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Case Study: Market risk Management at Chase Chase Manhattan…
Case Study: Market risk Management at Chase
Chase Manhattan (subsequent to the writing of this case, Chase acquired JP Morgan to form JP Morgan Chase), one of America’s largest banks, has a venerable history. It can trace its antecedents all the way back to a water-supply company founded in 1799, but the current institution is, by and large, the product of two mergers, each the largest in US banking history at the time. The first was the 1991 merger of Manufacturers Hanover and Chemical Bank; the second, the 1996 merger of Chase Manhattan (founded in 1877) and Chemical Bank (founded in 1823). This Chase Manhattan is a holding company operating three main lines of business:
1. The Global Bank, which offers commercial and investment banking services,
2. Global Services, which offers processing and settlement; and
3. National Consumer Services, which serves retail customers through a wide variety of financial products and services.
During the 1999 fiscal year, Chase boasted more than $400 billion in
assets, operating revenue of $23 billion (up 17 percent from $20 billion in 1998), operating earnings of $5.4 billion (up from $4.0 billion in 1998), and return on average common shareholders’ equity of 24 percent.
Chase attributes this performance to a number of factors. Prominent among these is a highly successful risk management system that emphasizes the creation of shareholder value and links it to employee compensation. It claims to view risk as a central aspect of its business and risk management as an area of competitive advantage. This assertion is supported by the fact that it devoted 19 of the 94 pages of its 1999 annual report to risk management. As the Chairman’s letter states:
Let me begin by stating the obvious: We are in the “risk” business, and managing risk smartly and proactively with sophisticated risk management systems can create significant strategic advantages.
This may be stating the obvious, but it certainly helps to set the tone for the organization. Risk management at Chase focuses on the following principles and activities:
Formal definition of risk management governance
Risk oversight independent of business units
Continual evaluation of risk appetite, communicated through risk limits
Diversification
Disciplined risk assessment and measurement, including Value-at-Risk analysis and portfolio stress testing
Allocation of economic capital to business units and measuring performance on the basis of shareholder value-added (SVA)
Three committees carry out the above activities: one dedicated to credit
risk, one to market risk, and one to capital. Their responsibilities are summarized in Figure 13.5, and each has decision-making authority within these areas. The Executive Committee, however, takes responsibility for major policy decisions, determines the company’s risk appetite, and formulates the company’s risks; it in turn reports to the Risk Policy Committee of the Board of Directors.
Chase’s Market Risk Management Group employed some 70 professionals around the world prior to its merger with JP Morgan. The group’s mandate is to develop appropriate risk measures, set and monitor limits, and keep the company’s risk profile within the boundaries of the risk appetite mandated by the Board. Part of the reason behind the team’s success is that it was born out of the global markets business, not from a traditional watchdog like audit, credit, or compliance. The market risk management approach also strives to balance business and risk management needs, and was developed by Don Layton and Lesley Daniels-Webster, both from the business side.
Development of the market risk group accelerated sharply with the 1996 Chase/Chemical merger. Daniels-Webster, now executive vice president and head of market risk management, said that the merger came at a fortuitous timetechnology had just reached the point where it was possible to take the huge book of business created by the merger and evaluate it from the bottom up, position by position. Neither company’s legacy systems were up to the job, however, and it was the bank’s willingness to spend heavily on new technology that proved critical.
The market risk group continues to enjoy the backing of Layton, now vice-chairman of global markets, and Marc Shapiro, vice-chairman of finance and risk. “Having these two senior people behind us gives us a lot of credibility, changing our role from one that’s there for the sake of the regulators to one that is there for adding value to the business units,” says John Duddy, a managing director of market risk management. The group manages the market risks generated on a number of different fronts:
Market risk in its trading portfolios due to changes in market prices and rates (i.e., interest rate risk, foreign exchange risk, equity risk, and commodity risk)
Asset/liability mismatch in its investment and commercial banking activities
Basis risk in trading, investment, and asset/liability activities
The bank recognizes that market risk measurement and management should extend across all three of these activities. It learned that lesson fairly cheaply back in 1994, according to Daniels-Webster. During that year, the Fed raised interest rates repeatedly and somewhat unexpectedly, with one result being considerable disruption in the market for mortgage-backed securities.
“What we found was that we were fine on the trading business side, but one of our small S&Ls [savings and loans] that was state chartered had invested its primary capital in MBSs [mortgage-backed securities],” says Daniels-Webster. “The financial impact was very small, but what turned out to be much bigger was that we learned that you can’t just look at a firm like Chase just in terms of trading activities.” That helped redefine market risk management in terms of the total economic return of an activity, not just its mark-to-market accounting valuationa definition that ties into Chase’s goal of pursuing and managing shareholder value.
Risk Measurement and Management
Chase does not believe there is a single statistic that captures all aspects of risk and therefore employs a number of complementary metrics. These include value-at-risk (VaR), stress-testing, and non-statistical measures such as net open positions, basis point values, option sensitivities, position concentration, and position turnover. These non-statistical measures provide extra information about the size and direction of risk exposures that can be particularly useful when the statistical measures break down (in anomalous market conditions, for example).
Chase views stress testing and value-at-risk as equally important in managing revenue volatility. Recognizing that value-at-risk numbers change relatively little once their calculation is well established, and say relatively little about the potential extremes of loss, Chase is more actively interested in stress tests. “Stress testing is the backbone of our risk management, not VaR,” says Duddy. “The beauty of VaR is that once you agree upon the statistical process, there’s nothing to argue about. With stress testing, it’s something that’s really evolving. It’s a very key part of our risk management tools to the extent that we allocate capital based on it.”
Stress tests are built around both actual events (e.g., the 1994 bond market sell-off, the 1994 Mexican peso crisis, and the 1998 liquidity crisis) and hypothetical economic scenarios. As of December 31, 1999, Chase was using six historical and five hypothetical scenarios to perform stress tests about once per month. The tests assume that no actions are taken during the event that change the company’s risk profile, a premise which simulates the decreased liquidity that is often seen during market crises. Each stress scenario is extremely detailed, specifying more than 11,000 individual shocks to market rates and prices and involving data on more than 60 countries. Stress tests are performed on all material trading, investment, and asset/ liability (A/L) portfolios. Chase believes that one key to successful stress testing is the continuous review and updating of scenarios to ensure that they remain relevant and are as detailed as possible.
Chase’s VaR methodology is based on historical simulation, reflecting a belief that historical changes in market indices are the best predictor of possible future changes. VaR calculations are performed daily on end-of-day positions, using the most recent one-year historical changes in market prices. The historical simulation is performed on individual positions as well as on aggregated positions by business, geography, currency, and type of risk. Because it realizes that historical VaR is dependent on the quality of the data available, Chase performs back tests for its VaR estimates against actual financial results and uses confidence intervals to examine the reasonableness of its VaR calculations.
The bank manages the market risks that it has measured through the use of various types of limits, approved by the Board of Directors as fall-ing in line with the risk appetite desired by the bank. The limit structure is specified at both the aggregate and business unit levels, going down as far as desk-level activities; it addresses authorized instruments, maximum tenors, statistical and non-statistical limits and loss advisories, and is based on rel-evant market analysis, market liquidity, prior track record, business strategy, and management experience and depth.
Risk limits are updated at least twice a year in order to reflect changes in trading strategies and market conditions. Chase uses stop-loss advisories to inform line management of losses that are being sustained. A review of the portfolio is automatically triggered if a Board-approved limit is breached. Chase believes that these procedures for tracking limits significantly reduce the likelihood that the daily VaR limit will be exceeded under normal mar-ket conditions.
Obstacles and Successes
One of the barriers to implementing the market risk program is the tension that arises naturally between risk managers and traders. This tension is usually a healthy one, ensuring that the bank balances business and risk objectives, but care must be taken to ensure that it does not turn into conflict or disregard for the rules. The problem tends to be at the desk level or below; senior business managers tend to understand and trust the risk managers more than those whose dominant concern is hitting their performance targets.
One way to deflate this problem is to make sure that risk management helps good, if complex, trades to get done, and does not just stop potentially troublesome ones. “We’re like cops. If someone tries to rob you and we’re there, you love us,” says Duddy. “But if you’re speeding and we catch you, you hate us.” If the risk managers can persuade the traders that they want them to make moneybut safelythey gain credibility.
A good example is unusually large transactions. “One-off trades undertaken for reasons of market opportunity or client demand usually involve hedging, structuring, and pricing issues such that we can either wring the risk out of it or price it smartly,” says Daniels-Webster. Balancing the academic smarts of the risk managers with the market experience of the business managers can reap great rewards in this respect.
The most obvious evidence of Chase’s success in implementing market risk management is the strength with which the company weathered the market turmoil of 1998. For that year, Chase reported earnings of $4.02 billion, up some 4.4 percent from the prior year. Chase had recorded
larger rises in other recent years, but the circumstances of 1998 made it remarkable that it posted any increase at all; many of its peers and competitors suffered significant losses.
Chase’s success in weathering the collapse of the Russian economy in 1998 can be attributed to two of the guiding principles of its risk management program: the value of learning from the past and the importance of stress testing. Until 1997, Chase had aimed to lose no more than $500 million in the event of market turbulence. That year, however, it lost around $100 million in Latin American trading. That alerted it to the possibility that losses might exceed $500 million fairly quickly under extreme market conditions, and that its risk exposure was therefore greater than it had believed. The company reset its target loss limit to $250 million. The second lesson that Chase gleaned from this incident was that financial blowups could be global in nature, contrary to the previous assumption that economic problems in one part of the world would be unlikely to affect the performance of financial positions in another part of the world.
This realization was, in turn, a factor in Chase’s decision to begin stress testing its entire trading and loan portfolio in late 1997, using scenarios that included global incidents. Stress testing using hypothetical scenarios enabled Chase to counterbalance the historical dependence implicit in its use of historical simulation in its VaR methodology. “We started doing these stress tests and got a number of about $500 million, which was a shock,” remembers Daniels-Webster. “We didn’t know what to do with such a large number except be skeptical of it.”
The tests were soon borne out, however, as the economies of South-East Asia started to nose-dive in fall 1997. Chase’s losses looked very similar, if smaller, than those predicted by the stress tests. The post-mortem proved a turning point in the risk management group’s interaction with the business units. “This was the cultural watershed where people who didn’t want to lose their jobs, who wanted discipline in their business, turned around and said they really needed these stress tests to understand the vulnerabilities in their businesses and hedge them.”
Chase had no more inkling than any other bank that the 1997 Asian crises would rumble on into 1998, lead to a global drought of liquidity, and briefly threaten the stability of the global financial markets. However, it had prepared for a general scenario that coincided remarkably well with what actually happeneda sudden, pronounced flight to quality as investors swarmed out of stocks and into bonds and liquidity all but vanished in many markets. Because Chase had already used stress testing to examine the impact this event would have on its portfolio and had taken steps to mitigate its risks accordingly, its losses were less than they otherwise would have been.
While the company did take a $200 million charge related to the liquidity
crisis, the changes the company had made to hedge against such a crisis put the bank in a strong position to take advantage of the financial opportunities that followed the panic. Its diversity and business mix (for example, the lack of a large equity business), coupled with sound risk management, put it in a strong position to carry on with its business. This allowed it to capitalize on market opportunities that others were too paralyzed to take advantage of, such as the plentiful opportunities for lucrative foreign exchange trading in October 1998. While competing banks stopped extending credit to clients during the market crisis, Chase continued to lend, a move that the company believes increased its prestige, won new clients, and increased business from existing customers.
A look to the future
The Russian crisis did leave its mark even on Chase, however. “A business that runs the same notional risk today as it did in 1997 will generate much more stress risk now, since we now include that scenario in our stress testing,” says Duddy. A simple business goalgrowing back to the volume of business done before Russiais therefore not easy to achieve. One of the market risk group’s new challenges is finding ways for that to happen. Another new frontier for the market risk group is in addressing the increasingly liquid loan market. “It is extremely important to look at credit risk from the perspective of loss upon default. The market is evolving very rapidly into a much more transaction-based and market-based approach,” says Daniels-Webster. For Chase, a market leader in loan syndication, it is extremely important to stay abreast of this evolution. The concept of risk as variation in economic value is key here; not only in recognizing the differences between loans, but also in the differences between loans and other credit instruments such as bonds. The next challenge will be to meaningfully integrate the market and credit risk management of the loan book.
What is the central issue the case is describing?
Based on your readings, what problem needs to be addressed?
Put yourself in the Chief Risk Officer’s chair and describe the considerations you would identify.
Agree or disagree with the solution described in the case and provide support for your position.
Provide a concise summary of the items you considered and your conclusion
