KeyBank 2006 Annual Report Download - page 47

47
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
RISK MANAGEMENT
Overview
Like other financial services companies, Key engages in business activities
with inherent risks. The ability to properly and effectively identify,
measure, monitor and report such risks is essential to maintaining
safety and soundness and to maximizing profitability. Management
believes that the most significant risks facing Key are market risk,
credit risk, liquidity risk and operational risk. Each type of risk is
defined and discussed in greater detail in the remainder of this section.
Key’s Board of Directors has established and follows a corporate
governance program that serves as the foundation for managing and
mitigating risk. In accordance with this program, the Board focuses on the
interests of shareholders, encourages strong internal controls, demands
management accountability, mandates adherence to Key’s code of ethics
and administers an annual self-assessment process. The Board has
established Audit and Risk Management committees whose appointed
members help the Board meet its risk oversight responsibilities.
• The Audit Committee provides review and oversight of the integrity
of Key’s financial statements, compliance with legal and regulatory
requirements, the independent auditors’ qualifications and inde-
pendence, and the performance of Key’s internal audit function and
independent auditors.
• The Risk Management Committee (formerly known as the Finance
Committee) assists the Board in its review and oversight of risk
management policies, strategies and activities that fall outside the
purview of the Audit Committee. This committee also assists in the
review and oversight of policies, strategies and activities related to
capital management, asset and liability management, capital
expenditures and various other financing and investing activities.
The Audit and Risk Management committees meet jointly, as
appropriate, to discuss matters that relate to each committee’s
responsibilities. Key’s Board and its committees meet bi-monthly.
However, more frequent contact is not uncommon. In addition to
regularly scheduled meetings, the Audit Committee convenes to discuss
the content of Key’s financial disclosures and press releases related to
quarterly earnings. Committee chairpersons routinely meet with
management during interim months to plan agendas for upcoming
meetings and to discuss events that have transpired since the preceding
meeting. Also, during interim months, all members of the Board
receive a formal reportdesigned to keep them abreast of significant
developments.
Market risk management
The values of some financial instruments vary not only with changes
in market interest rates, but also with changes in foreign exchange
rates. Financial instruments also are susceptible to factors influencing
valuations in the equity securities markets and other market-driven
rates or prices. For example, the value of a fixed-rate bond will
decline if market interest rates increase. Similarly, the value of the U.S.
dollar regularly fluctuates in relation to other currencies. When the
value of an instrument is tied to such external factors, the holder faces
“market risk.” Most of Key’s market risk is derived from interest rate
fluctuations.
Interest rate risk management
Interest rate risk, which is inherent in the banking business, is measured
by the potential for fluctuations in net interest income. Such fluctuations
may result from changes in interest rates and differences in the repricing
and maturity characteristics of interest-earning assets and interest-
bearing liabilities. To minimize the volatility of net interest income
and the economic value of equity, Key manages exposure to interest rate
risk in accordance with guidelines established by the Asset/Liability
Management Policy Committee (“ALCO”). This committee, which
consists of senior finance and business executives, meets monthly,
and periodically reports Key’s interest rate risk positions to the Risk
Management Committee of the Board of Directors.
Interest rate risk positions can be influenced by a number of factors other
than changes in market interest rates, including economic conditions, the
competitive environment within Key’s markets, consumer preferences for
specific loan and deposit products, and the level of interest rate exposure
arising from basis risk, gap risk, yield curve risk and option risk.
•Key faces “basis risk” when floating-rate assets and floating-rate
liabilities reprice at the same time, but in response to different market
factors or indices. Under those circumstances, even if equal amounts
of assets and liabilities are repricing, interest expense and interest
income may not change by the same amount.
•“Gap risk” occurs if interest-bearing liabilities and the interest-
earning assets they fund (for example, deposits used to fund loans) do
not mature or reprice at the same time.
•“Yield curve risk” exists when short-term and long-term interest
rates change by different amounts. For example, when U.S. Treasury
and other term rates decline, the rates on automobile loans also will
decline, but the cost of money market deposits and short-term
borrowings may remain elevated.
•A financial instrument presents “option risk” when one party to the
instrument can take advantage of changes in interest rates without
penalty. For example, when interest rates decline, borrowers may
choose to prepay fixed-rate loans by refinancing at a lower rate. Such
aprepayment gives Key a return on its investment (the principal plus
some interest), but unless there is a prepayment penalty, that return
may not be as high as the return that would have been generated had
payments been received over the original termof the loan. Floating-rate
loans that are capped against potential interest rate increases and
deposits that can be withdrawn on demand also present option risk.
Net interest income simulation analysis. The primary tool used by
management to measureKey’sinterest rate risk is a simulation analysis.
For purposes of this analysis, management estimates Key’s net interest
income based on the composition of its balance sheet and the current
interest rate environment. The simulation assumes that growth in the
balance sheet will reflect recent product trends, as well as consensus
economic forecasts.
The amount of net interest income at risk is measured by simulating the
change in the level of net interest income that would occur if the Fed Funds
Target rate were to gradually increase or decrease by 200 basis points over
the next twelve months, and term rates were to move in a similar fashion,
but not as dramatically.The amount of net interest income at risk is
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