Fifth Third Bank 2009 Annual Report Download - page 57

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Fifth Third Bancorp 55
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.
Net Interest Income (NII) Simulation Model
The Bancorp employs a variety of measurement techniques to
identify and manage its interest rate risk, including the use of an
NII simulation model to analyze the sensitivity of net interest
income 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 may 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 Management
Committee (ALCO), which includes senior management
representatives and is accountable to the Enterprise Risk
Management Committee, 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 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, 2009. In
accordance with the current policy, the rate movements are
assumed to occur over one year and are sustained thereafter.
At December 31, 2009, the Bancorp’s simulated exposure to
a change in interest rates as described above was effectively
neutral in year one and asset sensitive in year two. Table 45 shows
the Bancorp's estimated net interest income sensitivity profile and
ALCO policy limits as of December 31, 2009:
TABLE 45: ESTIMATED NII SENSITIVITY PROFILE
Percent Change in NII
(FTE) ALCO Policy Limits
Change in
Interest
Rates (bp)
12
Months
13 to 24
Months
12
Months
13 to 24
Months
+200 (0.15%) 1.45 (5.00) (7.00)
+100 0.10 1.08 - -
Market Value of Equity
The Bancorp also employs market value of equity (MVE) as a
measurement tool in managing interest rate risk. Whereas the
earnings simulation highlights exposures over a relatively short
time horizon, the MVE analysis incorporates all cash flows over
the estimated remaining life of all balance sheet and derivative
positions. The MVE 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 MVE to changes in the level of interest rates is a
measure of longer-term interest rate risk. MVE 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 MVE
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 MVE sensitivity profile as of December 31, 2009:
TABLE 46: ESTIMATED MVE SENSITIVITY PROFILE
Change in
Interest Rates (bp) Change in MVE ALCO Policy Limits
+200 (3.07%) (15.0)
+100 (0.86)
+25 0.09
-25 (0.08)
This MVE profile suggests that the Bancorp would benefit
modestly from an initial increase in rates, but would lose value as
rates continue to rise. 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 MVE measures the discounted
present value of cash flows over the estimated lives of
instruments, the change in MVE does not directly correlate to the
degree that earnings would be impacted over a shorter time
horizon (e.g., the current fiscal year). Further, MVE 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 NII simulation and MVE analyses do not
necessarily include certain actions that management may
undertake to manage this risk in response to anticipated changes
in interest rates.
Use of Derivatives to Manage Interest Rate Risk
An integral component of the Bancorp’s interest rate risk
management strategy is its use of derivative instruments to
minimize significant fluctuations in earnings caused by changes in
market interest rates. Examples of 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, principal only swaps, options and
swaptions.
As part of its overall risk management strategy relative to its
mortgage banking activity, the Bancorp enters into forward