MANAGEMENTGLYPH<213>S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES When an increase in short-term interest rates is expected to generate lower net interest income, the balance sheet is said to be “liability-sensitive,” meaning that rates paid on deposits and other liabilities respond more quickly to market forces than yields on loans and other assets. Conversely, when an increase in short-term interest rates is expected to generate greater net interest income, the balance sheet is said to be “asset-sensitive,” meaning that yields on loans and other assets respond more quickly to market forces than rates paid on deposits and other liabilities. Key has historically maintained a modest liability-sensitive position to increasing interest rates under our “standard” risk assessment. Management actively monitors the risk of rising interest rates and takes preventive actions, when deemed necessary, with the objective of assuring that net interest income at risk does not exceed internal guidelines. In addition, since rising rates typically reflect an improving economy, management expects that Key’s lines of business could increase their portfolios of market-rate loans and deposits, which would further mitigate the effect of rising rates on Key’s interest expense. For purposes of simulation modeling, we estimate net interest income starting with current market interest rates, and assume that those rates will not change in future periods. Then we measure the amount of net interest income at risk by gradually increasing or decreasing the Federal Funds target rate by 200 basis points over the next twelve months. At the same time, we adjust other market interest rates, such as U.S. Treasury, LIBOR, and interest rate swap rates, but not as dramatically. These market interest rate assumptions form the basis for our “standard” risk assessment in a stressed period for interest rate changes. We also assess rate risk assuming that market interest rates move faster or slower, and that the magnitude of change results in “steeper” or “flatter” yield curves. Short-term interest rates were relatively low at December 31, 2003. To make the working model more realistic in these circumstances, management modified Key’s standard rate scenario of a gradual decrease of 200 basis points over twelve months to a gradual decrease of 25 basis points over two months and no change over the following ten months. In addition to modeling interest rates as described above, Key models the balance sheet in three distinct ways to forecast changes over different periods and under different conditions. Our initial simulation of net interest income assumes that the composition of the balance sheet will not change over the next year. In other words, current levels of loans, deposits, investments, and other related assets and liabilities are held constant, and loans, deposits and investments that are assumed to mature or prepay are replaced with like amounts. Interest rate swaps and investments used for asset/liability management purposes, and term debt used for liquidity management purposes are allowed to mature without replacement. Unlike subsequent simulations of net interest income discussed below, this initial simulation assumes that all market interest rates increase or decrease at the same rate of change as the Federal Funds target rate, thereby producing a “parallel” change in the yield curve. In this simulation, we are simplistically capturing the impact of hypothetical changes in interest rates on future net interest income volatility. Additionally, growth in floating-rate loans and fixed- rate deposits, which naturally reduce the amount of net interest income at risk when interest rates are rising, are not captured in this simulation. Another simulation, using Key’s “most likely balance sheet,” assumes that the balance sheet will grow at levels consistent with consensus economic forecasts. Investments used for asset/liability management purposes will As described above, Key would be in an asset-sensitive position in the second year of the “most likely balance sheet” simulation because many of the interest rate swaps used for asset/liability management purposes mature during that year, and our natural business flows are biased towards more rate sensitive loans compared with deposits. be allowed to mature without replacement, and term debt used for liquidity management purposes will be incorporated to ensure a prudent level of liquidity. Forecasted loan, security, and deposit growth in the simulation model produces incremental risks, such as option risk, basis risk, and gap risk, that may increase interest rate risk. To mitigate some of these risks, management makes assumptions about future on- and off-balance sheet management strategies. In this simulation, we are testing the sensitivity of net interest income to future balance sheet volume changes while simultaneously capturing the impact of hypothetical changes in interest rates on future net interest income volatility. As of December 31, 2003, based on the results of our simulation model, and assuming that management does not take action to alter the outcome, Key would expect net interest income to decrease by approximately .96% if short-term interest rates gradually increase by 200 basis points over the next twelve months. Conversely, if short-term interest rates gradually decrease by 25 basis points over the next two months, net interest income would be expected to increase by approximately .07% over the next year. The results of the “most likely balance sheet” simulation form the basis for our “standard” risk assessment that is performed monthly and reported to Key’s risk governance committees in accordance with ALCO policy. There are a variety of factors that can influence the results of the simulation. Assumptions we make about loan and deposit growth strongly influence funding, liquidity, and interest rate sensitivity. Figure 25 illustrates the variability of the simulation results that can arise from changing certain major assumptions. It is important to note that net interest income volatility is the result of business flow assumptions that may, or may not, influence the interest rate risk profile. Finally, we simulate the impact of increasing market interest rates in the second year of a two-year time horizon. The first year of this simulation is identical to the “most likely balance sheet” simulation noted above except that we assume market interest rates do not change. In the second year, we assume that the balance sheet will continue to grow at levels consistent with consensus economic forecasts, interest rate swaps and investments used for asset/liability management purposes will be allowed to mature without replacement, and term debt will be used for liquidity management purposes. Increases in short-term borrowings remain constrained and incremental funding needs are met through term debt issuance. Forecasted loan, security and deposit growth in the second year of the simulation model produces incremental risks, such as option risk, basis risk and gap risk, that may increase interest rate risk, but unlike the first year of the simulation, management does not make any assumptions about future on- and off- balance sheet management strategies. As of December 31, 2003, based on the results of our simulation model, and assuming that management does not take action to alter the outcome, Key would expect net interest income in the second year to increase by approximately .84% if short-term interest rates gradually increase by 200 basis points during that year. Conversely, if short-term interest rates gradually decrease by 25 basis points over the first two months of the second year, net interest income would be expected to decrease by approximately .77% during that year. NEXT PAGE PREVIOUS PAGE SEARCH BACK TO CONTENTS 34