Fifth Third Bank 2003 Annual Report Download - page 35

Notes to Consolidated Financial Statements
FIFTH THIRD BANCORP AND SUBSIDIARIES
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party is the contract amount.
Foreign exchange contracts are for future delivery or purchase of
foreign currency at a specified price. As of December 31, 2003, the
Bancorp had entered into various foreign exchange (F/X) related
derivative instruments (F/X spots, F/X forwards, F/X options) with
commercial customers. Risks arise from the possible inability of
counterparties to meet the terms of their contracts and from any
resultant exposure to movement in foreign currency exchange rates,
limiting the Bancorp’s exposure to the replacement value of the
contracts rather than the notional amounts. The Bancorp generally
reduces its market risk for foreign exchange contracts by entering into
offsetting third-party forward contracts. The foreign exchange
contracts outstanding at December 31, 2003 generally mature in
one year or less.
The Bancorp enters into forward contracts for future delivery of
residential mortgage loans at a specified yield to reduce the interest
rate risk associated with fixed-rate residential mortgages held for sale
and commitments to fund residential mortgage loans. Credit risk
arises from the possible inability of the other parties to comply with
the contract terms. The majority of the Bancorp’s forward contracts
are to-be-announced securities backed by U.S. Government-
sponsored agencies (FNMA, FHLMC) with investment grade
companies.
The Bancorp manages a portion of the risk of the mortgage
servicing rights portfolio with a combination of derivatives.
Throughout 2003, the Bancorp entered into principal only swaps
and interest rate swaps and purchased and sold various options on
interest rate swaps. See Note 9 for the notional amounts, average
receive rate and average pay rate for the mortgage servicing rights
portfolio related derivatives at December 31, 2003.
The Bancorp also enters into interest rate swaps to convert
certain fixed-rate long-term debt to floating-rate debt and to convert
certain floating-rate debt to fixed-rate debt. See Note 9 for the
notional amounts, average receive rate and average pay rate on
interest rate swap derivative contracts at December 31, 2003.
As of December 31, 2003, the Bancorp had also entered into
various interest rate related derivative instruments (interest rate
swaps, interest rate floors and interest rate caps) with commercial
clients with an aggregate notional amount of $2.4 billion. The
Bancorp has hedged its interest rate exposure with commercial
clients by executing offsetting swap agreements with other
derivatives dealers. These transactions involve the exchange of fixed
and floating interest rate payments without the exchange of the
underlying principal amounts. Therefore, while notional principal
amounts are typically used to express the volume of these
transactions it does not represent the much smaller amounts that
are potentially subject to credit risk. Entering into interest rate
swap agreements involves the risk of dealing with counterparties
and their ability to meet the terms of the contract. The Bancorp
controls the credit risk of these transactions through adherence to a
derivatives products policy, credit approval policies and monitoring
procedures.
Interest rate lock commitments represent interest rate locks on
fixed-rate residential mortgage loan commitments that will be held
for sale. The interest rate exposure related to these interest rate lock
commitments is economically hedged primarily with forward
contracts. See Note 9 for the notional amounts and the weighted-
average remaining maturity in months on interest rate lock
commitments outstanding at December 31, 2003.
There are claims pending against the Bancorp and its subsidiaries
which have arisen in the normal course of business. Based on a
review of such litigation with legal counsel, management believes
any resulting liability would not have a material effect upon the
Bancorp’s consolidated financial position or results of operations.
14. Legal and Regulatory Proceedings
During 2003, eight putative class action complaints were filed in the
United States District Court for the Southern District of Ohio
against the Bancorp and certain of its officers alleging violations of
federal securities laws related to disclosures made by the Bancorp
regarding its integration of Old Kent and its effect on the Bancorp’s
infrastructure, including internal controls, and prospects and related
matters. The complaints seek unquantified damages on behalf of
putative classes of persons who purchased the Bancorp’s common
stock, attorneys’ fees and other expenses. Management believes there
are substantial defenses to these lawsuits and intends to defend them
vigorously. The impact of the final disposition of these lawsuits
cannot be assessed at this time.
The Bancorp and its subsidiaries are not parties to any other
material litigation other than those arising in the normal course of
business. While it is impossible to ascertain the ultimate resolution
or range of financial liability with respect to these contingent
matters, management believes any resulting liability from these
other actions would not have a material effect upon the Bancorp’s
consolidated financial position or results of operations.
On March 27, 2003, the Bancorp announced that it and Fifth
Third Bank had entered into a Written Agreement with the Federal
Reserve Bank of Cleveland and the State of Ohio Department of
Commerce, Division of Financial Institutions, which outlines a
series of steps to address and strengthen the Bancorp’s risk
management processes and internal controls. These steps include
independent third-party reviews and the submission of written plans
in a number of areas. These areas include the Bancorp’s
management, corporate governance, internal audit, account
reconciliation procedures and policies, information technology and
strategic planning. The Bancorp has submitted all documentation
and information currently required by the Written Agreement,
including all independent third-party reviews. The Bancorp has
largely completed the staffing of its Risk Management group and
has supplemented the size and expertise of the Internal Audit group.
The Bancorp believes the improvement of these areas, as well as
others described in the Written Agreement, is nearly completed.
The Bancorp is continuing to work in cooperation with the Federal
Reserve Bank and the State of Ohio and is devoting its attention to
assisting the Regulators in verifying this progress. The Bancorp is
targeting to accomplish this verification during the first quarter of
2004.
On November 12, 2002, the Bancorp was informed by a letter
from the Securities and Exchange Commission (the Commission)
that the Commission was conducting an informal investigation
regarding the after-tax charge of $54 million reported in the
Bancorp’s Form 8-K dated September 10, 2002 and the existence or
effects of weaknesses in financial controls in the Bancorp’s Treasury
and/or Trust operations. The Bancorp has responded to all of the
Commission’s requests.
In December of 2003, the Bancorp completed the merger of its
Fifth Third Bank, Kentucky, Inc., Fifth Third Bank, Northern
Kentucky, Inc., Fifth Third Bank, Indiana and Fifth Third Bank,
Florida subsidiary banks with and into Fifth Third Bank
(Michigan). Although these mergers changed the legal structure of
the subsidiary banks, there were no significant changes to the
Bancorp’s affiliate structure or operating model.