Huntington National Bank 2004 Annual Report Download - page 58

MANAGEMENT’S DISCUSSION AND ANALYSIS HUNTINGTON BANCSHARES INCORPORATED
Market Risk
Market risk represents the risk of loss due to changes in the market value of assets and liabilities. The Company incurs market risk in the
normal course of business. Market risk arises when the Company extends fixed-rate loans, purchases fixed-rate securities, originates
fixed-rate CDs, obtains funding through fixed-rate borrowings, and leases automobiles and equipment based on expected lease residual
values. The Company has identified three primary sources of market risk: interest rate risk, lease residual risk and price risk.
Interest Rate Risk
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 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 MRC 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. MRC 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.
The simulations for evaluating short-term interest rate risk exposure are scenarios that model gradual 100 and 200 basis point
increasing and decreasing parallel shifts in interest rates over the next 12-month period beyond the interest rate change implied by the
current yield curve. The table below shows the results of the scenarios as of December 31, 2004, and December 31, 2003. All of the
positions were well within the board of directors’ policy limits.
Net Interest Income at Risk (%)
Basis point change scenario –200 –100 +100 +200
Board Policy Limits –4.0% –2.0% –2.0% –4.0%
December 31, 2004 –1.2% –0.5% +0.2% +0.2%
December 31, 2003 N.M. –0.3% –0.2% –0.5%
N.M., not a meaningful value.
The primary simulations for EVE risk assume an immediate and parallel increase in rates of +/– 100 and +/– 200 basis points beyond
any interest rate change implied by the current yield curve. The table below outlines the results compared to the previous quarter and
policy limits.
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