Fifth Third Bank 2003 Annual Report Download - page 66

FIFTH THIRD BANCORP AND SUBSIDIARIES
64
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
assets or liabilities may shorten or lengthen as interest rates change. In
addition to the direct impact of interest rate changes on net interest
income, interest rates can indirectly impact earnings through their
effect on loan demand, credit losses, mortgage origination fees, the
value of mortgage servicing rights and other sources of the Bancorp’s
earnings. 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 re-pricing
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.
Actual results will differ from these 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 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. In addition to the risk management activities
of ALCO, the Bancorp in 2003 created a Market Risk Management
department as part of the Enterprise Risk Management division
which provides independent oversight of market risk activities. The
Bancorp’s current interest rate risk policy limits are determined by
measuring the anticipated change in net interest income over a 12
month and 24 month horizon assuming a 200 bp linear increase or
decrease in all interest rates. In accordance with the current policy,
the rate movements occur over one year and are sustained thereafter.
The following table shows the Bancorp’s estimated earnings
sensitivity profile as of December 31, 2003:
Table 27–Estimated Earnings Sensitivity Profile
Change in Percentage Change in
Interest Rates Net Interest Income
(basis points) Year 1 Year 2
+200 (1.4)% 1.4)%
-100 (.4)% (6.1)%
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 decrease by 1.4% in the first year and increase by
1.4% in the second year. A 100 bp linear decrease in interest rates
would decrease net interest income by .4% in the first year and an
estimated 6.1% in the second year. Given the low level of interest
rates, the Bancorp’s ALCO has measured the risk of a decrease in
interest rates at 100 basis points. Management does not expect any
significant adverse effect to net interest income in 2004 based on
the composition of the portfolio and anticipated trends in rates.
In the ordinary course of business, the Bancorp enters into
derivative transactions as a part of its overall strategy to manage its
interest rate risks and prepayment risks and to accommodate the
business requirements of its customers. Derivative instruments that
the Bancorp may use as part of its interest rate risk management
strategy include interest rate swaps, interest rate floors, interest rate
caps, forward contracts, options and swaptions. As part of its overall
risk management strategy relative to its mortgage banking activities,
the Bancorp enters into PO swaps, swaptions, floors, forward
contracts, options and interest rate swaps to economically hedge
interest rate lock commitments and changes in fair value of its
largely fixed rate MSR portfolio. The notional amounts and fair
values of these derivative instruments as of December 31, 2003 are
presented in Note 9 to the Consolidated Financial Statements.
Critical Accounting Policies
Reserve for Credit Losses: The Bancorp maintains a reserve to absorb
probable loan and lease losses inherent in the portfolio. The reserve
for credit losses is maintained at a level the Bancorp considers to be
adequate to absorb probable loan and lease losses inherent in the
portfolio and is based on ongoing quarterly assessments and
evaluations of the collectibility and historical loss experience of loans
and leases. Credit losses are charged and recoveries are credited to the
reserve. Provisions for credit losses are based on the Bancorp’s review
of the historical credit loss experience and such factors that, in
management’s judgment, deserve consideration under existing
economic conditions in estimating probable credit losses. In
determining the appropriate level of reserves, the Bancorp estimates
losses using a range derived from “base” and “conservative” estimates.
The Bancorp’s methodology for assessing the appropriate reserve level
consists of several key elements, as discussed below. The Bancorp’s
strategy for credit risk management includes a combination of
conservative exposure limits significantly below legal lending limits,
and conservative underwriting, documentation and collection
standards. The strategy also emphasizes diversification on a
geographic, industry and customer level, regular credit examinations
and quarterly management reviews of large credit exposures and loans
experiencing deterioration of credit quality.
Larger commercial loans that exhibit probable or observed credit
weaknesses are subject to individual review. Where appropriate,
reserves are allocated to individual loans based on management’s
estimate of the borrower’s ability to repay the loan given the
availability of collateral, other sources of cash flow and legal options
available to the Bancorp. Included in the review of individual loans are
those that are impaired as provided in SFAS No. 114, “Accounting by
Creditors for Impairment of a Loan.” Any reserves for impaired loans
are measured based on the present value of expected future cash
flows discounted at the loan’s effective interest rate or fair value of
the underlying collateral. The Bancorp evaluates the collectibility of
both principal and interest when assessing the need for a loss accrual.
Historical loss rates are applied to other commercial loans not subject
to specific reserve allocations. The loss rates are derived from a
migration analysis, which computes the net charge-off experience
sustained on loans according to their internal risk grade. These grades
encompass ten categories that define a borrower’s ability to repay their
loan obligations. The risk rating system is intended to identify and
measure the credit quality of all commercial lending relationships.
Homogenous loans, such as consumer installment, residential
mortgage loans, and automobile leases, are not individually risk
graded. Rather, standard credit scoring systems and delinquency
monitoring are used to assess credit risks. Reserves are established for
each pool of loans based on the expected net charge-offs for one year.
Loss rates are based on the average net charge-off history by loan
category.
Historical loss rates for commercial and consumer loans may be
adjusted for significant factors that, in management’s judgment,
reflect the impact of any current conditions on loss recognition.
Factors that management considers in the analysis include the effects
of the national and local economies, trends in the nature and volume