Fifth Third Bank 2008 Annual Report Download - page 50

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
48 Fifth Third Bancorp
general, the increase in historical loss reserve factors was
responsible for over half of the year-over-year increase in the
allowance for loan and lease losses.
As mentioned, real estate price deterioration, as measured by
the Home Price Index, was most prevalent in some of the key
lending markets of the Bancorp. The deterioration in real estate
values increased the expected loss once a loan becomes
delinquent, particularly for residential mortgage and home equity
loans with high loan-to-value ratios.
Economic trends such as gross domestic product,
unemployment rate, home sales and inventory and bankruptcy
filings have historically provided indicators of trends in loan and
lease loss rates. Compared to the prior year, negative trends in
general economic conditions in the national and local economies
caused increases in reserve factors used to determine the losses
inherent within the loan and lease portfolio.
The Bancorp continually reviews its credit administration and
loan and lease portfolio and makes changes based on the
performance of its products. Over the past year, the Bancorp has
reduced its lending to homebuilders and developers and
borrowers with non-owner occupied real estate as collateral,
eliminated brokered home equity production and engaged in
significant loss mitigation strategies.
MARKET RISK MANAGEMENT
Market risk arises from the potential for market fluctuations in
interest rates, foreign exchange rates and equity prices that may
result in potential reductions in net income. Interest rate risk, a
component of market risk, is the exposure to adverse changes in
net interest income or financial position due to changes in interest
rates. Management considers interest rate risk a prominent
market risk in terms of its potential impact on earnings. Interest
rate risk can occur for any one or more of the following reasons:
• Assets and liabilities may mature or reprice at different
times;
• Short-term and long-term market interest rates may change
by different amounts; or
• The expected 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
originations, the value of servicing rights and other sources of the
Bancorp’s earnings. Stability of the Bancorp’s net income is
largely dependent upon the effective management of interest rate
risk. Management continually reviews the Bancorp’s balance sheet
composition and earnings flows and models the interest rate risk,
and possible actions to reduce this risk, given numerous possible
future interest rate scenarios.
Earnings Simulation Model
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 the sensitivity of net interest
income and certain noninterest items to changing interest rates.
The model is based on contractual and assumed 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 of the future volume and pricing of each
of the product lines offered by the Bancorp as well as other
pertinent assumptions. 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 Executive Asset Liability 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
activities of ALCO, the Bancorp has a Market Risk Management
function as part of ERM that provides independent oversight of
market risk activities. The Bancorp’s interest rate risk exposure is
currently evaluated by measuring the anticipated change in net
interest income and mortgage banking net revenue over 12-month
and 24-month horizons assuming a 100 bp parallel ramped
increase and a 200 bp parallel ramped increase in interest rates.
The Fed Funds interest rate, targeted by the Federal Reserve at a
range of 0% to 0.25%, is currently set at a level that would be
negative in parallel ramped decrease scenarios; therefore, those
scenarios were omitted from the interest rate risk analyses for
December 31, 2008. In accordance with the current policy, the
rate movements are assumed to occur over one year and are
sustained thereafter.
Table 35 shows the Bancorp's estimated earnings sensitivity
profile and ALCO policy limits as of December 31, 2008:
TABLE 35: ESTIMATED EARNINGS SENSITIVITY PROFILE
Change in Earnings (FTE) ALCO Policy Limits
Change in
Interest
Rates (bp)
12
Months
13 to 24
Months
12
Months
13 to 24
Months
+200 (2.79%) (1.67) (5.00) (7.00)
+100 (2.28) (1.66) - -
Economic Value of Equity
The Bancorp also employs economic value of equity (EVE) as a
measurement tool in managing interest rate risk. Whereas the
earnings simulation highlights exposures over a relatively short
time horizon, the EVE analysis incorporates all cash flows over
the estimated remaining life of all balance sheet and derivative
positions. The EVE of the balance sheet, at a point in time, is
defined as the discounted present value of asset and derivative
cash flows less the discounted value of liability cash flows. The
sensitivity of EVE to changes in the level of interest rates is a
measure of longer-term interest rate risk. EVE values only the
current balance sheet and does not incorporate the growth
assumptions used in the earnings simulation model. As with the
earnings simulation model, assumptions about the timing and
variability of balance sheet cash flows are critical in the EVE
analysis. Particularly important are the assumptions driving
prepayments and the expected changes in balances and pricing of
the transaction deposit portfolios. The following table shows the
Bancorp’s EVE sensitivity profile as of December 31, 2008:
TABLE 36: ESTIMATED EVE SENSITIVITY PROFILE
Change in
Interest Rates (bp) Change in EVE ALCO Policy Limits
+200 (1.25%) (20.0)
+100 (0.15)
-25 (0.06)
While an instantaneous shift in interest rates is used in this
analysis to provide an estimate of exposure, the Bancorp believes
that a gradual shift in interest rates would have a much more
modest impact. Since EVE measures the discounted present
value of cash flows over the estimated lives of instruments, the
change in EVE does not directly correlate to the degree that
earnings would be impacted over a shorter time horizon (e.g., the
current fiscal year). Further, EVE does not take into account
factors such as future balance sheet growth, changes in product
mix, changes in yield curve relationships and changing product
spreads that could mitigate the adverse impact of changes in
interest rates. The earnings simulation and EVE analyses do not
necessarily include certain actions that management may
undertake to manage this risk in response to anticipated changes
in interest rates.