KeyBank 2014 Annual Report Download - page 93

occurs when interest-bearing liabilities and the interest-earning assets that they fund do not price or reprice
to the same term point on the yield curve.
/“Option risk” is the exposure to a customer or counterparty’s ability to take advantage of the interest rate
environment and terminate or reprice one of our assets, liabilities or off-balance sheet instruments prior to
contractual maturity without a penalty. Option risk occurs when exposures to customer and counterparty
early withdrawals or early prepayments are not mitigated with an offsetting position or appropriate
compensation.
Net interest income simulation analysis. The primary tool we use to measure our interest rate risk is simulation
analysis. For purposes of this analysis, we estimate our net interest income based on the current and projected
composition of our on- and off-balance sheet positions, accounting for recent and anticipated trends in customer
activity. The analysis also incorporates assumptions for the current and projected interest rate environments,
including a most likely macro-economic scenario. Simulation modeling assumes that residual risk exposures will
be managed to within the risk appetite.
We measure the amount of net interest income at risk by simulating the change in net interest income that would
occur if the federal funds target rate were to gradually increase or decrease over the next 12 months, and term
rates were to move in a similar fashion. Our standard rate scenarios encompass a gradual increase or decrease of
200 basis points, but due to the low interest rate environment, we have modified the standard to a gradual
decrease of 25 basis points over two months with no change over the following ten months. After calculating the
amount of net interest income at risk to interest rate changes, we compare that amount with the base case of an
unchanged interest rate environment. We also perform regular stress tests and sensitivities on the model inputs
that could materially change the resulting risk assessments. One set of stress tests and sensitivities assesses the
effect of interest rate inputs on simulated exposures. Assessments are performed using different shapes of the
yield curve, including a sustained flat yield curve, an inverted slope yield curve, changes in credit spreads, an
immediate parallel change in market interest rates, and changes in the relationship of money market interest rates.
Another set of stress tests and sensitivities assesses the effect of loan and deposit assumptions and assumed
discretionary strategies on simulated exposures. Assessments are performed on changes to the following
assumptions: the pricing of deposits without contractual maturities; changes in lending spreads; prepayments on
loans and securities; other loan and deposit balance shifts; investment, funding and hedging activities; and
liquidity and capital management strategies.
Simulation analysis produces only a sophisticated estimate of interest rate exposure based on judgments related
to assumption inputs into the simulation model. We tailor assumptions to the specific interest rate environment
and yield curve shape being modeled, and validate those assumptions on a regular basis. Our simulations are
performed with the assumption that interest rate risk positions will be actively managed through the use of on-
and off-balance sheet financial instruments to achieve the desired residual risk profile. However, actual results
may differ from those derived in simulation analysis due to unanticipated changes to the balance sheet
composition, customer behavior, product pricing, market interest rates, investment, funding and hedging
activities, and repercussions from unanticipated or unknown events.
Figure 33 presents the results of the simulation analysis at December 31, 2014, and December 31, 2013. At
December 31, 2014, our simulated exposure to changes in interest rates was moderately asset sensitive, and net
interest income would benefit over time from either an increase in short-term or intermediate-term interest rates.
Tolerance levels for risk management require the development of remediation plans to maintain residual risk
within tolerance if simulation modeling demonstrates that a gradual increase or decrease in short-term interest
rates over the next 12 months would adversely affect net interest income over the same period by more than 4%.
As shown in Figure 33, we are operating within these levels as of December 31, 2014.
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