TD Bank 2005 Annual Report Download - page 65

TD BANK FINANCIAL GROUP ANNUAL REPORT 2005 Management’s Discussion and Analysis 61
Stress Testing
Our trading business is subject to an overall global stress test
limit, and each global business has a stress test limit, and each
global business has an overall stress test limit. Also, each broad
risk class has an overall stress test limit. Stress scenarios are
designed to model extreme economic events, replicate worst-
case historical experiences or introduce large but plausible moves
in key market risk factors.
Stress tests are produced and reviewed regularly with the
Vice Chair and Chief Risk Officer, and with the Market Risk
and Capital Committee.
MARKET RISK IN INVESTMENT ACTIVITIES
We are also exposed to market risk in the Bank’s own investment
portfolio and in the merchant banking business. Risks are man-
aged through a variety of processes, including identification of
our specific risks and determining their potential impact. Policies
and procedures are established to monitor, measure and mitigate
those risks.
WHO MANAGES RISK IN INVESTMENT ACTIVITIES
The Risk Committee of the Boardreviews and approves the
investment policies and limits for the Bank’s own portfolio and
for the merchant banking business. The Investment Committee
regularly reviews the performance of the Bank’s investments
and assesses the success of the portfolio managers.
HOW WE MANAGE RISK IN INVESTMENT ACTIVITIES
We use advanced systems and measurement tools to manage
portfolio risk. Risk intelligence is embedded in the investment
decision-making process by integrating performance targets,
risk/return tradeoffs and quantified risk tolerances. Analysis of
returns identifies performance drivers such as sector and security
exposures, as well as the impact of certain processes such as
the execution of trades.
MARKET RISK IN NON-TRADING
BANKING TRANSACTIONS
We are exposed to market risk when we enter into non-trading
banking transactions with our customers. These transactions
primarily include deposit taking and lending, which are also
referred to as “asset and liability” positions.
Asset Liability Management
Asset liability management deals with managing the market risks
of our traditional banking activities. Market risks primarily include
interest rate risk and foreign exchange risk.
WHO IS RESPONSIBLE FOR
ASSET LIABILITY MANAGEMENT
The treasury and balance sheet management department
measures and manages the market risks of our non-trading
banking activities, with oversight from the Asset/Liability
Committee, which is chaired by the Vice Chair and Chief Risk
Officer and includes the Executive Vice President and Chief
Financial Officer as well as other senior executives. The Risk
Committee of the Board periodically reviews and approves all
asset liability management market risk policies and compliance
with approved risk limits.
HOW WE MANAGE OUR ASSET
AND LIABILITY POSITIONS
When Bank products are issued, risks are measured using a fully
hedged option-adjusted transfer-pricing framework that allows
treasury and balance sheet management to measure and man-
age product risk within a target risk profile. The framework also
ensures that business units engage in risk-taking activities only if
they are productive.
Managing Interest Rate Risk
Interest rate risk is the impact that changes in interest rates could
have on the Bank’s margins, earnings and economic value. The
objective of interest rate risk management is to ensure that earn-
ings are stable and predictable over time. To this end, the Bank
has adopted a disciplined hedging approach to managing the net
income contribution from its asset and liability positions includ-
ing a modeled maturity profile for non-rate sensitive assets,
liabilities and equity. Key aspects of this approach are:
•Evaluating and managing the impact of rising or falling interest
rates on net interest income and economic value.
•Measuring the contribution of each Bank product on a risk-
adjusted, fully hedged basis, including the impact of financial
options, such as mortgage commitments, that are granted to
customers.
•Developing and implementing strategies to stabilize net income
from all personal and commercial banking products.
We are exposed to interest rate risk when asset and liability
principal and interest cash flows have different interest payment
or maturity dates. These arecalled “mismatched positions.” An
interest sensitive asset or liability is re-priced when interest rates
change or when there is cash flow from final maturity, normal
amortization, or when customers exercise prepayment, conver-
sion or redemption options offered for the specific product.
Our exposure to interest rate risk depends on the size and
direction of interest rate changes, and on the size and maturity
of the mismatched positions. It is also affected by new business
volumes, renewals of loans or deposits, and how actively
customers exercise options such as prepaying a loan before
its maturity date.
Interest rate risk is measured using various interest rate
“shock” scenarios to estimate the impact of changes in interest
rates on both the Bank’sannual Earnings at Risk (EaR) and
Economic Value at Risk (EVaR). EaR is defined as the change in
the Bank’s annual net interest income from a 100-basis-point
unfavourable interest-rate shock due to mismatched cash flows.
EVaR is defined as the combined difference in the present value
of the Bank’sasset portfolio and the change in the present
value of the Bank’s liability portfolio, including off-balance-sheet
instruments, resulting from a 100-basis-point unfavourable
interest-rate shock.
Valuations of all asset and liability positions, as well as off-
balance-sheet exposures, are performed regularly. Our objectives
are to protect the present value of the margin booked at the
time of inception for fixed rate assets and liabilities, and to
reduce the volatility of net interest income over time.
The interest rate risk exposures from instruments with closed
(non-optioned) fixed rate cash flows are measured and managed
separately from imbedded product options. Projected future cash
flows include the impact of modeled exposures for:
•An assumed maturity profile for the Bank’scoredeposit
portfolio.
•The Bank’s targeted investment profile on its net equity
position.
•Liquidation assumptions on mortgages other than from
imbedded pre-payment options.