Huntington National Bank 2003 Annual Report Download - page 62

MANAGEMENT’S DISCUSSION AND ANALYSIS
I NTEREST R ATE R ISK
Interest rate risk is the primary market risk incurred by the company. It results from timing differences in the repricing and maturity of
assets and liabilities and changes in relationships between market interest rates and the yields on assets and rates on liabilities,
including the impact of embedded options.
Management seeks to minimize the impact of changing interest rates on the company’s net interest income and the fair value of assets
and liabilities. The board of directors establishes broad policies regarding interest rate and market risk, liquidity risk, counter-party
credit risk, and settlement risk. The asset and liability committee (ALCO) establishes specific operating limits within the parameters of
the board of directors’ policies.
Interest rate risk management is a dynamic process that encompasses monitoring loan and deposit flows, investment and funding
activities, and assessing the impact of the changing market and business environment. Effective management of interest rate risk begins
with understanding the interest rate characteristics of assets and liabilities and determining the appropriate interest rate risk posture
given market expectations and policy objectives and constraints. ALCO regularly monitors position concentrations and the level of
interest rate sensitivity to ensure compliance with board of directors approved risk tolerances.
Interest rate risk modeling is performed monthly. Two broad approaches to modeling interest rate risk are employed: income
simulation and economic value analysis. An income simulation analysis is used to measure the sensitivity of forecasted net interest
income to changes in market rates over a one-year horizon. Although bank owned life insurance and automobile operating lease assets
are classified as non-interest earning assets, and the income from these assets is in non-interest income, these portfolios are included in
the interest sensitivity analysis because both have attributes similar to fixed-rate interest earning assets. The economic value analysis
(Economic Value of Equity or EVE) is calculated by subjecting the period-end balance sheet to changes in interest rates and measuring
the impact of the changes in the value of the assets and liabilities.
The models used for these measurements take into account prepayment speeds on mortgage loans, mortgage-backed securities, and
consumer installment loans, as well as cash flows of other loans and deposits. Balance sheet growth assumptions are also considered in
the income simulation model. The models include the effects of embedded options, such as interest rate caps, floors, and call options,
and account for changes in relationships among interest rates.
The baseline scenario for the income simulation analysis, with which all other scenarios are compared, is based on market interest rates
implied by the prevailing yield curve as of the period end. Alternative interest rate scenarios are then compared with the baseline
scenario. These alternative market rate scenarios include parallel rate shifts on both a gradual and immediate basis, movements in rates
that alter the shape of the yield curve (i.e., flatter or steeper yield curve), and spot rates remaining unchanged for the entire
measurement period. Scenarios are also developed to measure basis risk, such as the impact of LIBOR-based rates rising or falling faster
than the prime rate.
When evaluating short-term interest rate risk exposure, the primary measurement represents scenarios that model a gradual 200 basis
point increasing (decreasing) parallel shift in rates over the next twelve-month period versus rates implied by the current yield curve.
At the end of 2003, that scenario modeled net interest income to be approximately 0.5% lower than the internal forecast of net interest
income using the baseline scenario. This compared with 0.7% lower net interest income as of December 31, 2002. Both of these
positions were well within the board of directors’ 4.0% policy limit for change in net interest income given a +/- 200 basis point change
in rates.
Factors affecting the net interest margin in 2003 included (1) the reduction of relatively high-yielding automobile loans as part of
Management’s objective to reduce the concentration of automobile loans; (2) faster prepayments on mortgage-related loans and securities;
(3) the maturity, and subsequent repricing at lower prevailing rates, of older fixed-rate loans not offset by corresponding repricing of
deposits; and (4) lower net interest margin on residential mortgages. The historically steep yield curve in 2003 dampened the impact of this
repricing since a substantial amount of funding sources reprice relative to short-term rates (such as 3-month LIBOR) while many assets
reprice relative to longer-term rates (two-to-five-year terms). A flattening of the yield curve (short-term rates rising more than long-term
rates, or long-term rates falling more than short-term rates) would have a negative effect on the net interest margin.
The primary measurement for EVE risk assumes an immediate and parallel increase in rates of 200 basis points. As of December 31,
2003, the model indicated that such an increase in rates would reduce the EVE by approximately 7.9%, compared with an estimated
negative impact of approximately 3.8% as of December 31, 2002. The increase in the EVE risk during 2003 resulted from (1) the
increase in interest rates and the resultant lengthening of the life of mortgage loans and securities, (2) an investment strategy designed
60 HUNTINGTON BANCSHARES INCORPORATED