified within Other VaR. Prior period VaR disclosures were not revised as a result of the business segment reorganization.
(f) The Treasury and CIO VaR includes Treasury VaR as of the third quarter of 2013.
(g) The minimum Asset Management VaR for 2012 was immaterial.
As presented in the table above, average Total VaR and average CIB VaR decreased during 2013 compared with 2012. These decreases were primarily driven by reduced risk in the synthetic credit portfolio and lower market volatility across multiple asset classes.
During the third quarter of 2012, the Firm applied a new VaR model to calculate VaR for CIO’s synthetic credit portfolio that had been transferred to the CIB on July 2, 2012. In the first quarter of 2013, in order to achieve consistency among like products within CIB and in conjunction with the implementation of Basel 2.5 requirements, the Firm moved CIO’s synthetic credit portfolio to an existing VaR model within the CIB. This change had an insignificant impact to the average fixed income VaR and average total CIB trading and credit portfolio VaR, and it had no impact to the average Total VaR compared with the model used in the third and fourth quarters of 2012.
Average Treasury and CIO VaR for the year ended December 31, 2013, decreased from 2012, predominantly reflecting the reduction in and transfer of risk from CIO’s synthetic credit portfolio to the CIB on July 2, 2012. The index credit derivative positions retained by CIO were effectively closed out during the three months ended September 30, 2012.
Average Mortgage Banking VaR for the year ended
December 31, 2013, decreased from 2012. The decrease is attributable to reduced risk across the Mortgage Production and Mortgage Servicing businesses.
The Firm’s average Total VaR diversification benefit was $9 million or 15% of the sum for 2013, compared with $45 million or 23% of the sum for 2012. In general, over the course of the year, VaR exposure can vary significantly as positions change, market volatility fluctuates and diversification benefits change.
Management’s discussion and analysis
146 JPMorgan Chase & Co./2013 Annual Report
VaR back-testing
The Firm evaluates the effectiveness of its VaR methodology by back-testing, which compares the daily Risk Management VaR results with the daily gains and losses recognized on market-risk related revenue.
Effective during the fourth quarter of 2013, the Firm revised its definition of market risk-related gains and losses to be consistent with the definition used by the banking regulators under Basel 2.5. Under this definition market risk-related gains and losses are defined as: profits and losses on the Firm’s Risk Management positions, excluding fees, commissions, fair value adjustments, net interest income, and gains and losses arising from intraday trading.
The following chart compares the daily market risk-related gains and losses on the Firm’s Risk Management positions for the year ended December 31, 2013, under the revised definition. As the chart presents market risk-related gains and losses related to those positions included in the Firm’s Risk Management VaR, the results in the table below differ from the results of backtesting disclosed in the Firm’s Basel 2.5 report, which are based on Regulatory VaR. The chart shows that for the year ended December 31, 2013, the Firm observed two VaR band breaks and posted gains on 177 of the 260 days in this period.
Prior to the fourth quarter of 2013, the Firm disclosed a histogram which presented the results of daily backtesting against its daily market risk-related gains and losses for positions included in the Firm’s Risk Management VaR calculation. Under this previous presentation, the market risk related revenue was defined as the change in value of:
principal transactions revenue for CIB, and Treasury and CIO; trading-related net interest income for CIB, Treasury and CIO, and Mortgage Production and Mortgage Servicing in CCB; CIB brokerage commissions, underwriting fees or
other revenue; revenue from syndicated lending facilities that the Firm intends to distribute; mortgage fees and related income for the Firm’s mortgage pipeline and warehouse loans, MSRs, and all related hedges; and market-risk related revenue from Asset Management hedges; gains and losses from DVA were excluded. Under this prior measure there were no VaR band breaks nor any trading loss days for the year ended December 31, 2013.
JPMorgan Chase & Co./2013 Annual Report 147
Other risk measures Economic-value stress testing
Along with VaR, stress testing is an important tool in measuring and controlling risk. While VaR reflects the risk of loss due to adverse changes in markets using recent historical market behavior as an indicator of losses, stress testing is intended to capture the Firm’s exposure to unlikely but plausible events in abnormal markets. The Firm runs weekly stress tests on market-related risks across the lines of business using multiple scenarios that assume significant changes in risk factors such as credit spreads, equity prices, interest rates, currency rates or commodity prices. The framework uses a grid-based approach, which calculates multiple magnitudes of stress for both market rallies and market sell-offs for each risk factor. Stress-test results, trends and explanations based on current market risk positions are reported to the Firm’s senior management and to the lines of business to allow them to better
understand the sensitivity of positions to certain defined events and to enable them to manage their risks with more transparency.
Stress scenarios are defined and reviewed by Market Risk, and significant changes are reviewed by the relevant Risk Committees. While most of the scenarios estimate losses based on significant market moves, such as an equity market collapse or credit crisis, the Firm also develops scenarios to quantify risk arising from specific portfolios or concentrations of risks, which attempt to capture certain idiosyncratic market movements. Scenarios may be redefined on an ongoing basis to reflect current market conditions. Ad hoc scenarios are run in response to specific market events or concerns. Furthermore, the Firm’s stress testing framework is utilized in calculating results under scenarios mandated by the Federal Reserve’s CCAR and ICAAP (“Internal Capital Adequacy Assessment Process”) processes.
Nonstatistical risk measures
Nonstatistical risk measures include sensitivities to variables used to value positions, such as credit spread sensitivities, interest rate basis point values and market values. These measures provide granular information on the Firm’s market risk exposure. They are aggregated by line-of-business and by risk type, and are used for tactical control and monitoring limits.
Loss advisories and profit and loss drawdowns Loss advisories and profit and loss drawdowns are tools used to highlight trading losses above certain levels of risk tolerance. Profit and loss drawdowns are defined as the decline in net profit and loss since the year-to-date peak revenue level.
Risk identification for large exposures
Individuals who manage risk positions consider potential material losses that could arise from specific, unusual events, such as a potential change in tax legislation, or a particular combination of unusual market moves. This information allows the Firm to monitor further earnings vulnerability that is not adequately covered by standard risk measures.
Earnings-at-risk
The VaR and stress-test measures described above illustrate the total economic sensitivity of the Firm’s Consolidated Balance Sheets to changes in market variables. The effect of interest rate exposure on reported net income is also important as interest rate risk represents one of the Firm’s significant market risks. Interest rate risk arises not only from trading activities but also from the Firm’s traditional banking activities, which include extension of loans and credit facilities, taking deposits and issuing debt. The CIO, Treasury and Corporate (“CTC”) Risk Committee establishes the Firm’s structural interest rate risk policies and market risk limits, which are subject to approval by the Risk Policy Committee of the Firm’s Board of Directors. CIO, working in partnership with the lines of business, calculates the Firm’s structural interest rate risk profile and reviews it with senior management including the CTC Risk Committee and the Firm’s ALCO.
Structural interest rate risk 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.
• Differences in the amounts of assets, liabilities and off-balance sheet instruments that are repricing at the same time.
• 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).
• The impact of changes in the maturity of various assets, liabilities or off-balance sheet instruments as interest rates change.
The Firm manages interest rate exposure related to its assets and liabilities on a consolidated, corporate-wide basis. Business units transfer their interest rate risk to Treasury through a transfer-pricing system, 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 experience, interest rate reset dates and maturities, rate indices used for repricing, and any interest rate ceilings or floors for adjustable rate products. All transfer-pricing assumptions are dynamically reviewed.
Oversight of structural interest rate risk is managed through a dedicated risk function reporting to the CTC CRO. This risk function is responsible for providing independent oversight,