Merrill Lynch's operating activities expose it to many risks that are continually monitored, evaluated, and managed. Proper management of these risks helps reduce the likelihood of earnings volatility. Trading units typically hedge risks arising either from individual transactions or portfolios of similar transactions to manage risk at the legal entity level. Hedging techniques will vary based on many factors, including the nature and extent of the risks involved.

To supplement risk management at the trading unit level, Merrill Lynch has developed corporate governance policies and procedures that require specific areas and units to assist in the identification, assessment, and control of these risks. These policies and procedures are performed by many units, including the Global Risk Management Group ("Risk Management"), the Credit Division ("Corporate Credit"), and other control units, including Finance, Audit, Operations, and Law and Compliance ("Control Units"). In addition to independent risk management responsibilities, senior management from Risk Management, Corporate Credit, and the Control Units take an active role in the oversight of the risk management process through the Risk Control and Reserve Committees.

The Risk Control Committee and Risk Management provide general risk oversight for all institutional trading activities. The Risk Control Committee reports periodically to the Audit and Finance Committee of the Board of Directors and is independent of Merrill Lynch's trading units. The Risk Control Committee's activities are designed to ensure compliance with Merrill Lynch's commitment under the Derivatives Policy Group's Framework for Voluntary Oversight.

The Reserve Committee monitors valuation and certain other risks associated with assets and liabilities. Merrill Lynch establishes reserves in the Consolidated Balance Sheets for existing conditions, events, or circumstances that may reduce the carrying value of an asset or incur a liability. The Reserve Committee, chaired by the Chief Financial Officer, reviews and approves firmwide reserve levels, as well as changes in reserve methodologies. The Reserve Committee meets monthly to review current market conditions and acts on specific issues. Merrill Lynch's reserves take into account management's judgment and are generally based on (i) identification of risks and exposures, (ii) formulas, and (iii) aging, concentration, and liquidity analyses.

The following discussions of Market Risk, Credit Risk, and Other Risks highlight the corporate policies and procedures for risk identification, assessment, and control. Further discussion of market and credit risk is contained in Note 3 to the Consolidated Financial Statements.

Market risk is the potential change in a financial instrument's value caused by fluctuations in interest and currency exchange rates, equity and commodity prices, and credit spreads. Over the last several years, measuring market risk with mathematical models has become the focal point of many risk management efforts worldwide, with the term "risk management" becoming almost synonymous with "risk measurement."

Merrill Lynch believes that the use of mathematical risk models alone may provide a greater sense of security than warranted and therefore reliance on these models should be limited. In fact, because of the inability of mathematical risk models to quantify large-scale potential financial events with any precision, Merrill Lynch only employs these models to supplement other risk management efforts.

In general, Merrill Lynch believes that the primary risk of a product is not in the product itself, but in the way in which the product is managed. Breaches of discipline or lapses in supervision can result in losses irrespective of the products involved or the mathematical models used.

Nearly ten years ago, Merrill Lynch implemented a firmwide risk process based on the belief that there is more to risk management than identifying and measuring risk. The process itself has been strengthened by experience, but the underlying philosophy is essentially unchanged. This philosophy is based on the following six principles:

• The most important tools in any risk process are experience, judgment, and constant communication with risk-takers.

• Vigilance, discipline, and an awareness of risk must be continuously emphasized throughout the firm.

• Management must provide a clear and simple statement as to what can and cannot be done in committing capital.

• Risk Management must consider the unexpected, to probe for potential problems, to test for weaknesses, and to help identify potential for loss.

• The process must be flexible, to permit adaptation to changing environments, including the evolving goals of Merrill Lynch itself.

• The key objective must be to minimize the possibility of incurring unacceptable loss. Such losses usually arise from unexpected events that most statistical and model-based risk methodologies cannot predict.

In keeping with these principles, Merrill Lynch's risk management process relies on three key elements: (i) communication, (ii) controls and guidelines, and (iii) risk technology.

Risk Management is organized along geographic and product lines to ensure direct, frequent communication with specific trading areas. In addition, Risk Management performs regular, formal risk reviews with senior trading managers.

Risk Management has established certain controls and guidelines to supplement hedging techniques at the trading unit level (see Trading Assets and Liabilities in the Balance Sheet section for further information on these techniques). Risk Management sets and monitors trading limits, which may not be exceeded without prior approval. In addition, Risk Management and representatives from other Control Units approve new types of transactions as part of the new product review process. The commitment process subjects certain commitments, including equity, high-yield, and emerging market securities underwritings; real estate financings; and bridge loans, to prior approval from Risk Management and other Control Units. Risk Management also has the authority to require reductions in specific trading desk exposures or to veto proposed transactions.

Risk Management uses several risk technology tools, including a risk inventory database, a trading limit monitoring system, trading systems access, and stress scenarios. The risk inventory database provides a daily consolidation of securities inventory exposure by product, credit rating, country, etc., along with concentrations of exposure. The trading limit monitoring system enables Risk Management to review compliance with established limits. Access to trading systems allows Risk Management to monitor positions and perform computerized analytics.

Stress scenarios estimate gains or losses under both moderate and severe market movements. Each scenario considers a specific change in key risk factors, such as interest and currency exchange rates, equity and commodity prices, credit spreads, and volatilities, holding all other variables constant. Based on these scenarios, market risks can be monitored firmwide and portfolios rebalanced, as necessary.

Credit risk represents the amount of loss that Merrill Lynch would incur if a counterparty or client failed to perform its contractual obligations. Policies and procedures have been established with the objective of protecting against such losses, which include reviewing and establishing limits for credit exposures, limiting transactions with specific counterparties or clients, obtaining rights to collect collateral or terminate transactions in the event of a credit downgrade, maintaining collateral, and continually assessing the creditworthiness of counterparties and clients. The responsibility for compliance with these policies and procedures rests with business units, and is monitored by Corporate Credit.

Corporate Credit is centralized and organized geographically. Credit officers analyze and determine the creditworthiness of counterparties and clients, which, in many cases, is enhanced by due diligence meetings. Credit officers also set initial and ongoing credit limits by counterparty or client, recommend credit reserves, manage credit exposures, and participate in the new product review process.

Many types of transactions, including most derivatives and syndicated loans, are subject to prior approval from Corporate Credit. Within Corporate Credit, required approval levels have been established based on counterparty or client credit quality and the potential risk of the transaction. Transactions that exceed prescribed levels must be approved by the Credit Committee, which includes several approved by the Credit Committee, which includes several Directors of Credit and the Chief Credit Officer.

The credit system tracks information from automated and manual sources to enable Corporate Credit to monitor counterparty/client, product, and country concentrations. This system aggregates credit exposure by counterparty/client, maintains overall counterparty/client and specific product limits, and identifies limit review dates by counterparty/client. Detailed information on firmwide inventory positions and executed transactions, including current and potential credit exposure, is updated frequently and compared with limits. Collateral, which reduces credit exposure, is obtained as needed and tracked on the credit system.

Corporate Credit works with the trading units to develop and refine credit risk measurement models and to analyze potential credit exposures for complex derivative transactions. Corporate Credit also monitors credit exposures related to Merrill Lynch's retail customer business, including mortgages and home equity lines of credit, customer margin accounts, and working capital facilities to small businesses.

Operational risk focuses on Merrill Lynch's ability to accumulate, process, and communicate information necessary to conduct business in a global market environment. Merrill Lynch manages operational risk in many ways, including maintaining backup facilities, using technology, and employing experienced personnel. Information systems provide operational risk assessments on transactions in major markets which allow Merrill Lynch to promptly respond to changing market conditions worldwide. Management information reports enable senior management to effectively identify potential risk and control risk exposures, and promote compliance with both internal management policies and regulatory requirements. Experienced operations personnel provide support and control for trading, clearance, and settlement activities, and perform custodial functions for customer and proprietary assets. Operations and trading personnel report independently to senior management.