Lesley Daniels Webster is an executive vice president and head of market risk management at J.P. Morgan Chase & Co. At the time of this interview, she held the same titles at Chase Manhattan Corp, where she was responsible for the measurement, monitoring and control of the market risks associated with the bank's corporate-wide business activities. She joined Chase in1994 from UBS, where she was managing director and global head of the proprietary and arbitrage trading group, and head of U.S. dollar swaps and risk management. She has a Ph.D. in economics from Stanford, and served as an assistant professor at Washington University from 1977 to 1983. She spoke in November with William Rhode.

Derivatives Strategy: A lot of mergers end up with one institution reigning supreme. Will that happen with Chase and JP Morgan?

Lesley Daniels Webster: If you want the best of both, you have to approach a merger with an open mind. There's a lot of talent on both sides. For managers, the key is to appoint people based on merit. At the same time, you can't have a lot of generalists running around, because every market is idiosyncratic and the products are unique. You have to have people who are, frankly, very smart and have the right set of experiences. These two firms have an enormous amount of talent, so we'll probably end up with something like an even split.

DS: What does each firm bring to the new combined entity?

LDW: Morgan has tremendous product breadth and depth—not in everything, but in certain areas like public equities, equity derivatives and sovereign debt trading, to name a few. Some of that speaks to the depth of its research, its prowess at analytical modeling, and some of that speaks to the strategic directions and choices it has made.

"The new firm will be more diversified, it will be more balanced, and the types of risk it takes will be deeper in particular product lines. There will also be more reliance on complex and hybrid products.”

Chase has a long history of superb market-making, great depth in high-grade corporate bonds, in high yield, the Asian equity markets and so on. When you put all this together, you see less overlap than a casual observer might assume. The new firm will be more diversified, it will be more balanced geographically, and the types of risk it takes will be deeper in particular product lines because of the combination of the broader client set and broader product set. There will be more reliance on complex and hybrid products, and greater depth in some of the newer markets than, say, I would have experienced on the Chase side.

DS: What are your main primary concerns as a risk manager?

LDW: At the moment, we have reasonable merger-execution risk, and we'll have that over the next six months. From a risk management perspective, that means making sure we're capturing our risks completely and measuring them in a way that allows us to see the integrated profile of the firm, but that also allows us to look at it in a granular fashion.

Another piece of this is to make sure that the limit structure and approval mechanisms are in place to work for the new firm. They will be different from what Morgan had and they will be different from what Chase had. Presumably, they will take the best of both and will equip us to deal with a complex firm with a very broad product set and a very different set of risks. So there are execution risks around risk measurement, monitoring, limits and approval, and around more difficult things like model risk.

DS: Are you choosing a Morgan risk management model or a Chase model?

LDW: It's a hybrid. Starting with the merger announcement, we instituted a number of teams consisting of the best people from Morgan and from Chase to tackle a variety of topics. They covered things like valuation and reserve practices, market risk, model risk, what we should do about simple matters like policies and procedures, governance issues—the whole waterfront. A group has been working on determining what the combined exposure will look like for the new firm, and the extent to which we have adequate diversification or concentrations that we need to address.

"Local risk managers will report to me, but they also need to be empowered. The person who's closest to the deal should be the person who approves it.”

The byproduct of that work is a bottom-up—rather than a top-down—consensus view of what is right for the new firm. I'm sure any of my sister firms would jump at the opportunity to sit down, take a premier firm and say, "Hmm, I get to find out everything they do and how they do it, and talk to their smartest people and plumb their thought processes.”

DS: How will the risk management division be organized?

LDW: We've decided that risk management has to be a segregated function. It has to function independently, but in partnership with the lines of business. We will also aim for a balance between product and geography. That's important because for the new firm—compared with the two predecessor firms—the geographic balance of revenues and risks will be quite different, and more evenly spread throughout the world than either firm had previously experienced. Because of that, as well as the measurement, monitoring and—most important—control of risk, there have to be people knowledgeable in geographies that are strong on brains and backbone to be able to do this function effectively within the firm.

DS: Will they be allowed to make risk management decisions themselves?

LDW: We will be decentralized. I don't think we could run the volume of transactions and all the types of risks we do through one central process. Local risk managers will report to me, but they also need to be empowered. The person who's closest to the deal, who's knowledgeable enough to do it, should be the person who approves it.

DS: How will the new entity, with its broad diversification, cope with the possibility of another Russian default or some other huge market disruption?

LDW: We plan to use the same risk measurement methodology for the new firm that we have used at Chase. It allows us to get a granular look at where risks actually reside, and who has those risks. Things that are previously uncorrelated do become correlated in crises, but—just as in anything—there are ways in crises to make money and there are ways in crises to be positioned so that you actually have some P and not just L. That's an art—and that's why we pay traders, desk managers and heads of businesses a lot of money. This can't be perfectly foretold. But it's very important to know where you stand in advance of an event.

"There are ways in crises to be positioned so that you actually have some P and not just L. That's an art—and that's why we pay traders, desk managers and heads of businesses a lot of money.”

The good news is that our risk measurement methodology enables us to see how we would fare in a crisis—a not inconsiderable undertaking because of the sheer magnitude of this corporation. From day one, we will be providing measures of what our potential downside risk is to catastrophe. We've already done preliminary measurements to understand how we would fare in the event of a fairly broad spectrum of market events.

DS: Would you be responsible for making the call when events diverge from the models? I remember you telling me once that risk management in a crisis has more to do with reading the headlines than the computer screen.

LDW: It's better to anticipate what the headlines might look like than to read them after the fact. One of my roles is to determine what our exposures are. But there has to be a shared agenda between market risk, the senior people in the different lines of business, the executive committee and the board of directors. If there are different views among those constituencies, you have a potential problem. But if everybody's looking at the same information and has the same agenda—to make the right returns, smartly, and to invest in the right way—then it's in everybody's interest to come to the same conclusion.

DS: Is there always one right answer?

LDW: I don't think you can have the right outcome—that is, a decent performance—without consensus. We are in the business of taking risks, and any firm in this business has to accept losses. But we must agree that our exposure is at the right level to make the returns we need to make. And we have to agree that that's also the right amount of risk for the shareholders. In my experience, a good outcome is always one that everybody can live with. It is very rare—as scarce as hens' teeth—when one can't find points of agreement. And this usually leads to a stronger, better-structured deal.

DS: So I can't call you the most powerful policewoman in the financial world?

LDW: Oh, that would be ghastly.

DS:But aren't you the one who will end up taking the blame if things go wrong?

LDW: The judgments made are shared judgments, by and large. It's very rare to have just one person calling the shots. In a well-managed firm, with massive businesses run by truly brilliant people who have survived difficult markets, you're looking at an extraordinary group of risk-takers. It's unlikely their views and my view will diverge substantially. That doesn't mean going along to get along, but it does mean that it's quite rare when we can't find a consensus.

DS: Do you know on a daily basis what the market risk exposure of the firm is?

LDW: Yes. Our systems help answer any questions we might have. We don't rely on a set routine, because things are always changing in the markets. The headlines are changing, the geopolitical realities are changing. We look at the numbers, we read the papers, we ask questions—that's how we understand the market risk exposure of the firm on a day-to-day basis.

DS: How do you know what the right market risk exposure is for a firm that doesn't yet exist?

LDW: We have benchmarks. The first is simply determining a good balance of returns for risk. If that balance is out of bounds, you'll have a hard time explaining to your stakeholders why you took that much risk. There's also the fundamental question of what types of losses the firm is prepared to bear. Another question is what kinds of volatility in earnings we can accept; that's different from simply estimating the potential downside loss on one day that may be extinguished within a week. Another benchmark could be what kind of an asset mix presents you with the amount of diversification that allows you to live comfortably. External benchmarking is difficult to do, because of the lack of comparable information from other firms. You can't simply say, "Well, I'm prepared to take twice as much risk as Firm X, or half as much as Firm Y.” You just don't know.

DS: In all of your merger experience, is there one lesson you've learned well?

LDW: For any merger to be successful, one has to do one's own job, as well as the extra work around the merger. Mergers can be difficult and stressful. Decisions have to be revisited, new people have to be met, and reputations need to be established. The key to minimizing integration risk is having partners on the other side with whom you have a real dialogue, and whose judgment you trust. When you have that kind of shared agenda, it makes the work—well, I can't quite say pleasurable, but it makes it so much easier than when you approach a merger as though the opposite side is an adversary who can't be trusted, who you can't discuss things with, who you can't share views with. Luckily, I'm blessed with great partners in this merger.