Fifth Third Bank 2004 Annual Report Download - page 31

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Fifth Third Bancorp 29
leases and other assets, including other real estate owned declined
to .51% as of December 31, 2004 from .61% as of December
31, 2003. Loans and leases 90 days past due have also declined
at December 31, 2004 compared to December 31, 2003. The
Bancorp expects credit quality trends in 2005 to remain similar
to 2004.
At December 31, 2004, there were $40.9 million of loans
and leases currently performing in accordance with contractual
terms, but for which there were serious doubts as to the ability of
the borrower to comply with such terms. For the years 2004 and
2003, interest income of $6 million and $5 million, respectively,
was recorded on nonaccrual and renegotiated loans and leases.
For the years 2004 and 2003, additional interest income of $33
million and $23 million, respectively, would have been recorded if
the nonaccrual and renegotiated loans and leases had been current
in accordance with the original terms.
Analysis of Net Loan Charge-offs
Net charge-offs as a percent of average loans and leases outstanding
decreased 18 bp to .45% for 2004 from .63% for 2003. The decrease
in net charge-offs in the current year compared to 2003 was primar-
ily due to lower net charge-offs in commercial loans and commercial
and consumer lease fi nancing. Total commercial loan net charge-offs
decreased $55 million to $81 million in 2004 compared to $136
million in 2003. Commercial loan net charge-offs as a percentage of
average commercial loans outstanding were .54% in 2004, compared
to 1.00% in 2003. The decrease in commercial loan net charge-offs
compared to 2003 was concentrated in several markets, includ-
ing Columbus and Chicago. The Bancorp experienced signifi cant
improvement in commercial loan net charge-off activity in 2004
as compared to 2003 as a result of overall improving credit trends
and economic outlook. Commercial mortgage net charge-offs were
comparable to the low level seen in 2003. Commercial leasing net
charge-offs improved due to charge-offs related to two commercial
airline leases totaling $20 million occurring in 2003. Total consumer
loan net charge-offs in 2004 increased to $115 million compared
with $96 million in 2003, with increases not concentrated in any
specifi c market. The ratio of consumer loan net charge-offs to aver-
age loans outstanding increased slightly to .63% in 2004 from .58%
in 2003, and the ratio for residential mortgage loan net charge-offs
improved from .57% to .27% due to improvements in most of the
Bancorp’s markets.
Provision and Reserve for Loan and Lease Losses
The reserve for loan and lease losses provides coverage for probable
and estimable losses in the loan and lease portfolio. The Bancorp
evaluates the reserve each quarter to determine that it is adequate
to cover inherent losses. In the current year, the Bancorp has not
substantively changed any aspect to its overall approach in the
determination of the reserve for loan and lease losses, and there have
been no material changes in assumptions or estimation techniques
as compared to prior periods that impacted the determination of the
current period reserve. Table 21 shows the changes in the reserve for
loan and lease losses during 2004. As of December 31, 2004, the
reserve for unfunded commitments has been reclassifi ed from the
reserve for loan and lease losses to other liabilities. The December 31,
2003 reserve for unfunded commitments and all subsequent activity
has been reclassifi ed to conform to current period presentation.
The increase in the balance of the reserve for loan and lease
losses in 2004 compared to 2003 is primarily due to the increase
in the total loan and lease portfolio. The reserve for loan and lease
losses at December 31, 2004 decreased to 1.19% of the total loan
and lease portfolio compared to 1.33% at December 31, 2003
due to improvements in credit quality trends. Additionally, the
Bancorp’s long history of low exposure limits, minimal exposure to
national or sub-prime lending businesses, centralized risk manage-
ment and its diversifi ed portfolio reduces the likelihood of signifi -
cant unexpected credit losses. Table 22 provides the amount of the
reserve for loan and lease losses by category.
MARKET RISK MANAGEMENT
Market risk arises from fl uctuations in interest rates, foreign
exchange rates and equity prices that may result in the potential
reduction in net interest income. Interest rate risk, a component
of market risk, is the exposure to adverse changes in net interest
income due to changes in interest rates. Management considers
interest rate risk a prominent market risk in terms of its poten-
tial impact on earnings. Interest rate risk can occur for any one or
more of the following reasons: (i) assets and liabilities may mature
or reprice at different times; (ii) short-term and long-term market
interest rates may change by different amounts or; (iii) the remain-
ing maturity of various 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 servicing rights and other
sources of the Bancorp’s earnings. Consistency of the Bancorp’s net
interest income is largely dependent upon the effective manage-
ment of interest rate risk.
Net Interest Income Simulation Model
The Bancorp employs a variety of measurement techniques to iden-
tify and manage its interest rate risk, including the use of an earn-
ings simulation model to analyze net interest income sensitivity to
changing interest rates. The model is based on actual cash fl ows and
repricing characteristics for all of the Bancorp’s fi nancial instru-
ments 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 and incorporates the loss of free funding result-
ing from the Bancorp’s share repurchase activity. 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 Risk Management Committee
(“ALCO”), which includes senior management representatives and
is accountable to the Risk and Compliance Committee of the Board
of Directors, monitors and manages interest rate risk within Board
approved policy limits. In addition to the risk management activi-
ties of ALCO, the Bancorp 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 are assumed to occur over one year and
are sustained thereafter. 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. Additionally, in order to further illus-
trate the estimated earnings sensitivity of interest rate changes, the
Bancorp has included the anticipated change to net interest income
over a 12-month and 24-month horizon assuming a 100 bp linear
increase. The following table shows the Bancorp’s estimated earn-
ings sensitivity profi le on the asset and liability positions as of
December 31, 2004:
TABLE 24: ESTIMATED EARNINGS SENSITIVITY PROFILE
Change in
Net Interest Income
Change in Interest Rates (bp) 12 Months 24 Months
+200 .34% 4.07
+100 .32 2.86
-100 .04 (4.05)