KeyBank 2005 Annual Report Download - page 43

42
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
the maximum potential one-day loss with a 95% confidence level.
Statistically, this means that losses will exceed VAR, on average, one out
of 100 trading days, or two to three times each year. Key’s Financial
Markets Committee has established VAR limits for our trading units.
At December 31, 2005, the aggregate one-day trading limit set by the
committee was $4.4 million. In addition to comparing VAR exposure
against limits on a daily basis, management monitors loss limits, uses
sensitivity measures and conducts stress tests.
Key is operating within the above constraints. During 2005, Key’s
aggregate daily average, minimum and maximum VAR amounts were
$2.1 million, $.8 million and $5.3 million, respectively. During 2004,
Key’s aggregate daily average, minimum and maximum VAR amounts
were $1.6 million, $.8 million and $4.1 million, respectively.
As noted in the discussion of investment banking and capital markets
income on page 26, Key used interest rate swaps to manage the economic
risk associated with its sale of the indirect automobile loan portfolio.
Even though these derivatives were not subject to VAR trading limits,
Key measured their exposure on a daily basis and the results are
included in the VAR amounts indicated above for 2005. The daily
average, minimum and maximum VAR exposures for these derivatives
were $.8 million, zero and $3.6 million, respectively.
Credit risk management
Credit risk represents the risk of loss arising from an obligor’s inability or
failure to meet contractual payment or performance terms. It is inherent
in the financial services industry and results from extending credit to clients,
purchasing securities and entering into financial derivative contracts.
Credit policy, approval and evaluation. Key manages its credit risk
exposure through a multi-faceted program. Independent committees
approve both retail and commercial credit policies. Once approved, these
policies are communicated throughout Key with the objective of having
a consistent approach to granting credit.
The Credit Risk Management department performs credit approval.
Credit Risk Management is independent of Key’s lines of business and
comprises senior officers who have extensive experience in structuring
and approving loans. Only Credit Risk Management officers are
authorized to grant significant exceptions to credit policies. Exceptions
to established policies are normal when mitigating circumstances dictate.
Most major lending units have been assigned specific thresholds designed
to keep exceptions within a manageable level. Key has a well-established
process in place to monitor compliance with credit policies known as the
quarterly Underwriting Standards Review (“USR”). The quarterly USR
report provides data on all commercial loans over $2 million at the time
of their approval. Each quarter, the data is analyzed to determine if lines
of business have adhered to established exception limits. Further, the USR
report identifies grading trends of new business, hurdle rate exceptions,
transactions with higher risk and other pertinent lending information.
This process is intended to allow Key to take timely action to modify
lending practices when necessary.
Credit Risk Management is responsible for assigning loan grades at
the time of origination and as the loans season. Most extensions of
credit at Key are subject to loan grading or scoring. This risk rating
methodology blends management’s judgment and quantitative modeling.
On the commercial side, loans generally are assigned two internal risk
ratings. The first rating reflects the probability that the borrower will
default on an obligation; the second reflects expected loss, given default,
on a particular credit facility. Both ratings work from a twenty grade
rating scale. The assessment of default probability is based, among
other factors, on the financial strength of the borrower, an assessment
of the borrower’s management, the borrower’s competitive position
within its industry sector and an assessment of industry risk within the
context of the general economic outlook. Types of exposure and
transaction structure, including credit risk mitigants, are additional
factors that affect the expected loss assessment.
Externally and internally developed risk models are used to evaluate
consumer loans. These models (“scorecards”) forecast probability of
serious delinquency and default for an applicant. The scorecards are
embedded in our application processing system, which allows for real
time scoring and automated decisions for many of Key’s products. Key
periodically validates the loan grading and scoring processes.
Key maintains an active concentration management program to help
diversify its credit portfolios. On exposures to individual obligors, Key
employs a sliding scale of exposure (“hold limits”), which is dictated by the
strength of the borrower. Internal hold limits are higher for borrowers with
higher credit quality. Key’s legal lending limit is well in excess of $1
billion for any individual borrower. However, internal hold limits generally
restrict the largest exposures to less than half that amount. As of December
31, 2005, Key had fourteen client relationships with loan commitments of
more than $200 million. The average amount outstanding on these
commitments at December 31 was $78 million. In general, Key’s philosophy
is to maintain a diverse portfolio with regard to credit exposures.
Key manages industry concentrations using several methods. On smaller
portfolios, we sometimes set limits according to a percentage of Key’s
overall loan portfolio. On larger, or higher risk portfolios, Key may
establish a specific dollar commitment level or a level of economic
capital that is not to be exceeded.
In addition, Key takes an active role in managing the overall loan
portfolio in a manner consistent with our asset quality objectives.
Actions taken to manage the loan portfolio could entail the use of
derivatives to buy or sell credit protection, loan securitizations, portfolio
swaps or bulk purchases and sales. The overarching goal is to continually
manage the loan portfolio within a desirable range of asset quality.
Allowance for loan losses. The allowance for loan losses at December
31, 2005, stood at $966 million, or 1.45% of loans. This compares with
$1.138 billion, or 1.80% of loans, at December 31, 2004. The allowance
includes $6 million that was specifically allocated for impaired loans of
$9 million at December 31, 2005, compared with $12 million that
was allocated for impaired loans of $38 million one year ago. For
more information about impaired loans, see Note 9 (“Impaired Loans
and Other Nonperforming Assets”) on page 73. At December 31,
2005, the allowance for loan losses was 348.74% of nonperforming
loans, compared with 369.48% at December 31, 2004.
During the first quarter of 2004, Key reclassified $70 million of its
allowance for loan losses to a separate allowance for probable credit losses
inherent in lending-related commitments. Earnings for the first quarter of
2004 and prior period balances were not affected by this reclassification.
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