Fifth Third Bank 2002 Annual Report Download - page 59

FIFTH THIRD BANCORP AND SUBSIDIARIES
57
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
the use of the Federal Home Loan Bank (FHLB) as a funding
source and issuing notes payable through its FHLB member
subsidiaries. Management does not rely on any one source of
liquidity and manages availability in response to changing balance
sheet needs. Given the continued strength of the balance sheet, stable
credit quality, risk management policies and revenue growth
trends, management does not expect any downgrade in the credit
ratings based on financial performance in the upcoming year.
Management considers interest rate risk the Bancorp’s most
significant market risk. Interest rate risk is the exposure to adverse
changes in net interest income due to changes in interest rates.
Consistency of the Bancorp’s net interest income is largely dependent
upon the effective management of interest rate risk.
The Bancorp employs a variety of measurement techniques to
identify and manage its interest rate risk including the use of an
earnings simulation model to analyze net interest income sensitivity
to changing interest rates. The model is based on actual cash flows
and repricing characteristics for all of the Bancorp’s financial
instruments and incorporates market-based assumptions regarding
the effect of changing interest rates on the prepayment rates of
certain assets and liabilities. The model also includes senior
management projections for activity levels in each of the product
lines offered by the Bancorp. Assumptions based on the historical
behavior of deposit rates and balances in relation to changes in
interest rates are also incorporated into the model. These
assumptions are inherently uncertain, and as a result, the model
cannot precisely measure net interest income or precisely predict the
impact of fluctuations in interest rates on net interest income.
Actual results will differ from simulated results due to timing,
magnitude, and frequency of interest rate changes as well as changes
in market conditions and management strategies.
The Bancorp’s Asset/Liability Management Committee (ALCO),
which includes senior management representatives and reports to the
Board of Directors, monitors and manages interest rate risk within
Board-approved policy limits. The Bancorp’s current interest rate risk
policy limits are determined by measuring the anticipated change in
net interest income over a 24 month horizon assuming a 200 basis
point linear increase or decrease in all interest rates. Current policy
limits this exposure to plus or minus 7% of net interest income for
the first and second year.
The following table shows the Bancorp’s estimated earnings
sensitivity profile as of December 31, 2002:
Change in Percentage Change in
Interest Rates Net Interest Income
(basis points) Year 1 Year 2
+200 1.8% 6.2%
-125 (2.0)% (6.9)%
Given a linear 200 bp increase in the yield curve used in the
simulation model, it is estimated that net interest income for the
Bancorp would increase by 1.8% in the first year and 6.2% in the
second year. A 125 bp linear decrease in interest rates would
decrease net interest income by 2.0% in the first year and an
estimated 6.9% in the second year. The ALCO limits are
established for a 200 basis point linear increase or decrease in all
interest rates. The Bancorp is in compliance with the interest rate
risk policy for the increase in rates by 200 basis points. The
Bancorp’s ALCO, along with senior management, have deemed the
risk of a 200 bp decrease in rates to be low as a 200 bp decrease
would result in a negative short term interest rate and therefore has
measured the risk of decrease in the interest rate at 125 basis points.
The Bancorp’s interest rate risk profile has been impacted by the
origination of floating rate home equity lines and increases in core
deposits, which do not always move in step with market rates. The
Bancorp’s ALCO, along with senior management, views the
origination of home equity products and gathering of core deposits
as beneficial to the strength and stability of the Bancorp’s balance
sheet and earnings. Management does not expect any significant
adverse effect to net interest income in 2003 based on the
composition of the portfolio and anticipated trends in rates.
In order to reduce the exposure to interest rate fluctuations and
to manage liquidity, the Bancorp has developed securitization and
sale procedures for several types of interest-sensitive assets. The
majority of long-term, fixed-rate single family residential mortgage
loans underwritten according to Federal Home Loan Mortgage
Corporation or Federal National Mortgage Association guidelines are
sold for cash upon origination. Periodically, additional assets such as
adjustable-rate residential mortgages, certain consumer leases and
certain short-term commercial loans are also securitized, sold or
transferred off balance sheet. In 2002 and 2001, a total of $9.9 billion
and $12.0 billion, respectively, were sold, securitized, or transferred
off balance sheet (excluding $1.2 billion of divestiture related sales in
2001).
Management focuses its efforts on consistent net interest revenue
and net interest margin growth through each of the retail and
wholesale business lines.
New Accounting Pronouncements
In June 2001, SFAS No. 142, “Goodwill and Other Intangible
Assets” was issued. This statement discontinued the practice of
amortizing goodwill and indefinite lived intangible assets and initiated
an annual review for impairment. Impairment is to be examined
more frequently if certain indicators are encountered. The Bancorp
has completed the initial and the annual goodwill impairment test
required by this standard and has determined that no impairment
exists. Intangible assets with a determinable useful life will continue to
be amortized over that period. The Bancorp adopted the amortization
provisions of SFAS No. 142 effective January 1, 2002. The effect
of the elimination of goodwill amortization increased net income
by approximately $34 million in 2002.
The pro forma after-tax effect of the elimination of goodwill
amortization as if SFAS No. 142 had been effective in 2001 and 2000
was approximately $34 million and $25 million, respectively. The
following table provides an illustration of the impact to diluted
earnings per share, ROA, ROE and efficiency ratios as if the new
accounting standard was effective beginning January 1, 2000.
2001 2000
Year Ended Pro forma Pro forma
2002 2001 2000 Restated Restated
Earnings Per
Diluted Share . . $2.76 $1.86 $1.98 $1.92 $2.02
ROA . . . . . . . . . . 2.18% 1.55% 1.71% 1.59% 1.75%
ROE . . . . . . . . . . 19.9% 15.1% 19.1% 15.5% 19.4%
Efficiency Ratio . . 44.9% 54.8% 50.7% 53.8% 49.9%
In June 2001, the FASB issued SFAS No. 143, “Accounting for
Asset Retirement Obligations.” This statement addresses financial
accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset
retirement costs. This statement is effective for financial statements