TD Bank 2009 Annual Report Download - page 78

TD BANK FINANCIAL GROUP ANNUAL REPORT 2009 MANAGEMENT’S DISCUSSION AND ANALYSIS74
Validation of VaR Model
For each of our trading portfolios, and for the portfolio as a whole, we
use a back testing process to compare the actual and theoretical profit
and losses to VaR to ensure that they are consistent with the statistical
assumptions of the VaR model. The theoretical change in profit and
loss is generated using the daily price movements on the assumption
that there is no change in the composition of the portfolio.
Stress Testing
Our trading business is subject to an overall global stress test limit. In
addition, each global business has a stress test limit, and 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 severe but plausible changes in key market
risk factors. The stress testing program includes scenarios developed
using actual historical market data during periods of market disruption.
The events we have modeled include the 1987 equity market crash,
the 1998 Russian debt default crisis, and the aftermath of September
11, 2001 and the 2007 Canadian ABCP crisis. We have also modeled
fixed income specific scenarios based on the collapse of Lehman
Brothers in 2008.
Stress tests are produced and reviewed regularly 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 managed
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 these risks.
WHO MANAGES MARKET RISK IN INVESTMENT ACTIVITIES
The TDBFG Investment Committee regularly reviews the performance of
the Bank’s own investments and assesses the performance of portfolio
managers. Similarly, the Merchant Banking Investment Committee
reviews and approves merchant banking investments. The Risk Commit-
tee of the Board reviews and approves the investment policies and limits
for the Bank’s own portfolio and for the merchant banking business.
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 influence
of market factors.
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. Such market risks primarily include
interest rate risk and foreign exchange risk.
WHO IS RESPONSIBLE FOR ASSET/LIABILITY MANAGEMENT
The Treasury and Balance Sheet Management (TBSM) Department
measures and manages the market risks of our non-trading banking
activities, with oversight from the Asset/Liability Committee (ALCO),
which is chaired by the Executive Vice President, Corporate Develop-
ment, and includes other senior executives. The Risk Committee of the
Board periodically reviews and approves all asset/liability management
market risk policies and receives reports on 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 us to
measure and manage 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 our margins, earnings and economic value. The objective of
interest rate risk management is to ensure that earnings are stable
and predictable over time. To this end, we have adopted a disciplined
hedging approach to managing the net income contribution from
our 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, when there is cash
flow from final maturity, normal amortization, or when customers
exercise prepayment, conversion 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 our annual net interest income
from a 100 bps unfavourable interest rate shock due to mismatched
cash flows. EVaR is defined as the difference in the change in the pres-
ent value of our asset portfolio and the change in the present value
of our liability portfolio, including off-balance sheet instruments,
resulting from a 100 bps unfavourable interest rate shock.
The Bank’s policy sets overall limits on EVaR and EaR based on a
100 bps adverse interest rate shock for its management of Canadian
and U.S. non-trading interest rate risk.
We regularly perform valuations of all asset and liability positions, as
well as off-balance sheet exposures. 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 generate more stable net interest
income over time.
The interest rate risk exposures from products with closed (non-
optioned) fixed-rate cash flows are measured and managed separately
from products that offer customers prepayment options. We project
future cash flows by looking at the impact of:
•An assumed maturity profile for our core deposit portfolio.
•Our targeted investment profile on our 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, so that net interest income becomes
more predictable.
Product options, whether they are freestanding options such as
mortgage rate commitments or embedded in loans and deposits,
expose us to a significant financial risk. We model our exposure from
freestanding mortgage rate commitment options using an expected
funding profile based on historical experience. We model our exposure
to written options embedded in other products, such as the rights to
prepay or redeem, based on analysis of rational customer behaviour.
We also model the margin compression that would be caused by
declining interest rates on certain interest rate sensitive demand deposit
accounts. To manage product option exposures we purchase options
or use a dynamic hedging process designed to replicate the payoff on
a purchased option.