Capital One 1998 Annual Report Download - page 32

30Capital One Financial Corporation
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
Interest Rate Sensitivity
Interest rate sensitivity refers to the change in earnings that may
result from changes in the level of interest rates. To the extent that
managed interest income and expense do not respond equally to
changes in interest rates, or that all rates do not change uniformly,
earnings could be affected. The Company’s managed net interest
income is affected by changes in short-term interest rates, primarily
LIBOR, as a result of its issuance of interest-bearing deposits, vari-
able rate loans and variable rate securitizations. The Company
manages and mitigates its interest rate sensitivity through several
techniques which include, but are not limited to, changing the
maturity, repricing and distribution of assets and liabilities and
entering into interest rate swaps.
The Company measures exposure to its interest rate risk through
the use of a simulation model. The model generates a distribution
of possible twelve-month managed net interest income outcomes
based on (i) a set of plausible interest rate scenarios, as determined
by management based upon historical trends and market expecta-
tions, (ii) all existing financial instruments, including swaps, and
(iii) an estimate of ongoing business activity over the coming twelve
months. The Company’s asset/liability management policy requires
that based on this distribution there be at least a 95% probability
that managed net interest income achieved over the coming twelve
months will be no more than 3% below the mean managed net
interest income of the distribution. As of December 31, 1998, the
Company was in compliance with the policy; more than 95% of the
outcomes generated by the model produced a managed net interest
income of no more than 1.8% below the mean outcome. The inter-
est rate scenarios evaluated as of December 31, 1998, included
scenarios in which short-term interest rates rose by as much as
400 basis points or fell by as much as 175 basis points over
twelve months.
The analysis does not consider the effects of the changed level
of overall economic activity associated with various interest rate
scenarios. Further, in the event of a rate change of large magnitude,
management would likely take actions to further mitigate its expo-
sure to any adverse impact. For example, management may reprice
interest rates on outstanding credit card loans subject to the right
of the consumers in certain states to reject such repricing by giving
timely written notice to the Company and thereby relinquishing
charging privileges. However, the repricing of credit card loans
may be limited by competitive factors as well as certain legal
constraints.
Interest rate sensitivity at a point in time can also be analyzed
by measuring the mismatch in balances of earning assets and inter-
est-bearing liabilities that are subject to repricing in future periods.
Dividend Policy
Although the Company expects to reinvest a substantial portion of
its earnings in its business, the Company intends to continue to pay
regular quarterly cash dividends on the Common Stock. The decla-
ration and payment of dividends, as well as the amount thereof, is
subject to the discretion of the Board of Directors of the Company
and will depend upon the Company’s results of operations, financial
condition, cash requirements, future prospects and other factors
deemed relevant by the Board of Directors. Accordingly, there can
be no assurance that the Corporation will declare and pay any divi-
dends. As a holding company, the ability of the Company to pay
dividends is dependent upon the receipt of dividends or other pay-
ments from its subsidiaries. Applicable banking regulations and
provisions that may be contained in borrowing agreements of the
Company or its subsidiaries may restrict the ability of the Com-
pany’s subsidiaries to pay dividends to the Corporation or the ability
of the Corporation to pay dividends to its stockholders.
Off-Balance Sheet Risk
The Company is subject to off-balance sheet risk in the normal
course of business including commitments to extend credit, reduce
the interest rate sensitivity of its securitization transactions and its
off-balance sheet financial instruments. The Company enters into
interest rate swap agreements in the management of its interest
rate exposure. The Company also enters into forward foreign cur-
rency exchange contracts and currency swaps to reduce its sensitiv-
ity to changing foreign currency exchange rates. These off-balance
sheet financial instruments involve elements of credit, interest rate
or foreign currency exchange rate risk in excess of the amount rec-
ognized on the balance sheet. These instruments also present the
Company with certain credit, market, legal and operational risks.
The Company has established credit policies for off-balance sheet
instruments as it has for on-balance sheet instruments.
Additional information regarding off-balance sheet financial
instruments can be found in Note O to the Consolidated Financial
Statements.