KeyBank 2006 Annual Report Download - page 48

48
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
compared to the base case of an unchanged interest rate environment. The
analysis also considers sensitivity to changes in a number of other
variables, including other market interest rates and deposit mix. In
addition, management assesses the potential effect of different shapes in
the yield curve, including a sustained flat yield curve, an inverted slope yield
curve and yield curve twists. (The yield curve depicts the relationship
between the yield on a particular type of security and its term to maturity.)
Management also performs stress tests to measure the effect on net
interest income of an immediate change in market interest rates.
Simulation analysis produces only a sophisticated estimate of interest rate
exposure based on assumptions and judgments related to balance sheet
growth, customer behavior, new products, new business volume, pricing
and anticipated hedging activities. Management tailors the assumptions
used in simulation analysis to the specific interest rate environment and
yield curve shape being modeled, and validates those assumptions on a
periodic basis. Consistent with current practice, simulations are
performed with the assumption that interest rate risk positions will be
actively managed through the use of on- and off-balance sheet financial
instruments to achieve the desired risk profile. Actual results may differ
from those derived in simulation analysis due to the timing, magnitude
and frequency of interest rate changes, actual hedging strategies
employed and changes in balance sheet composition. Figure 28 illustrates
the variability of the simulation results that can arise from changes in
certain major assumptions.
Per $100 Million of New Business Net Interest Income Volatility Interest Rate Risk Profile
Floating-rate commercial loans Increases annual net interest income $1.3 million. No change.
at 6.50% funded short-term.
Two-year fixed-rate CDs at 4.75% Rates unchanged: Increases annual net interest Reduces the “standard” simulated
that reduce short-term funding. income $.5 million. net interest income at risk to rising
rates by .03%.
Rates up 200 basis points over 12 months:
Increases annual net interest income $1.6 million.
Five-year fixed-rate home equity Rates unchanged: Increases annual net interest Increases the “standard” simulated
loans at 7.50% funded short-term. income $2.3 million. net interest income at risk to rising
rates by .03%.
Rates up 200 basis points over 12 months:
Increases annual net interest income $1.2 million.
Premium money market deposits at Rates unchanged: Increases annual net interest Reduces the “standard” simulated
4.75% that reduce short-term funding. income $.5 million. net interest income at risk to rising
rates by .01%.
Rates up 200 basis points over 12 months:
Increases annual net interest income $.7 million.
Information presented in the above figureassumes a short-termfunding rate of 5.25%.
FIGURE 28. NET INTEREST INCOME VOLATILITY
Figure29 presents the results of the simulation analysis at December
31, 2006 and 2005. At December 31, 2006, Key’s simulated exposure
to a rising interest rate environment was essentially neutral, though
exposure to a falling interest rate environment decreased from 2005.
ALCO policy guidelines for risk management call for preventive
measures if simulation modeling demonstrates that a gradual 200
basis point increase or decrease in short-term rates over the next
twelve months would adversely affect net interest income over the same
period by morethan 2%. As shown in Figure 29, Key is operating
within these guidelines.
Basis point change assumption
(short-term rates) –200 +200
ALCO policy guidelines –2.00% –2.00%
INTEREST RATE RISK ASSESSMENT
December 31, 2006 +1.29% –.07%
December 31, 2005 +.51 +.75
FIGURE 29. SIMULATED CHANGE
IN NET INTEREST INCOME
During 2005 and the first half of 2006, Key was operating with a
slightly asset-sensitive position, which protected net interest income as
interest rates increased. Since July 2006, the Federal Reserve has held
short-term interest rates constant, and there is uncertainty with regard
to the future direction of these rates. Accordingly, management has taken
action to move toward a relatively neutral position. Key’s long-term bias
is to be modestly liability-sensitive, which will help protect net interest
income in a declining interest rate environment.
Management also conducts simulations that measure the effect of
changes in market interest rates in the second year of a two-year
horizon. These simulations are conducted in a manner similar to those
based on a twelve-month horizon. To capture longer-term exposures,
management simulates changes to the economic value of equity as
discussed below.
Economic value of equity modeling. Economic value of equity (“EVE”)
measures the extent to which the economic values of assets, liabilities
and off-balance sheet instruments may change in response to changes
in interest rates. EVE is calculated by subjecting the balance sheet to
an immediate 200 basis point increase or decrease in interest rates, and
measuring the resulting change in the values of assets and liabilities.
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