Huntington National Bank 2008 Annual Report Download - page 59

Interest Rate Risk
Interest rate risk is the risk to earnings and value arising from changes in market interest rates. Interest rate risk arises from timing
differences in the repricings and maturities of interest bearing assets and liabilities (reprice risk), changes in the expected maturities
of assets and liabilities arising from embedded options, such as borrowers’ ability to prepay residential mortgage loans at any time
and depositors’ ability to terminate certificates of deposit before maturity (option risk), changes in the shape of the yield curve
whereby interest rates increase or decrease in a nonparallel fashion (yield curve risk), and changes in spread relationships between
different yield curves, such as U.S. Treasuries and LIBOR (basis risk.)
Our board of directors establishes broad policy limits with respect to interest rate risk. Our Market Risk Committee (MRC)
establishes specific operating guidelines within the parameters of the board of directors’ policies. In general, we seek to minimize
the impact of changing interest rates on net interest income and the economic values of assets and liabilities. Our MRC regularly
monitors the level of interest rate risk sensitivity to ensure compliance with board of directors approved risk limits.
Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by
investment and funding activities. Effective management of interest rate risk begins with understanding the dynamic characteristics
of assets and liabilities and determining the appropriate interest rate risk position given Line of Business forecasts, management
objectives, market expectations, and policy constraints.
“Asset sensitive position” refers to a decrease in short-term interest rates that is expected to generate lower net interest income as
rates earned on our interest earning assets would reprice downward more quickly than rates paid on our interest bearing liabilities.
Conversely, “liability sensitive position” refers to a decrease in short-term interest rates that is expected to generate higher net
interest income as rates paid on our interest bearing liabilities would reprice downward more quickly than rates earned on our
interest earning assets.
Income Simulation and Economic Value Analysis
Interest rate risk measurement 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 time horizon. Although bank owned life insurance and automobile operating
lease assets are classified as noninterest earning assets, and the income from these assets is in noninterest income, these portfolios
are included in the interest sensitivity analysis because both have attributes similar to fixed-rate interest earning assets. Economic
value of equity (EVE) analysis is used to measure the sensitivity of the values of period-end assets and liabilities to changes in
market interest rates. EVE serves as a complement to income simulation modeling as it provides risk exposure estimates for time
periods beyond the one-year simulation horizon.
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 assets and liabilities. Balance sheet growth assumptions are also
considered in the income simulation model. The models include the effects of derivatives, such as interest rate swaps, interest rate
caps, floors, and other types of interest rate options.
The baseline scenario for 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 interest rate scenarios include parallel rate shifts on both a gradual and immediate basis,
movements in interest rates that alter the shape of the yield curve (e.g., flatter or steeper yield curve), and current interest rates
remaining unchanged for the entire measurement period. Scenarios are also developed to measure short-term repricing risks, such
as the impact of LIBOR-based interest 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 parallel shifts in market interest rates over the next 12-month period beyond the interest rate change implied by the current
yield curve. As of December 31, 2008, management instituted an assumption that market interest rates would not fall below 0%
over the next 12-month period for the scenarios that used the “-100” and “-200” basis point parallel shift in market interest rates.
The table below shows the results of the scenarios as of December 31, 2008, and December 31, 2007. All of the positions were well
within the board of directors’ policy limits.
57
Management’s Discussion and Analysis Huntington Bancshares Incorporated