MANAGEMENTGLYPH<213>S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES Interest rate risk management RISK MANAGEMENT Overview Audit Committee Finance Committee Market risk management 33 NEXT PAGE BACK TO CONTENTS SEARCH PREVIOUS PAGE The values of some financial instruments vary not only with changes in market interest rates, but also with changes in foreign exchange rates, factors influencing valuations in the equity securities markets and other market- driven rates or prices. For example, the value of a fixed-rate bond will decline if market interest rates increase. Similarly, the value of the U.S. dollar regularly fluctuates in relation to other currencies. When the value of an instrument is tied to such external factors, the holder faces “market risk.” Most of Key’s market risk is derived from interest rate fluctuations. Key’s risk management guidelines call for preventive measures to be taken if simulation modeling demonstrates that a gradual 200 basis point increase or decrease in short-term rates over the next twelve months, defined as a stressed interest rate scenario, would adversely affect net interest income over the same period by more than 2%. Key is operating within these guidelines. Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions and judgments, related primarily to loan and deposit growth, asset and liability prepayments, interest rate variations, product pricing, and on- and off-balance sheet management strategies. Management believes that the assumptions used are reasonable. Nevertheless, simulation modeling produces only a sophisticated estimate, not a precise calculation of exposure. Measurement of short-term interest rate exposure. Key uses a simulation model to measure interest rate risk. The model estimates the impact that various changes in the overall level of market interest rates would have on net interest income over one and two-year time periods. The results help Key develop strategies for managing exposure to interest rate risk. Key’s Board and its committees meet bi-monthly. However, it is not uncommon for more frequent contact to occur. In addition to regularly scheduled meetings, the Audit Committee will convene to discuss the content of Key’s financial disclosures and press releases related to quarterly earnings. Committee chairpersons routinely meet with management during interim months to plan agendas for upcoming meetings and to discuss events that have transpired since the preceding meeting. Also, during interim months, all members of the Board receive a formal report designed to keep them abreast of significant developments. The Finance Committee assists the Board in its review and oversight of Key’s policies, strategies and activities related to risk management that fall outside the scope of responsibility of the Audit Committee described above. This committee also assists in the review and oversight of policies, strategies and activities related to capital management, asset and liability management, capital expenditures and various other financing and investing activities. The Audit Committee provides review and oversight of the integrity of Key’s financial statements, compliance with legal and regulatory requirements, the independent auditors’ qualifications and independence, and the performance of Key’s internal audit function and independent auditors. Key’s Board of Directors (“Board”) has established and follows a corporate governance program that serves as the foundation for managing and mitigating risk. In accordance with this program, the Board focuses on the interests of shareholders, encourages strong internal controls, demands management accountability, advocates adherence to Key’s code of ethics and administers an annual self- assessment process. The Board has established two committees whose appointed members play an integral role in helping the Board meet its risk oversight responsibilities. Certain risks are inherent in the business activities conducted by financial services companies. As such, the ability to properly and effectively identify, measure, monitor and report such risks is essential to maintaining a company’s safety and soundness and to maximizing its profitability. Management believes that the most significant risks to which Key is exposed are market risk, credit risk, liquidity risk and operational risk. Each of these types of risk is defined and discussed in greater detail in the remainder of this section. Key’s Asset/Liability Management Policy Committee (“ALCO”) has developed a program to measure and manage interest rate risk. This senior management committee is also responsible for approving Key’s asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing Key’s interest rate sensitivity exposure. Factors contributing to interest rate exposure. Key uses interest rate exposure models to quantify the potential impact that a variety of possible interest rate scenarios may have on earnings and the economic value of equity. The various scenarios estimate the level of Key’s interest rate exposure arising from option risk, basis risk and gap risk. •Afinancial instrument presents  “option risk” when one party to the instrument can take advantage of changes in interest rates without penalty. For example, when interest rates decline, borrowers may choose to prepay fixed-rate loans by refinancing at a lower rate. Such a prepayment gives Key a return on its investment (the principal plus some interest), but unless there is a prepayment penalty, that return may not be as high as the return that would have been generated had payments been received over the original term of the loan. Floating-rate loans that are capped against potential interest rate increases and deposits that can be withdrawn on demand also present option risk. • One approach that Key follows to manage interest rate risk is to use floating-rate liabilities (such as borrowings) to fund floating-rate assets (such as loans). That way, as our interest expense increases, so will our interest income. We face  “basis risk” when our floating-rate assets and floating-rate liabilities reprice in response to different market factors or indices. Under those circumstances, even if equal amounts of assets and liabilities are repricing at the same time, interest expense and interest income may not change by the same amount. • Key often uses interest-bearing liabilities to fund interest-earning assets. For example, Key may sell certificates of deposit and use the proceeds to make loans. That strategy presents  “gap risk” if the related liabilities and assets do not mature or reprice at the same time.