Bank of Montreal 1999 Annual Report Download - page 44

38 Bank of Montreal Group of Companies 1999 Annual Report
At the enterprise-wide level, we seek to ensure investors’
return expectations and debt holders’ risk assessments,
which impact the cost at which we can raise funds, are
appropriately balanced in our choice of strategies. This
results in the need to manage the risk profile against tol-
erance levels that are in line with those Board-approved
strategies. This may be shown as follows:
The rest of this section describes how we manage
specific risks, including their measurement, to achieve
the risk/return balance depicted above. A discussion of
our performance against these risk measures is also pro-
vided in each section.
The Aggregation of Risks Across the Enterprise –
Capital at Risk
The enterprise is moving toward using the concept of Capital
at Risk (CaR) to determine capital requirements for the organiza-
tion
and the respective lines of business. The returns required
on normal levels of risk are expected to be received from the
respective revenue-generating activity, whereas capital is
required to cover the potential for unexpected loss beyond the
normal range. CaR is calculated for each of the various risk
components (e.g. credit risk, market risk, operational risk) for a
defined level of probability within a specified time interval.
CaR then provides a unit of risk, which can be aggregated to
provide total risk-based capital requirements.
Using CaR ensures that management understands the true
capital cost for the risks it takes. This process is designed to
generate the risk component in the performance measurement
of risk and return, e.g. RAROC, which contributes to measure-
ment of the economic profit and of the increase in shareholder
value. CaR is therefore becoming a key tool in enabling the
enterprise to optimize the appropriate risk management behav-
iour in accomplishing approved strategies, and to indicate how
performance compares to enterprise goals.
Enterprise-Wide Risk Management Framework
Credit Risk
Strategy:
Maintain a well-diversified asset portfolio within
approved risk tolerance levels; and earn a return appro-
priate to the risk profile of the portfolio.
Approach:
Diversification of risk within the loan and investment
portfolios is a key requirement in effective risk manage-
ment, particularly in the corporate and institutional
portfolios, where the concentration of risk can be a sig-
nificant issue. For large credit transactions, management
uses advanced models to assess the correlation of risks
before authorization of new exposures. Exposure to
specific industries is governed by these models, or by
aggregate portfolio authorization limits. Credit risk man-
agement
of our client base requires personal account-
ability, clear delegation of decision-making authority,
and disciplined portfolio management.
Credit transactions are evaluated by skilled lenders for
commercial, corporate and institutional borrowers. Our
credit function then provides an independent assessment
of all significant transactions, and agreement from this
function is normally required before lending commit-
ments are approved. Our independent internal audit
group also reviews management processes to ensure that
established credit policies are followed.
Technological tools and development have allowed us
to focus time and resources on higher-risk transactions.
The prompt recognition of problem loans is stressed,
with material loans being transferred to skilled special-
ists to manage these accounts.
Monitoring of performance and pricing of credit
transactions are commensurate with risk and are deter-
mined using Risk Adjusted Return on Capital (RAROC)†
(described below) in addition to other methodologies.
RAROC is applied to all large commercial transactions
and draws upon a number of external market data feeds,
including credit ratings and stock exchange data.
Risk Adjusted Return on Capital (RAROC)
RAROC facilitates the comparison, aggregation and management
of market, credit and operational risks across an organization.
This methodology was implemented to support risk assessment
and measurement applications. RAROC allows management
to view these risks on a comparative basis, differentiating by risk
class. These comparisons, which can be performed by trans-
action, client and line of business, enable management to
better understand sustainable performance, actively manage
the composition of portfolio risk, and allocate capital to those
businesses that can most advantageously deploy the capital
to maximize shareholder value. This provides a framework for
measuring risk in relation to return at each level of our activity.
Shareholders’
expected
returns
Risk Tolerance Levels
Standards/guidelines/limits
approved by the Board of Directors
for each major category of risk,
which are delegated to
line of business management.
Optimal debt
rating, given target
business mix
 
Enterprise-Wide Risk Management
†Defined in the glossary on page 104.