Bank of Montreal 1999 Annual Report Download - page 110

104 Bank of Montreal Group of Companies 1999 Annual Report
Glossary of Financial Terms
Allowance for Credit Losses
An amount set aside and deemed ade-
quate by management to absorb potential
credit-related losses in a bank’s portfolio
of loans, acceptances, guarantees, letters
of credit, deposits with other banks
and derivatives. Allowances for credit
losses can be specific or general and are
accounted for as deductions from the
related assets in the financial statements.
Assets under Administration
and under Management
Assets administered and/or managed by
a financial institution that are benefi-
cially owned by clients or investors
and
are therefore not reported on the balance
sheet of the financial institution.
Average Earning Assets
This amount represents the daily or
monthly average balance over a one-
year period of deposits with other banks,
loans and securities.
Bankers’ Acceptance (BA)
A bill of exchange or negotiable instru-
ment drawn by the borrower for payment
at maturity and accepted by a bank. BAs
constitute a guarantee of payment by
the bank and can be traded in the money
market. The bank earns a “stamping fee”
for providing this guarantee.
Basis Point
Oneone-hundredthofapercentagepoint.
Collateralized Bond Obligation
Debt instrument supported by pool of
high-yield or investment grade bonds.
Counterparty
The opposite side of any transaction,
typically a bank’s corporate or commer-
cial clients or another financial institu-
tion. Counterparty risk refers to the risk
that the counterparty will not be able
to meet its financial obligations under
the terms of the contract or transaction
it has entered into.
Derivatives
A derivative is a contract whose value
is “derived” from interest rates, foreign
exchange rates, or equity or commodity
prices. Use of derivatives allows for the
transfer, modification or reduction of
current or expected risks from changes
in interest rates, foreign exchange rates,
and equity and commodity prices. See
also individual definitions of forwards
and futures, forward rate agreements,
options and swaps.
Duration
A measure of the average time interval
required for an expected stream of cash
flows to repay the original investment,
i.e., shorter duration means faster
recovery of the original investment.
Earnings at Risk
Earnings at Risk is the impact on net
income over the following 12 months of a
one-time change in market rates/prices.
Economic Value at Risk
Economic Value at Risk is the impact
on the value of our assets and liabilities
of a change in market rates/prices.
Forwards and Futures
Contractual agreements to either buy
or sell a specified currency or financial
instrument on a specified future date
at a specified price. Forwards are cus-
tomized contracts transacted in the
over
-the-counter market. Futures are
transacted in standardized amounts
on regulated exchanges and are subject
to daily cash margining.
Forward Rate Agreement (FRA)
A type of derivative obliging two parties
tomakeacashsettlementatafuturedate
for the difference between a contracted
rate of interest and the current
market
rate, based on a notional amount. An FRA
can act as a hedge against future
move-
ments in market interest rates.
Group of Seven
This international group, also known
as G-7, comprises the seven leading
industrial democracies, namely Britain,
Canada, France, Germany, Italy, Japan
and the United States. The group
was established in 1986 to coordinate
economic and monetary policy.
Guarantees and Standby
Letters of Credit
Primarily represent a bank’s obligation
to make payments to third parties on
behalf of its clients if its clients are unable
to make the required payments or meet
other contractual requirements.
Hedge
A risk management technique used to
neutralize/manage interest rate or for-
eign currency exchange exposures
arising from normal banking operations.
Impaired Loans
Loans are classified as impaired when,
in the opinion of management, there
is no longer reasonable assurance of the
timely collection of principal and
interest. Interest on impaired loans is
only recognized as interest revenue
when management has reasonable assur
-
ance of the timely collection of the full
amount of principal and interest.
Margining
Margins for futures contracts are money
or securities used as an initial deposit
as assurance that the contract will be
fulfilled. Margining refers to adjustments
made to the initial deposit as market
movement causes the fair value of the
instrument to fluctuate, possibly re-
quiring additional deposits to be placed
with the exchange.
Mark-to-Market
Valuation at market rates, as of the
balance sheet date, of securities and
derivatives held for trading purposes.
Net Interest Income
The difference between what a bank
earns on assets such as loans and securi -
ties and what it pays on liabilities such
asdepositsandsubordinateddebentures.
Net Interest Margin
Average net interest margin is the ratio
of net interest income to average assets.
Notional Amount
The amount considered as principal
when calculating interest and other
payments for derivative contracts. This
amount traditionally does not change
hands under the terms of a derivative
contract.
Off-Balance Sheet
Financial Instrument
An asset or liability that is not recorded
on the balance sheet, but has the poten-
tial to produce positive or negative cash
flows in the future if a contingent event
occurs. A variety of products offered
to clients can be classified as off-balance
sheet and they fall into two broad cate-
gories: (i) credit-related arrangements,
which provide clients with liquidity
protection, and (ii) derivatives.
Options
Contractual agreements that convey
the right, but not the obligation, to either
buy or sell a specific amount of a finan-
cial instrument at a fixed price either at
a fixed future date or at any time within
a fixed future period.
Over-the-Counter (OTC)
Trading that occurs outside of organized
or regulated securities exchanges, carried
out by broker-dealers who communi-
cate with one another by telephone and
quotation terminals. Prices on OTC
instruments are negotiated between
buying and selling brokers. Certain OTC
instruments are traded in accordance
with rules prescribed by self-regulating
bodies.
Provision for Credit Losses
A charge to income which represents
an appropriate expense given the com-
position of our credit portfolios, their
probability of default, the economic envi-
ronment and the allowance for cred
it
losses already established. Specific
provisions are established to reduce the
book value of specific assets (primarily
loans) to establish the amount expected
to be recovered on the loans. A country
risk provision is established for loans
to and securities of countries identified
by OSFI that have restructured or ex-
perienced difficulties in servicing all
or part of their external debt to commer-
cial banks. A general allowance for loan
losses is established in recogni tion of
the fact that not all of the impairment
in
a loan portfolio can be specifically
identified on a loan-by-loan basis.
Regulatory Capital Ratios
The percentage of risk-weighted
assets supported by capital, as defined
by the Office of the Superintendent
of Financial Institutions Canada (OSFI)
under the framework of risk-based
capital standards developed by the Bank
for International Settlements. These
ratios are labelled Tier 1 and Tier 2.
Tier 1 capital is considered to be more
permanent in nature, consisting of com-
mon shares together with any qualifying
non-cumulative preferred shares less
unamortized goodwill. Tier 2 capital
consists of other preferred shares,
subordinated debentures and general
allowances.
Replacement Cost of
Derivative Contracts
The cost of replacing a derivative
contract that has a positive fair value at
current market rates should a counter-
party fail to settle.
Repurchase Agreement (Repo)
A type of transaction where a security
is sold with the commitment by the
seller to repurchase the security at a
specified price and time.
Return on Equity (ROE)
This represents net income, less
preferred share dividends, expressed
as a percentage of average common
shareholders’ equity.
Reverse Repurchase Agreement
(Reverse Repo)
See Securities Purchased under Resale
Agreements.
Risk
Country Risk
Also known as sovereign risk, it is the
risk that economic or political change
in a country may impact repayments to
creditor banks. This risk is considered
higher for certain emerging market and
lesser-developed countries specifically
identified by OSFI.
Credit Risk
The possibility that a loss may be
incurred in the event that borrowers
or counterparties to financial instru-
ments transacted with a bank will be
unable to discharge their obligations
under the instruments.
Foreign Exchange Risk
Foreign exchange risk refers to pos-
sible losses resulting from exchange
rate movements. A foreign currency
devaluation, for example, could result
in losses on an overseas investment.
Interest Rate Risk
Interest rate risk is the potential im-
pact on a bank’s earnings and economic
value due to changes in interest rates.
Rising interest rates could, for example,
increase funding costs and reduce the
net interest margin earned on a fixed
yield mortgage portfolio.
Liquidity Risk
Refers to potential demands on a bank
for cash resulting from commitments
to extend credit, deposit maturities and
many other transactions.
Market Risk
Market risk is the risk of loss that
results from changes in interest rates,
foreign exchange rates, equity and
commodity prices, spread and basis
risk and the implied volatility of these
rates and prices.
Operational Risk
The potential loss, including adverse
impact on reputation, resulting from
a breakdown in communications,
information or transaction processing
or legal/compliance issues, due to
systems or procedural failures, error,
natural
disasters or criminal activity.
This risk represents a bank’s potential
exposure to unexpected loss as a result
of pursuing business objectives.
Replacement Risk
The risk that a financial contract will
need to be replaced in the open market
at a cost to the bank/enterprise.
Risk Adjusted Return On
Capital (RAROC)
A measurement tool that enables
management to allocate capital, and the
related cost of capital, in respect of
credit, market and operational risk by
type of transaction, client and line
of business. This facilitates the deploy-
ment of capital to business units that
can provide the maximum shareholder
value on the capital invested.
Risk-Weighted Assets
Used in the calculation of risk-based
capital ratios. The face amount of assets
is discounted using predetermined
risk-weighting factors in order to reflect
a comparable risk per dollar among all
types of assets. Adjusting notional values
to balance sheet (or credit) equivalents
and then applying appropriate risk-
weighting factors also recognizes the risk
inherent in off-balance sheet instruments.
Securities Purchased under
Resale Agreements
A type of transaction that involves the
purchase of a security, normally a gov-
ernment bond, with the commitment
by the buyer to resell the security to the
original seller at a specified price on
a specified date in the future.
Securities Sold Short
A transaction in which the seller sells
securities it does not own. The seller bor-
rows the securities in order to deliver
them to the purchaser. At a later date, the
seller buys identical securities in the
market to replace the borrowed securi-
ties. On the balance sheet, this category
represents our obligation to deliver
securities that we did not own at the
time of sale.
Spread
Spread is the difference between two
product rates, typically an asset and
a liability.
Swaps
Contractual agreements between two
parties to exchange a series of cash flows.
For interest rate swaps, counterparties
generally exchange fixed and floating
rate
interest payments based on a notiona
l
value in a single currency. For cross-
currency interest rate swaps, principal
amounts and fixed and floating rate
interest payments are exchanged in
different currencies.
Taxable Equivalent Basis
(TEB) Adjustment
An addition to interest income to gross
up the tax-exempt income earned on cer-
tain securities (primarily loan substitute
securities) to an amount which, had it
been taxable at the statutory rate, would
result in the same after-tax net income
that appears in the financial statements.
This results in a better reflection of the
pre-tax economic yield of these assets and
facilitates uniform measurement and
comparison of net interest income.
Total Shareholder Return (TSR)
This amount is calculated as the annual-
ized total return on an investment in our
common shares made at the beginning
of a designated period, usually one or five
years. Total return on common shares
includes the effect of a change in the
share price and assumes that dividends
received on common shares are rein-
vested in additional common shares.
Value at Risk (VaR)
VaR measures the adverse impact on the
value of a portfolio, over a specified time
period, of potential changes in market
rates and prices. VaR is usually measured
at a 99% confidence interval and assumes
that changes in rates and prices are
correlated.
Volatility
A term which generally refers to a
measure of price variance, usually the
standard deviation of returns from a
security or a portfolio of securities over
a specified period of time.