KeyBank 2007 Annual Report Download - page 48

46
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Guarantees
Key is a guarantor in various agreements with third parties. As guarantor,
Key may be contingently liable to make payments to the guaranteed party
based on changes in a specified interest rate, foreign exchange rate or
other variable (including the occurrence or nonoccurrence of a specified
event). These variables, known as underlyings, may be related to an asset
or liability, or another entity’s failure to perform under a contract.
Additional information regarding these types of arrangements is
presented in Note 18 under the heading “Guarantees” on page 98.
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,
liquidity risk, credit risk, and operational risk and that these risks
must be managed across the entire enterprise. Key continues to evolve
and strengthen its Enterprise Risk Management practices and uses a
risk adjusted capital framework to manage these risks. This framework
is approved and managed by the Risk Capital Committee, which
consists of senior finance, risk management and business executives.
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
Audit and Risk Management committees help the Board meet these risk
oversight responsibilities.
• The Audit Committee reviews and monitors the integrity of Key’s
financial statements, compliance with legal and regulatory requirements,
the independent auditors’ qualifications and independence, and the
performance of Key’s internal audit function and independent auditors.
• The Risk Management 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 quarterly earnings releases.
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 report
designed 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 industry, is measured
by the potential for fluctuations in net interest income and the economic
value of equity. 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 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
a prepayment 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 term of the loan. Deposits that
can be withdrawn on demand also present option risk.