JPMorgan Chase & Co./2014 Annual Report 131
Management’s discussion and analysis
132 JPMorgan Chase & Co./2014 Annual Report
The following table summarizes by LOB the predominant business activities that give rise to market risk, 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)
CIB • Makes markets and services clients across fixed income, foreign exchange, equities and commodities
• Market risk arising from a potential decline in net income as a result of changes in market prices; e.g. rates and credit spreads
• Market risk(a) related to:
• Trading assets/liabilities - debt and equity instruments, and derivatives, including hedges of the retained loan portfolio and CVA
• Certain securities purchased under resale agreements and securities borrowed
• Certain securities loaned or sold under repurchase agreements
• Structured notes
• Derivative CVA
• Principal investing activities
• Retained loan portfolio
• Deposits
• DVA and FVA on derivatives and structured notes
CCB • Originates and services mortgage loans
• Complex, non-linear interest rate and 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 • Manages 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
Treasury and CIO
• Primarily derivative positions measured at fair value through earnings, classified as derivatives
• Private equity and other related investments
• 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, managed by AM
• Initial seed capital investments and related hedges classified as derivatives
• Capital invested alongside third-party investors, typically in privately distributed collective vehicles managed by AM (i.e., co-Investments)
• Retained loan portfolio
• Deposits
(a) Market risk for derivatives is generally measured after consideration of DVA and FVA on those positions; market risk for structured notes is generally measured without consideration to such adjustments.
JPMorgan Chase & Co./2014 Annual Report 133
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. The Firm has a single
overarching VaR model framework used for calculating Risk Management VaR and Regulatory VaR.
The framework is employed across the Firm using 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 Valuation process in Note 3 for further information on the Firm’s valuation process). VaR model calculations require 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. The Firm therefore considers other measures in addition to VaR, such as stress testing, to capture and manage its market risk positions.
In addition, 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 and nonstatistical measures as described further below.
The Firm’s VaR model calculations are periodically 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 139.
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 Basel III. 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 III, which may be different than the positions included in the Firm’s Risk Management VaR. For example, credit derivative hedges of accrual loans are included in the Firm’s Risk Management VaR, while Regulatory VaR excludes these credit derivative hedges. In addition, in contrast to the Firm’s Risk Management VaR, Regulatory VaR currently excludes the diversification benefit for certain VaR models.
Management’s discussion and analysis
134 JPMorgan Chase & Co./2014 Annual Report
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
Basel III Pillar 3 Regulatory Capital Disclosures reports, which are available on the Firm’s website (http://
investor.shareholder.com/jpmorganchase/basel.cfm).
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, 2014 2013 At December 31,
(in millions) Avg. Min Max Avg. Min Max 2014 2013
CIB trading VaR by risk type
Fixed income $ 34 $ 23 $ 45 $ 43 $ 23 $ 62 $ 34 $ 36
Foreign exchange 8 4 25 7 5 11 8 9
Equities 15 10 23 13 9 21 22 14
Commodities and other 8 5 14 14 11 18 6 13
Diversification benefit to CIB trading VaR (30)(a) NM (b) NM (b) (34)(a) NM (b) NM (b) (32)(a) (36)(a)
CIB trading VaR 35 24 49 43 21 66 38 36
Credit portfolio VaR 13 8 18 13 10 18 16 11
Diversification benefit to CIB VaR (8)(a) NM (b) NM (b) (9)(a) NM (b) NM (b) (9)(a) (5)(a)
CIB VaR 40 29 56 47 25 74 45 42
Mortgage Banking VaR 7 2 28 12 4 24 3 5
Treasury and CIO VaR (c) 4 3 6 6 3 14 4 4
Asset Management VaR 3 2 4 4 2 5 2 3
Diversification benefit to other VaR (4)(a) NM (b) NM (b) (8)(a) NM (b) NM (b) (3)(a) (5)(a)
Other VaR 10 5 27 14 6 28 6 7
Diversification benefit to CIB and other VaR (7)(a) NM (b) NM (b) (9)(a) NM (b) NM (b) (5)(a) (5)(a)
Total VaR $ 43 $ 30 $ 70 $ 52 $ 29 $ 87 $ 46 $ 44
(a) 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.
(b) 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.
(c) The Treasury and CIO VaR includes Treasury VaR as of the third quarter of 2013.
As presented in the table above, average Total VaR and average CIB VaR decreased during 2014, compared with 2013. The decrease in Total VaR was primarily due to risk reduction in CIB and Mortgage Banking as well as lower volatility in the historical one-year look-back period during 2014 versus 2013.
Average CIB trading VaR decreased during 2014 primarily due to lower VaR in Fixed Income (driven by unwinding of risk and redemptions in the synthetic credit portfolio, and lower volatility in the historical one-year look-back period) and to reduced risk positions in commodities.
Average Mortgage Banking VaR decreased during 2014 as a result of reduced exposures due to lower loan originations.
Average Treasury and CIO VaR decreased during 2014, compared with 2013. The decrease predominantly reflected the unwind and roll-off of certain marked to market
positions, and lower market volatility in the historical one-year look-back period.
The Firm’s average Total VaR diversification benefit was $7 million or 16% of the sum for 2014, compared with $9 million or 17% of the sum for 2013. In general, over the course of the year, VaR exposure can vary significantly as positions change, market volatility fluctuates and diversification benefits change.
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.
The Firm’s definition of market risk-related gains and losses is consistent with the definition used by the banking regulators under Basel III. 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, certain valuation adjustments (e.g., liquidity and DVA), net interest income, and gains and losses arising from intraday trading.
JPMorgan Chase & Co./2014 Annual Report 135
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, 2014. 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 Market Risk section of the
Firm’s Basel III Pillar 3 Regulatory Capital Disclosures reports, which are based on Regulatory VaR applied to covered positions. The chart shows that for the year ended December 31, 2014, the Firm observed five VaR band breaks and posted gains on 157 of the 260 days in this period.
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. 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.
Management’s discussion and analysis
136 JPMorgan Chase & Co./2014 Annual Report
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.
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 the Firm’s 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 Firm evaluates its structural interest rate risk exposure through earnings-at-risk, which measures the extent to which changes in interest rates will affect the Firm’s core net interest income (see page 78 for further discussion of core net interest income) and interest rate-sensitive fees.
Earnings-at-risk excludes the impact of trading activities and MSR, as these sensitivities are captured under VaR.
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. In addition, 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 and governance around assumptions; and establishing and monitoring limits for structural interest rate risk.
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.
The Firm manages structural interest rate risk generally through its investment securities portfolio and related derivatives.
The Firm conducts simulations of changes in structural interest rate-sensitive revenue under a variety of interest rate scenarios. Earnings-at-risk scenarios estimate the potential change in this revenue, and the corresponding impact to the Firm’s pretax core net interest income, over the following 12 months, utilizing multiple assumptions as described below. These scenarios highlight exposures to changes in interest rates, pricing sensitivities on deposits, optionality and changes in product mix. The scenarios include forecasted balance sheet changes, as well as prepayment and reinvestment behavior. Mortgage prepayment assumptions are based on current interest rates compared with underlying contractual rates, the time since origination, and other factors which are updated periodically based on historical experience.
JPMorgan Chase’s 12-month pretax core net interest income sensitivity profiles.
(Excludes the impact of trading activities and MSRs) Instantaneous change in rates
(in millions) +200 bps +100 bps -100 bps -200 bps December 31, 2014 $ 4,667 $ 2,864 NM (a) NM (a) (a) Downward 100- and 200-basis-points parallel shocks result in a
federal funds target rate of zero and negative three- and six-month U.S. Treasury rates. The earnings-at-risk results of such a low-probability scenario are not meaningful.
The Firm’s benefit to rising rates is largely a result of reinvesting at higher yields and assets re-pricing at a faster pace than deposits.
Additionally, another interest rate scenario used by the Firm
— involving a steeper yield curve with long-term rates rising by 100 basis points and short-term rates staying at current levels — results in a 12-month pretax core net interest income benefit of $566 million. The increase in core net interest income under this scenario reflects the Firm reinvesting at the higher long-term rates, with funding costs remaining unchanged.