## Operational risk management 

Key, like all businesses, is subject to operational risk, which represents the risk of loss resulting from inadequate or failed internal processes, people and systems, and external events, including legal proceedings. Resulting losses could take the form of explicit charges, increased operational costs, harm to Key’s reputation or forgone opportunities. Key seeks to mitigate operational risk through a system of internal controls that are designed to keep operational risks at appropriate levels. 

We continuously look for opportunities to improve our oversight of Key’s operational risk. For example, we recently implemented a loss-event database to track the amounts and sources of operational losses. This tracking mechanism, when fully developed, gives us another resource to promptly identify weaknesses in Key and the need to take corrective action. 

In addition, we continuously strive to strengthen Key’s system of internal controls to ensure compliance with laws, rules and regulations. Primary responsibility for managing internal control mechanisms lies with the managers of Key’s various lines of business. The lines of business and the Risk Management group monitor and assess the overall effectiveness of our system of internal controls on an ongoing basis. Risk Management reports the results of reviews on internal controls and systems to management and the Audit Committee and independently supports the Audit Committee’s oversight process in this regard. 

We recently invested in sophisticated software programs designed to assist in monitoring our control processes. We believe this technology will enhance timely reporting of the effectiveness of our controls to our management and Board. 

Also, we have established a senior management committee designed to oversee Key’s level of operational risk and to respond accordingly. The Operational Risk Committee (“ORCO”) is responsible for directing and supporting Key’s operational infrastructure and related activities. Specific responsibilities include: establishing operational risk policies; defining elements of operational risk; overseeing the effectiveness of internal controls and taking actions to improve weaknesses; monitoring and approving significant risk mitigation techniques, and ensuring Key’s preparedness for Basel II expectations regarding operational risk. 

## FOURTH QUARTER RESULTS 

Some of the highlights of Key’s fourth quarter results are summarized below. Key’s financial performance for each of the past eight quarters is summarized in Figure 35. 

Net income. Key had net income of $234 million, or $.55 per common share, for the fourth quarter of 2003, compared with net income of $245 million, or $.57 per share, for the same period in 2002. The decline in earnings resulted from a decrease in net interest income and a higher level of noninterest expense. These adverse changes were offset in part by growth in noninterest income and a reduction in the provision for loan losses. 

On an annualized basis, Key’s return on average total assets for the fourth quarter of 2003 was 1.11%, compared with a return of 1.17% for the fourth quarter of 2002. The annualized return on average equity was 13.37% for the fourth quarter of 2003, compared with a return of 14.46% for the year-ago quarter. 

Net interest income. Net interest income was $671 million for the fourth quarter of 2003, down from $712 million for the fourth quarter of 2002. Key’s net interest margin decreased by 20 basis points to 3.78%, while average earning assets grew by $559 million. Growth in our home equity lending and commercial lease financing businesses, and an increase in short-term investments more than offset declines in the commercial and indirect lease financing portfolios. The decrease in indirect lease financing is a result of Key’s May 2001 decision to scale back or exit certain types of lending. 

Noninterest income. Key’s noninterest income was $466 million for the fourth quarter of 2003, compared with $446 million for the year-ago quarter. The increase reflects a $12 million decrease in net losses incurred on the residual values of leased vehicles and equipment. In addition, Key had $8 million of net gains from principal investing in the fourth quarter of 2003, compared with $13 million of net losses in the fourth quarter of 2002. These improvements were partially offset by lower income from service charges on deposit accounts. 

Noninterest expense. Noninterest expense for the fourth quarter of 2003 totaled $698 million, compared with $668 million for the fourth quarter of 2002. A $25 million rise in personnel expense accounted for most of the growth from the year-ago quarter with the largest increases occurring in pension costs (up $7 million), stock-based compensation (up $6 million) and severance expense (up $5 million). 

Provision for loan losses. Key’s provision for loan losses was $123 million for the fourth quarter of 2003, compared with $147 million for the fourth quarter of 2002. Net loan charge-offs for the quarter totaled $123 million, or .78% of average loans, compared with $186 million, or 1.18%, for the year-ago quarter. Included in fourth quarter 2002 net charge-offs are $39 million of losses charged to the now depleted portion of Key’s allowance for loan losses that had been segregated in connection with management’s decision to discontinue many credit-only relationships in the leveraged financing and nationally syndicated lending businesses and to facilitate sales of distressed loans in other portfolios. For more information about Key’s allowance for loan losses, see the section entitled “Allowance for loan losses,” which begins on page 37. 

