## Trading portfolio risk management 

Key’s trading portfolio is described in Note 19. 

Management uses a value at risk (“VAR”) model to estimate the potential adverse effect of changes in interest and foreign exchange rates and equity prices on the fair value of Key’s trading portfolio. Using statistical methods, this model estimates the maximum potential one-day loss with 95% probability. At December 31, 2003, Key’s aggregate daily VAR was $1.4 million, compared with $.9 million at December 31, 2002. Aggregate daily VAR averaged $1.2 million for 2003, compared with an average of $1.4 million during 2002. VAR modeling augments other controls that Key uses to mitigate the market risk exposure of the trading portfolio. These controls include loss and portfolio size limits that are based on market liquidity and the level of activity and volatility of trading products. 

## Credit risk management 

Credit risk represents the risk of loss arising from an obligor’s inability or failure to meet contractual payment or performance terms. It is inherent in the financial services industry and results from extending credit to clients, purchasing securities and entering into financial derivative contracts. 

Credit policy, approval and evaluation. Key manages its credit risk exposure through a multi-faceted program. Both retail and commercial credit policies are approved by independent committees, which are chaired by Key’s Chief Risk Officer. Once approved, these policies are communicated throughout Key to ensure consistency in our approach to granting credit. 

Exceptions to established policies are normal when mitigating circumstances dictate. Most major lending units have been assigned specific thresholds designed to keep exception levels within reason. Key has a well-established process in place to monitor compliance with credit policies known as the Underwriting Standards Analysis (“USA”). The quarterly USA report provides data on all commercial loans over $1 million at the time of their approval. Each quarter, the data is analyzed to determine if lines of business have adhered to established exception limits. Further, the USA report identifies grading trends of new business, hurdle rate exceptions, transactions with higher risk and other pertinent lending information. This process allows Key to take timely action to modify its lending practices when necessary. 

Credit approval is performed by the Credit Administration department. Credit Administration is independent of Key’s lines of business and is comprised of senior officers who have extensive experience in structuring and approving loans. Only Credit Administration officers are authorized to grant exceptions to credit policies. Credit Administration is also responsible for ensuring the accuracy of loan grading at the time of origination and as the loans season. 

Most extensions of credit at Key are subject to loan grading or scoring. This risk rating methodology is a blended process of expert judgment and quantitative modeling. On the commercial side, loans are generally assigned two internal risk ratings. The first rating reflects the probability of the borrower defaulting on an obligation; the second reflects expected loss on a particular credit facility. Both ratings work from a twenty grade rating scale. The assessment of default probability is based, among other factors, on the financial strength of the borrower, an assessment of the borrower’s management, the borrower’s competitive position within its industry sector and an assessment of industry risk within the context of the general economic outlook. Types of exposure and 

transaction structure, including credit risk mitigants, are additional factors that affect the expected loss assessment. 

Externally and internally developed risk models are used to evaluate consumer loans. These models (“scorecards”) forecast probability of serious delinquency and default for an applicant. The scorecards are embedded in our application processing system, which allows for real time scoring and automated decisions for many of Key’s products. Key’s Risk Management group periodically validates the loan grading and scoring processes. 

Key maintains an active concentration management program to help diversify its credit portfolios. On exposures to individual obligors, Key employs a sliding scale of exposure (“hold limits”), which is dictated by the strength of the underlying borrower. The higher the quality of credit, the higher the internal hold limit established. Key’s legal lending limit is well in excess of $1 billion. However, internal hold limits generally restrict the largest exposures to less than half that amount. As of December 31, 2003, Key had 10 client relationships with loan commitments of more than $200 million. In general, Key’s philosophy is to maintain a very granular portfolio with regard to credit exposures. 

Key manages industry concentrations using several methods. On smaller portfolios, we sometimes set limits according to a percentage of the overall loan portfolio. On larger, or higher risk portfolios, Key often establishes a specific dollar commitment level or a level of economic capital that is not to be exceeded. For example, Key has allocated a specific level of economic capital for its nonowner-occupied commercial real estate portfolio. This approach allows the commercial real estate line of business to actively manage the content of its portfolio: higher risk exposures consume more of the economic capital allocation; lower risk exposures consume less. This concentration methodology serves as a flexible constraint; availability expands as asset quality improves and contracts as asset quality deteriorates. 

In addition, Key recently established a senior management committee named Credco. Although still in its early stages, Credco’s mission is to take an active role in managing the overall loan portfolio in a manner consistent with Key’s asset quality objectives. Actions taken by Credco to manage the loan portfolio could entail the use of derivatives to buy or sell credit protection, loan securitizations, portfolio swaps or bulk purchases and sales. The overarching goal of Credco is to continually manage the loan portfolio within a range of comfort. 

Allowance for loan losses. The allowance for loan losses at December 31, 2003, was $1.4 billion, or 2.24% of loans. This compares with $1.5 billion, or 2.32% of loans, at December 31, 2002. The allowance includes $73 million that was specifically allocated for impaired loans of $183 million at December 31, 2003, compared with $179 million that was allocated for impaired loans of $377 million a year ago. For more information about impaired loans, see Note 9 (“Impaired Loans and Other Nonperforming Assets”) on page 66. At December 31, 2003, the allowance for loan losses was 202.59% of nonperforming loans, compared with 153.98% at December 31, 2002. 

Management estimates the appropriate level of the allowance for loan losses on a quarterly (and at times more frequent) basis. The methodology used is described in Note 1 (“Summary of Significant Accounting Policies”) under the heading “Allowance for Loan Losses” on page 51. 

