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 23.
Risk management at the Company is a multi-faceted process with independent
oversight that 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, as well as other
committees established to manage and monitor specific risks, review the risk
monitoring and risk management policies and procedures relating to the Company's
market
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Morgan Stanley Dean Witter * 1998 Annual Report
and credit risk profile, sales practices, pricing of consumer loans and reserve
adequacy, legal enforceability and operational and systems risks. The
Controllers, Treasury, Law, Compliance and Governmental Affairs and Firm Risk
Management 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, periodically examines and
evaluates the Company's operations and control environment. 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 predictions 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 11 to
the consolidated financial statements.
TRADING AND RELATED ACTIVITIES
Primary Market Risk Exposures and Market Risk Management
During fiscal 1998, 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, French franc and, on a going-forward basis,
the euro. 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
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 on a
Company-wide basis, 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 limits have
been approved for the Company and each major trading division of the Company
worldwide (equity, fixed income, foreign exchange and commodities). Discrete
market risk limits are assigned to trading desks and, as appropriate, products
and regions, that are compatible with the trading division limits. Trading
division risk managers, desk risk managers and the Firm Risk Management
Department all monitor market risk measures against limits and report major
market and position events to senior management.
The Firm Risk Management 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
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Morgan Stanley Dean Witter * 1998 Annual Report
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 Firm Risk Management Department.
Value-at-Risk
The statistical technique known as Value-at-Risk ("VaR") is one of the tools
used by management to measure, monitor and review the market risk exposures of
the Company's trading portfolios. The Company's independent Firm Risk Management
Department calculates and distributes daily VaR-based risk measures to various
levels of management.
VaR Methodology, Assumptions and Limitations
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 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 movements, would have been exceeded with a frequency
of 1%, or once in 100 trading days.
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.
Market risks that are incorporated in the VaR model include equity and commodity
prices, interest rates, foreign exchange rates and associated volatilities, as
well as correlation that exists among these variables. As a supplement to the
use of historical simulation for major market risk factors, the Company's VaR
model uses Monte Carlo simulation to capture name-specific risk in global
equities and in U.S. corporate and high-yield bonds. As of November 30, 1998, a
total of approximately 500 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.
VaR models such as the Company's are continually evolving as the
composition of trading portfolios change and as modeling techniques and systems
capabilities improve. During fiscal 1998, as part of the Company's ongoing
program of VaR model enhancement, position and risk coverage were broadened and
risk measurement methodologies were refined. Included in such enhancements were
improved capture of implied volatility risks in certain derivative products and
interest rate related risks in mortgage-backed and emerging-market financial
instruments, which had the primary effect of increasing the VaR for interest
rate risk.
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 can cover a wide
range of portfolio assets yet are relatively easy to interpret. However, VaR
risk measures should be interpreted in light of the methodology's limitations,
which include the following: past changes in market risk factors will not always
yield accurate predictions of the distributions and correlations of future
market movements; changes in portfolio value in response to market movements may
differ from the responses implicit in a VaR model; published VaR results reflect
past trading positions while future risk depends on future positions; 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; and the historical market risk
factor data used for VaR estimation may provide only limited insight into losses
that could be incurred under certain unusual market movements. 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 1998
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, 1998 and November 30, 1997, incor-
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Morgan Stanley Dean Witter * 1998 Annual Report
porating substantially all financial instruments generating market risk
(including funding liabilities related to hedging trading positions, retail
trading activities and certain private equity positions that are not reported
separately because the aggregate impact on the Company's VaR was not material).
However, a small proportion of trading positions generating market risk 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, some
commodity price risks (such as electricity price risk) and liquidity risks in
certain financial products.
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.
99%/One-Day VaR
Primary Market Risk Category at November 30,
(dollars in millions, pre-tax) 1998 1997(1)
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Interest rate $36 $42
Equity price 17 17
Foreign exchange rate 5 7
Commodity price 6 6
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Subtotal 64 72
Less diversification benefit(2) 26 26
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Aggregate Value-at-Risk $38 $46
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(1) The Interest rate and Aggregate Value-at-Risk for fiscal 1997 have been
restated to reflect the estimated impact of enhancements to the Company's
VaR model made during fiscal 1998 described above.
(2) 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 also are taken into
account within each such category.
The change in Aggregate Value-at-Risk from November 30, 1997 to November 30,
1998 primarily reflected a reduction in certain interest rate risk positions.
In order to facilitate comparison with other global financial services
firms, the Company notes that its aggregate VaR at November 30, 1998 for other
confidence levels and time horizons was as follows: $26 million for 95%/one-day
VaR and $121 million for 99%/two-week VaR.
The table below presents the average, high and low 99%/one-day VaR over the
course of fiscal 1998 for substantially all of the Company's institutional
trading activities. This measure of VaR incorporates most of the Company's
trading-related market risks. Certain market risks included in the year-end VaR
discussed above are excluded from this measure (i.e., those associated with the
Company's retail trading activities, equity price risk in certain private equity
positions and funding liabilities related to hedging trading positions).
Primary Market Risk Category Daily 99%/One-Day VaR for Fiscal 1998
(dollars in millions, pre-tax) High Low Average
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Interest rate $50 $35 $41
Equity price 19 12 15
Foreign exchange rate 10 3 5
Commodity price 8 5 6
Aggregate Value-at-Risk $50 $35 $43
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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. Despite volatile market conditions during fiscal 1998, there
were no days during which the Company incurred daily trading losses in its
institutional trading business in excess of the 99%/one-day VaR which
incorporates the enhancements to the Company's VaR model made during fiscal
1998.
The chart below presents the Company's daily 99%/one-day VaR for its
institutional trading activities over the course of fiscal 1998:
[LINE GRAPH APPEARS HERE]
Description of the Line Graph: Shown on page 50 is a line graph displaying
99%/one-day Value-at-Risk, as defined in the annual report text, for trading
days in fiscal year 1998. 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 $45-50 million range and end the fiscal year in the $35-40
million range. The maximum VaR, of approximately $50 million, is reached in the
first quarter and the minimum VaR, of approximately $35 million, is reached in
the fourth quarter.
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Morgan Stanley Dean Witter * 1998 Annual Report
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, Federal
Funds and short-term bank notes.
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 and cap agreements, to achieve its matched financing objectives.
Interest rate swap agreements effectively convert the underlying asset or
financing from fixed to variable repricing, from 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.
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 its fiscal year-end, the Company assumes 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 with rates that are fixed at
fiscal year-end, 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 fiscal year-end, 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 fiscal year-end, 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
fiscal year-end, 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, 1998, pre-tax income of consumer lending and related activities
over the following 12-month period would be reduced by approximately $65
million. The comparable reduction of pre-tax income for the 12-month period
following November 30, 1997 was estimated to be approximately $66 million.
The hypothetical model assumes that the balances of interest rate sensitive
assets and liabilities at fiscal year-end 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
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Morgan Stanley Dean Witter * 1998 Annual Report
the near term, including the likelihood of an immediate 100 basis point change
in market interest rates nor necessarily the actual effect on earnings if such
rate changes were to occur.
The Company anticipates the repricing of a substantial portion of its
existing credit card receivables to a fixed interest rate during fiscal 1999.
The Company does not believe this repricing will have a material impact on its
interest rate sensitivity due to the Company's matched financing objectives.
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, which could result 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 also are 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 scoring models (statistical evaluation models) based on
information obtained from credit bureaus. The Company's credit scoring systems
include both industry and customized models 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 Discover/NOVUS Network merchants and conducts
annual reviews of merchants, with the 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 adequate documentation (e.g., master agreements) is 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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