EXHIBIT 13.4
RISK MANAGEMENT
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RISK MANAGEMENT POLICY AND CONTROL STRUCTURE
Risk is an inherent part of the Company's business and activities. The extent to
which the Company properly and effectively identifies, assesses, monitors and
manages each of the various types of risk involved in its activities is critical
to its soundness and profitability. The Company's broad-based portfolio of
business activities helps reduce the impact that volatility in any particular
area or related areas may have on its net revenues as a whole. The Company seeks
to identify, assess, monitor and manage, in accordance with defined policies and
procedures, the following principal risks involved in the Company's business
activities: market risk, credit risk, operational risk, legal risk and funding
risk. Funding risk is discussed in the Liquidity and Capital Resources section
of Management's Discussion and Analysis of Financial Condition and Results of
Operations beginning on page 36.
Risk management at the Company is a multi-faceted process with independent
oversight which requires constant communication, judgment and knowledge of
specialized products and markets. The Company's senior management takes an
active role in the risk management process and has developed policies and
procedures that require specific administrative and business functions to assist
in the identification, assessment and control of various risks. In recognition
of the increasingly varied and complex nature of the global financial services
business, the Company's risk management policies and procedures are evolutionary
in nature and are subject to ongoing review and modification.
The Management Committee, composed of the Company's most senior officers,
establishes the overall risk management policies for the Company and reviews the
Company's performance relative to these policies. The Management Committee has
created several Risk Committees to assist it in monitoring and reviewing the
Company's risk management practices. These Risk Committees, among other things,
review the general framework, levels and monitoring procedures relating to the
Company's market and credit risk profile, general sales practice policies,
pricing of consumer loans and reserve adequacy, legal enforceability and
operational and systems risks. The Controllers, Treasury, Law, Compliance and
Governmental Affairs and Market Risk Departments, which are all independent of
the Company's business units, assist senior management and the Risk Committees
in monitoring and controlling the Company's risk profile. In addition, the
Internal Audit Department, which also reports to senior management, evaluates
the Company's operations and control environment through periodic examinations
of business operational areas. The Company continues to be committed to
employing qualified personnel with appropriate expertise in each of its various
administrative and business areas to implement effectively the Company's risk
management and monitoring systems and processes.
The following is a discussion of the Company's risk management policies and
procedures for its principal risks (other than funding risk). The discussion
focuses on the Company's securities trading (primarily its institutional trading
activities) and consumer lending and related activities. The Company believes
that these activities generate a substantial portion of its principal risks.
This discussion and the estimated amounts of the Company's market risk exposure
generated by the Company's statistical analyses are forward looking statements.
However, the analyses used to assess such risks are not projections of future
events, and actual results may vary significantly from such analyses due to
actual events in the markets in which the Company operates and certain other
factors described below.
MARKET RISK
Market risk refers to the risk that a change in the level of one or more market
prices, rates, indices, volatilities, correlations or other market factors, such
as liquidity, will result in losses for a specified position or portfolio. For a
discussion of the Company's currency exposure relating to its net monetary
investments in non-U.S. dollar functional currency subsidiaries, see Note 10 to
the consolidated financial statements.
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TRADING AND RELATED ACTIVITIES
Primary Market Risk Exposures and Market Risk Management
During fiscal 1997, the Company had exposures to a wide range of interest rates,
equity prices, foreign exchange rates and commodity prices -- and associated
volatilities and spreads -- related to a broad spectrum of global markets in
which it conducts its trading activities. The Company is exposed to interest
rate risk as a result of maintaining market making and proprietary positions and
trading in interest rate sensitive financial instruments (e.g., risk arising
from changes in the level or volatility of interest rates, the timing of
mortgage prepayments, the shape of the yield curve and credit spreads for
corporate bonds and emerging market debt). The Company is exposed to equity
price risk as a result of making markets in equity securities and equity
derivatives and maintaining proprietary positions. The Company is exposed to
foreign exchange rate risk in connection with making markets in foreign
currencies, foreign currency options and maintaining foreign exchange positions.
The Company's currency trading covers many foreign currencies including the yen,
deutsche mark, pound sterling and French franc. The Company is exposed to
commodity price risk as a result of trading in commodity-related derivatives and
physical commodities.
The Company manages its trading positions by employing a variety of hedging
strategies, which include diversification of risk exposures and the purchase or
sale of positions in related securities and financial instruments, including a
variety of derivative products (e.g., swaps, options, futures and forwards). The
Company manages the market risk associated with its trading activities
Company-wide, on a trading division level worldwide and on an individual product
basis. The Company manages and monitors its market risk exposures in such a way
as to maintain a portfolio that the Company believes is well-diversified with
respect to market risk factors. Market risk guidelines and limits have been
approved for the Company and each trading division of the Company worldwide
(equity, fixed income, foreign exchange and commodities). Discrete market risk
limits are assigned to trading divisions and trading desks within trading areas
which are compatible with the trading division limits. Trading division risk
managers, desk risk managers and the Market Risk Department all monitor market
risk measures against limits and report major market and position events to
senior management.
The Market Risk Department independently reviews the Company's trading
portfolios on a regular basis from a market risk perspective utilizing
Value-at-Risk and other quantitative and qualitative risk measurements and
analyses. The Company may use measures, such as rate sensitivity, convexity,
volatility and time decay measurements, to estimate market risk and to assess
the sensitivity of positions to changes in market conditions. Stress testing,
which measures the impact on the value of existing portfolios of specified
changes in market factors, for certain products is performed periodically and
reviewed by trading division risk managers, desk risk managers and the Market
Risk Department.
Value-at-Risk
The Company uses a statistical technique known as Value-at-Risk ("VaR") to
assist management in measuring its exposure to market risk related to its
trading positions. The VaR model is one of the tools used by senior management
to monitor and review the market risk exposure of the Company's trading
portfolios.
VaR Methodology, Assumptions and Limitations. VaR incorporates numerous
variables that could impact the fair value of the Company's trading portfolio,
including equity and commodity prices, interest rates, foreign exchange rates
and associated volatilities, as well as correlation that exists among these
variables. The VaR model generally takes into account linear and non-linear
exposures to price and interest rate risk and linear exposure to implied
volatility risks. The Company estimates VaR using a model based on historical
simulation with a confidence level of 99%. Historical simulation involves
constructing a distribution of hypothetical daily changes in trading portfolio
value. The hypothetical changes in portfolio value are based on daily observed
percentage changes in key market indices or other market factors ("market risk
factors") to which the portfolio is sensitive. In the case of the Company's VaR,
the historical
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observation period is approximately four years. The Company's one-day 99% VaR
corresponds to the negative change in portfolio value that, based on observed
market risk factor moves, would have been exceeded with a frequency of 1%, or
once in 100 trading days.
VaR models such as the Company's are continually evolving as trading
portfolios become more diverse and modeling techniques and systems capabilities
improve. During fiscal 1997, the position and risk coverage of the Company's VaR
model were broadened and risk measurement methodologies were refined. Among the
most significant enhancements were the incorporation of name-specific risk in
global equities and in U.S. corporate and high-yield bonds. As of November 30,
1997, a total of approximately 420 market risk factor benchmark data series were
incorporated in the Company's VaR model covering interest rates, equity prices,
foreign exchange rates, commodity prices and associated volatilities. In
addition, the model includes market risk factors for approximately 7,500 equity
names and 60 classes of corporate and high-yield bonds.
Among their benefits, VaR models permit estimation of a portfolio's
aggregate market risk exposure, incorporating a range of varied market risks;
reflect risk reduction due to portfolio diversification; and are comprehensive
yet relatively easy to interpret. However, VaR risk measures should be
interpreted in light of the methodology's limitations, which include that past
changes in market risk factors will not always accurately predict future changes
in a portfolio's value; it is not possible to perfectly model all of a trading
portfolio's market risk factors; published VaR results reflect past trading
positions while future risk depends on future positions; and VaR using a one-day
time horizon does not fully capture the market risk of positions that cannot be
liquidated or hedged within one day. The Company is aware of these and other
limitations and therefore uses VaR as only one component in its risk management
review process. This process also incorporates stress testing and extensive risk
monitoring and control at the trading desk, division and Company levels.
VaR for Fiscal 1997. The table below presents the results of the Company's VaR
for each of the Company's primary market risk exposures and on an aggregate
basis at November 30, 1997 incorporating substantially all financial instruments
generating market risk (including funding liabilities related to trading
positions and certain merchant banking positions). A small proportion of trading
positions however, were not covered, and the modeling of the risk
characteristics of some positions involved approximations which could be
significant under certain circumstances. Market risks that the Company has found
particularly difficult to incorporate in its VaR model include certain risks
associated with mortgage-backed securities and certain commodity price risks
(such as electricity price risk).
Since VaR is based on historical data and changes in market risk factor
returns, VaR should not be viewed as predictive of the Company's future
financial performance or its ability to manage and monitor risk and there can be
no assurance that the Company's actual losses on a particular day will not
exceed the VaR amounts indicated below or that such losses will not occur more
than once in 100 trading days.
(1) Equals the difference between aggregate VaR and the sum of the VaRs for the
four risk categories. This benefit arises because the simulated 99%/one-
day losses for each of the four primary market risk categories occur on
different days; similar diversification benefits are also taken into
account within each such category.
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In order to facilitate comparison with other global financial services firms,
the Company notes that its aggregate year-end VaR for other confidence levels
and time horizons was as follows: $21 million for 95%/one-day VaR and $98
million for 99%/two-week VaR.
The chart below presents supplemental information regarding 99%/one-day VaR
over the course of fiscal 1997 for substantially all of the Company's
institutional trading activities. These activities include most of the Company's
trading-related market risk, but exclude certain market risks incorporated in
the Company's November 30, 1997 VaR calculation discussed above such as market
risks related to the Company's retail trading activities, equity price risk in
certain merchant banking positions and funding liabilities related to trading
positions.
[LINE CHART APPEARS HERE]
Description of Line Chart: Shown on page 62 is a line graph displaying 99%/one-
day Value-at-Risk, as defined in the annual report text, for trading days in
fiscal year 1997. The horizontal axis of the chart is marked to indicate the
start of each fiscal quarter. The vertical axis of the chart is marked to
indicate VaR in millions of dollars. The values displayed in the graph start the
fiscal year in the $30-35 million range and end the fiscal year in the $35-40
million range. The maximum VaR, in the $40-45 million range is reached in the
first quarter and the minimum VaR, in the $20-25 million range is reached in the
second quarter.
The Company evaluates the reasonableness of its VaR model by comparing the
potential declines in portfolio values generated by the model with actual
trading results.
The histogram below shows daily trading revenue net of interest expense for
fiscal 1997 for substantially all of the Company's institutional trading
activities. In fiscal 1997, the Company did not incur any daily trading losses
in its institutional trading business in excess of the corresponding daily
99%/one-day VaR.
[HISTOGRAM APPEARS HERE]
Description of Histogram: Shown on page 62 is a histogram displaying the
frequency distribution of daily trading revenue, as defined in the annual report
text. The horizontal axis of the chart is marked to indicate the daily trading
revenue in millions of dollars beginning at less than $15 million on the left
and increasing from the $15 million level at intervals at $2 1/2 million to
greater than $50 million on the right. The vertical axis is marked to indicate
the number of days. The histogram shows that daily trading revenue was most
frequently in the range of $17.5-20 million, and that trading revenue fell
within this range on 48 days. The histogram shows that the number of days in a
range generally, but not invariably, falls the further one goes above or below
this range. The histogram also shows that trading revenue was less than - $15
million on one day and exceeded $50 million on four days.
CONSUMER LENDING AND RELATED ACTIVITIES
Interest Rate Risk and Management
In its consumer lending activities, the Company is exposed to market risk
primarily from changes in interest rates. Such changes in interest rates impact
interest earning assets, principally credit card and other consumer loans and
net servicing fees received in connection with consumer loans sold through asset
securitizations, as well as the interest sensitive liabilities which finance
these assets, including asset securitizations, commercial paper, medium-term
notes, long-term borrowings, deposits, asset-backed commercial paper, Fed Funds
and short-term bank notes.
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The Company's interest rate risk management policies are designed to reduce
the potential volatility of earnings which may arise from changes in interest
rates. This is accomplished primarily by matching the repricing of credit card
and consumer loans, and the related financing. To the extent that asset and
related financing repricing characteristics of a particular portfolio are not
matched effectively, the Company utilizes interest rate derivative contracts,
such as swap, cap and cost of funds agreements, to achieve its matched financing
objectives. Interest rate swap agreements effectively convert the underlying
asset or financing from fixed to variable repricing, variable to fixed
repricing, or in more limited circumstances from variable to variable repricing.
Interest rate cap agreements effectively establish a maximum interest rate on
certain variable rate financings. Cost of funds agreements, entered into in
connection with certain private label credit card merchant agreements,
effectively establish a fixed rate of financing for the related private label
credit card portfolio.
Sensitivity Analysis Methodology, Assumptions and Limitations
For its consumer lending activities, the Company uses a variety of techniques to
assess its interest rate risk exposure, one of which is interest rate
sensitivity simulation. For purposes of presenting the possible earnings effect
of a hypothetical, adverse change in interest rates over the 12-month period
from November 30, 1997, the Company assumed that all interest rate sensitive
assets and liabilities will be impacted by a hypothetical, immediate 100 basis
point increase in interest rates as of the beginning of the period.
Interest rate sensitive assets are assumed to be those for which the stated
interest rate is not contractually fixed for the next 12-month period. Thus,
assets which have a market-based index, such as the prime rate, which will reset
before the end of the 12-month period, or assets whose rates are fixed at
November 30, 1997, but which will mature, or otherwise contractually reset to a
market-based indexed rate prior to the end of the 12-month period, are
rate-sensitive. The latter category includes certain credit card loans which may
be offered at below-market rates for an introductory period, such as for balance
transfers and special promotional programs, after which the loans will
contractually reprice in accordance with the Company's normal market-based
pricing structure. For purposes of measuring rate-sensitivity for such loans,
only the effect of the hypothetical 100 basis point change in the underlying
market-based index, such as the prime rate, has been considered rather than the
full change in the rate to which the loan would contractually reprice. For
assets which have a fixed rate at November 30, 1997 but which contractually
will, or are assumed to, reset to a market-based index during the next 12
months, earnings sensitivity is measured from the expected repricing date. In
addition, for all interest rate sensitive assets, earnings sensitivity is
calculated net of expected loan losses.
Interest rate sensitive liabilities are assumed to be those for which the
stated interest rate is not contractually fixed for the next 12-month period.
Thus, liabilities which have a market-based index, such as the prime, commercial
paper, or LIBOR rates, which will reset before the end of the 12-month period,
or liabilities whose rates are fixed at November 30, 1997, but which will mature
and be replaced with a market-based indexed rate prior to the end of the
12-month period, are rate-sensitive. For liabilities which have a fixed rate at
November 30, 1997, but which are assumed to reset to a market-based index during
the next 12 months, earnings sensitivity is measured from the expected repricing
date.
Assuming a hypothetical, immediate 100 basis point increase in the interest
rates affecting all interest rate sensitive assets and liabilities as of
November 30, 1997, pre-tax income of consumer lending activities (Credit and
Transaction Services) over the next 12-month period would be reduced by
approximately $66 million.
The hypothetical model assumes that the balances of interest rate sensitive
assets and liabilities at November 30, 1997 will remain constant over the next
12-month period. It does not assume any growth, strategic change in business
focus, change in asset pricing philosophy, or change in asset/liability funding
mix. Thus, this model represents a static analysis which cannot adequately
portray how the Company would respond to significant changes in market
conditions. Furthermore, the analysis does not necessarily reflect the Company's
expectations regarding the movement of interest rates in the near term,
including the likelihood of an immediate 100 basis point
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change in market interest rates nor necessarily the actual effect on earnings if
such rate changes were to occur.
CREDIT RISK
The Company's exposure to credit risk arises from the possibility that a
customer or counterparty to a transaction might fail to perform under its
contractual commitment, resulting in the Company incurring losses. With respect
to its trading activities, the Company has credit guidelines which limit the
Company's credit exposure to any one counterparty. Specific credit risk limits
based on the credit guidelines are also in place for each type of counterparty
(by rating category) as well as for secondary positions in high-yield and
emerging market debt. In addition to monitoring credit limits, the Company
manages the credit exposure relating to the Company's trading activities by
reviewing counterparty financial soundness periodically, by entering into master
netting agreements and collateral arrangements with counterparties in
appropriate circumstances and by limiting the duration of exposure. With respect
to its consumer lending activities, potential credit card holders undergo credit
reviews by the Credit Department to establish that they meet standards of
ability and willingness to pay. Credit card applications are evaluated using
credit scoring systems (statistical evaluation models that assign point values
to information contained in applications). The Company's credit scoring systems
are customized using the Company's criteria and historical data. Each
cardmember's credit line is reviewed at least annually, and actions resulting
from such review may include lowering a cardmember's credit line or closing the
account. In addition, the Company reviews the creditworthiness of prospective
Novus Network merchants and conducts annual reviews of merchants, with greatest
scrutiny given to merchants with substantial sales volume.
OPERATIONAL RISK
Operational risk refers to the risk of loss resulting from improper processing
of transactions or deficiencies in the Company's operating systems or control
processes. With respect to its trading activities, the Company has developed and
continues to enhance specific policies and procedures that are designed to
provide, among other things, that all transactions are accurately recorded and
properly reflected in the Company's books and records and confirmed on a timely
basis; position valuations are subject to periodic independent review
procedures; and collateral and adequate documentation (e.g., master agreements)
are obtained from counterparties in appropriate circumstances. With respect to
its consumer lending activities, operating systems are designed to provide for
the efficient servicing of consumer loan accounts. The Company manages
operational risk through its system of internal controls which provides checks
and balances to ensure that transactions and other account-related activity
(e.g., new account solicitation, transaction authorization and processing,
billing and collection of delinquent accounts) are properly approved, processed,
recorded and reconciled. Disaster recovery plans are in place on a Company-wide
basis for critical systems, and redundancies are built into the systems as
deemed appropriate.
LEGAL RISK
Legal risk includes the risk of non-compliance with applicable legal and
regulatory requirements and the risk that a counterparty's performance
obligations will be unenforceable. The Company is generally subject to extensive
regulation in the different jurisdictions in which it conducts its business. The
Company has established procedures based on legal and regulatory requirements on
a worldwide basis that are designed to ensure compliance with all applicable
statutory and regulatory requirements. The Company, principally through the Law,
Compliance and Governmental Affairs Department, also has established procedures
that are designed to ensure that senior management's policies relating to
conduct, ethics and business practices are followed globally. In connection with
its business, the Company has various procedures addressing issues, such as
regulatory capital requirements, sales and trading practices, new products, use
and safekeeping of customer funds and securities, credit granting, collection
activities, money-laundering and recordkeeping. The Company also has established
procedures to mitigate the risk that a counterparty's performance obligations
will be unenforceable, including consideration of counterparty legal authority
and capacity, adequacy of legal documentation, the permissibility of a
transaction under applicable law and whether applicable bankruptcy or insolvency
laws limit or alter contractual remedies.
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