TD Bank 2014 Annual Report Download - page 86

TD BANK GROUP ANNUAL REPORT 2014 MANAGEMENT’S DISCUSSION AND ANALYSIS84
MARKET RISK IN OTHER WHOLESALE BANKING ACTIVITIES
The Bank is also exposed to market risk arising from a legacy portfolio
of bonds and preferred shares held in TD Securities and in its remain-
ing merchant banking investments. Risk Management reviews and
approves policies and procedures, which are established to monitor,
measure, and mitigate these risks.
The Bank is exposed to market risk when it enters into non-trading
banking transactions with its 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
TD’s traditional banking activities. Such market risks primarily include
interest rate risk and foreign exchange risk.
WHO IS RESPONSIBLE FOR ASSET/LIABILITY MANAGEMENT
TBSM measures and manages the market risks of the Bank’s non-
trading banking activities, with oversight from the Asset/Liability and
Capital Committee, which is chaired by the Group Head Insurance,
Credit Cards and Enterprise Strategy, and includes other senior execu-
tives. The Market Risk Control function provides independent oversight,
governance, and control over these market risks. The Risk Committee
of the Board periodically reviews and approves key asset/liability
management and non-trading market risk policies and receives reports
on compliance with approved risk limits.
HOW TD MANAGES ITS ASSET AND LIABILITY POSITIONS
Non-trading interest rate risk is viewed as a non-productive risk as it
has the potential to increase earnings volatility and incur loss without
providing long run expected value. As a result, TBSM’s mandate is to
structure the asset and liability positions of the balance sheet in order
to achieve a target profile that controls the impact of changes in inter-
est rates on the Bank’s net interest income and economic value that is
consistent with the Bank’s RAS.
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 earnings are stable
and predictable over time. The Bank has adopted a disciplined hedging
approach to manage the net interest income contribution from its
asset and liability positions, including an assigned target-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, and developing
strategies to manage overall sensitivity to rates across varying
interest rate scenarios;
• measuring the contribution of each TD product on a risk-adjusted,
fully-hedged basis, including the impact of financial options such
as mortgage commitments that are granted to customers; and
• developing and implementing strategies to stabilize net interest
income from all retail banking products.
The Bank is exposed to interest rate risk when asset and liability princi-
pal and interest cash flows have different interest 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.
TD’s 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 embedded options,
such as prepaying a loan or redeeming a deposit before its maturity date.
Interest rate risk exposure, after economic hedging activities, is
measured using various interest rate “shock” scenarios to estimate the
impact of changes in interest rates on the Bank. Two measures that
are used are Earnings at Risk (EaR) and Economic Value at Risk (EVaR).
EaR is defined as the change in net interest income over the next
twelve months for an immediate and sustained 100 bps unfavourable
interest rate shock. EaR measures the extent to which the maturing
and repricing asset and liability cash flows are matched over the next
twelve-month period and reflects how the Bank’s net interest income
will change over that period as a result of the interest rate shock.
EVaR is defined as the difference between the change in the present
value of the Bank’s asset portfolio and the change in the present value
of the Bank’s liability portfolio, including off-balance sheet instruments
and assumed profiles for non-rate sensitive products, resulting from
an immediate and sustained 100 bps unfavourable interest rate shock.
EVaR measures the relative sensitivity of asset and liability cash flow
mismatches to changes in long-term interest rates. Closely matching
asset and liability cash flows reduces EVaR and mitigates the risk of
volatility in future net interest income.
To the extent that interest rates are sufficiently low and it is not
feasible to measure the impact of a 100 bps decline in interest rates,
EVaR and EaR exposures will be calculated by measuring the impact
of a decline in interest rates where the resultant rate does not
become negative.
The model used to calculate EaR and EVaR captures the impact of
changes to assumed customer behaviours, such as interest rate sensi-
tive mortgage prepayments, but does not assume any balance sheet
growth, change in business mix, product pricing philosophy, or
management actions in response to changes in market conditions.
TD’s policy sets overall limits on EVaR and EaR which are linked
to capital and net interest income, respectively. These Board limits are
consistent with the Bank’s enterprise risk appetite and are periodically
reviewed and approved by the Risk Committee of the Board. Exposures
against Board limits are routinely monitored and reported, and breaches
of these Board limits, if any, are escalated to both the ALCO and the
Risk Committee of the Board.
In addition to Board policy limits, book-level risk limits are set
for TBSM’s management of non-trading interest rate risk by Risk
Management. These book-level risk limits are set at a more granular
level than Board policy limits for EaR and EVaR, and developed to
be consistent with the overall Board Market Risk policy. Breaches
of these book-level risk limits, if any, are escalated to the ALCO
in a timely manner.
The Bank regularly performs valuations of all asset and liability
positions, as well as off-balance sheet exposures. TD’s objective is to
stabilize net interest income over time through disciplined asset/liability
matching and hedging.
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. The Bank
projects future cash flows by looking at the impact of:
• a target interest sensitivity profile for its core deposit portfolio;
• a target investment profile on its net equity position; and
• liquidation assumptions on mortgages other than from embedded
pre-payment options.