KeyBank 2005 Annual Report Download - page 39

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Key’s Board of Directors (“Board”) has established and follows a
corporate governance program that serves as the foundation for managing
and mitigating risk. In accordance with this program, the Board focuses
on the interests of shareholders, encourages strong internal controls,
demands management accountability, mandates adherence to Key’s code
of ethics and administers an annual self-assessment process. The Board
has established Audit and Finance committees whose appointed members
play an integral role in helping the Board meet its risk oversight
responsibilities. Those committees meet jointly, as appropriate, to discuss
matters that relate to each committee’s responsibilities.
Audit Committee
The Audit Committee provides review and oversight of the integrity of
Key’s financial statements, compliance with legal and regulatory
requirements, the independent auditors’ qualifications and independence,
and the performance of Key’s internal audit function and independent
auditors.
Finance Committee
The Finance Committee assists the Board in its review and oversight
of Key’s policies, strategies and activities related to risk management
that fall outside the scope of responsibility of the Audit Committee.
This committee also assists in the review and oversight of policies,
strategies and activities related to capital management, asset and liability
management, capital expenditures and various other financing and
investing activities.
Key’s Board and its committees meet bi-monthly. However, it is not
uncommon for more frequent contact to occur. In addition to regularly
scheduled meetings, the Audit Committee convenes to discuss the content
of Key’s financial disclosures and press releases related to quarterly
earnings. Committee chairpersons routinely meet with management
during interim months to plan agendas for upcoming meetings and to
discuss events that have transpired since the preceding meeting. Also,
during interim months, all members of the Board receive a formal report
designed to keep them abreast of significant developments.
Market risk management
The values of some financial instruments vary not only with changes in
market interest rates, but also with changes in foreign exchange rates,
factors influencing valuations in the equity securities markets and other
market-driven rates or prices. For example, the value of a fixed-rate bond
will decline if market interest rates increase. Similarly, the value of the
U.S. dollar regularly fluctuates in relation to other currencies. When
the value of an instrument is tied to such external factors, the holder
faces “market risk.” Most of Key’s market risk is derived from interest
rate fluctuations.
Interest rate risk management
Key’s Asset/Liability Management Policy Committee has developed a
program to measure and manage interest rate risk. This senior management
committee is also responsible for approving Key’s asset/liability management
(“A/LM”) policies, overseeing the formulation and implementation of
strategies to improve balance sheet positioning and earnings, and reviewing
Key’s sensitivity to changes in interest rates.
Factors contributing to interest rate exposure. Key uses interest rate
exposure models to quantify the potential impact that a variety of
possible interest rate scenarios may have on earnings and the economic
value of equity. The various scenarios estimate the level of Key’s interest
rate exposure arising from gap risk, option risk and basis risk.
• Key often uses interest-bearing liabilities to fund interest-earning
assets. For example, Key may sell certificates of deposit and use the
proceeds to make loans. That strategy presents “gap risk” if the
related liabilities and assets do not mature or reprice at the same time.
• A financial instrument presents “option risk” when one party to the
instrument can take advantage of changes in interest rates without
penalty. For example, when interest rates decline, borrowers may
choose to prepay fixed-rate loans by refinancing at a lower rate.
Such a prepayment gives Key a return on its investment (the principal
plus some interest), but unless there is a prepayment penalty, that
return may not be as high as the return that would have been
generated had payments been received over the original term of the
loan. Floating-rate loans that are capped against potential interest rate
increases and deposits that can be withdrawn on demand also present
option risk.
• One approach that Key follows to manage interest rate risk is to use
floating-rate liabilities (such as borrowings) to fund floating-rate
assets (such as loans). That way, as our interest expense increases, so
will our interest income. We face “basis risk” when our floating-rate
assets and floating-rate liabilities reprice in response to different
market factors or indices. Under those circumstances, even if equal
amounts of assets and liabilities are repricing at the same time, interest
expense and interest income may not change by the same amount.
Measurement of short-term interest rate exposure. Key uses a simulation
model to measure interest rate risk. The model estimates the impact that
various changes in the overall level of market interest rates would have
on net interest income over one- and two-year time periods. The results
help Key develop strategies for managing exposure to interest rate risk.
Like any forecasting technique, interest rate simulation modeling is based
on a large number of assumptions and judgments. Primary among these
for Key are those related to loan and deposit growth, asset and liability
prepayments, interest rate variations, product pricing, and on- and off-
balance sheet management strategies. Management believes its assumptions
are reasonable. Nevertheless, simulation modeling produces only a
sophisticated estimate, not a precise calculation of exposure.
Key’s risk management guidelines call for preventive measures to be taken
if simulation modeling demonstrates that a gradual 200 basis point
increase or decrease in short-term rates over the next twelve months,
defined as a stressed interest rate scenario, would adversely affect net
interest income over the same period by more than 2%. Key is operating
within these guidelines.
When an increase in short-term interest rates is expected to generate lower
net interest income, the balance sheet is said to be “liability-sensitive,”
meaning that rates paid on deposits and other liabilities respond more
quickly to market forces than yields on loans and other assets. Conversely,
when an increase in short-term interest rates is expected to generate
greater net interest income, the balance sheet is said to be “asset-sensitive,”
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