TD Bank 2006 Annual Report Download - page 66

TD BANK FINANCIAL GROUP ANNUAL REPORT 2006 Management’s Discussion and Analysis
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WHO MANAGES RISK IN INVESTMENT ACTIVITIES
The Risk Committee of the Board reviews 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 meas-
ures and manages the market risks of our non trading banking
activities, with oversight from the Asset/Liability Committee,
which includes the Executive Vice President and Chief Financial
Officer as well as other senior executives, and is chaired by the
Chief Risk Officer (currently, it is chaired by the Chief Financial
Officer on an interim basis). 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 ensurethat
earnings arestable and predictable over time. Tothis end, the
Bank has adopted a disciplined hedging approach to managing
the net income contribution from its asset and liability positions
including 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 payment or
maturity dates. These are called “mismatched positions.” An
interest-sensitive asset or liability is repriced 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’s annual Earnings at Risk (EaR) and
Economic Value at Risk (EVaR). EaR is defined as the change in
the Bank’sannual net interest income from a 100-basis-point
unfavourable interest-rate shock due to mismatched cash flows.
EVaR is defined as the difference in the change 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-bal-
ance-sheet exposures, areperformed 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 aremeasured and managed
separately from embedded 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
embedded pre-payment options.
The objective of portfolio management within the closed book
is to eliminate cash flow mismatches, thereby reducing the
volatility of net interest income.
Product options, whether they are freestanding options such
as mortgage rate commitments or embedded in loans and
deposits, expose the Bank to a significant financial risk.
Our exposure from freestanding mortgage rate commitment
options is modelled based on an expected funding ratio derived
from historical experience. We model our exposure to written
options embedded in other products, such as the rights to pre-
pay or redeem, based on analysis of rational customer behaviour.
We also model an exposure to declining interest rates resulting in
margin compression on certain interest rate-sensitive demand
deposit accounts. Product option exposures aremanaged by pur-
chasing options or through a dynamic hedging process designed
to replicate the payoff on a purchased option.