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Bank of Montreal Group of Companies 1999 Annual Report 39
We calculate the expected loss (EL) for individual
transactions (as part of the calculation of their RAROC)
and for the portfolio as a whole (in order to establish a
prudent annual forecast of loan loss provisions and the
appropriate level of general allowance for credit losses).
We define EL as management’s estimate, for the forth-
coming fiscal year, of one year’s credit losses. The esti-
mate relies upon judgement, in addition to the follow
ing:
the probability of default(s);
the amount of outstanding exposure at the time of
default(s);
the difference between the book value and market
value/realizable value of loans, if default(s) occurred;
and
the effect of economic/industry cycles on asset quality
and loan values.
EL should provide a reliable estimate of one year’s losses
for both the forthcoming year and each successive year
under a normal economic cycle. These estimates are
supported by quantitative analysis of these factors where
possible. Estimates and assumptions underlying EL cal-
culations may be supported by portfolio monitoring,
historical experience, market data and/or proxies for
market data, and modelling of economic and business-
specific events. Further information on EL is provided in
the box below.
Expected Loss (EL)
We express EL in either gross or net terms. Gross EL captures
all exposure to credit loss regardless of accounting treatment (e.g.
credit losses occurring in subsidiaries, affiliates, joint ventures,
securitization vehicles, etc.), unless the risk has been fully trans-
ferred
to third parties or has already been recognized (e.g. via
first loss protection or capital allocation). Net EL includes only
the estimates of losses from credit risk that would, if incurred,
result in a charge to the Bank’s provision for credit losses.
Adjustments are made for percentage ownership in sub-
sidiaries, affiliates and joint ventures, as well as for securitiza-
tions, where loss is recognized as a non-interest revenue item
rather than being included in the provision for credit losses. When
considering the sufficiency of the general allowance, we calcu-
late the amount of the allowance as a multiple of gross EL.
We also measure the degree of potential volatility around the
estimated EL, since the volatility of risk is a more important
factor for certain assets than the EL. Therefore the exposure to the
extremes of volatility requires the maintenance of an adequate
levelofcapital.Asaresult,weusevolatilityoflossmeasurements
as a key input in determining the capital at risk (CaR).
Measures:
Credit risk is measured by both the provisioning ratio
and gross impaired loans as a percentage of equity plus
the allowance for credit losses. These are our two pri-
mary measures and are discussed in more detail in the
Credit Risk section on page 33, which provides an analy-
sis of loan quality and losses for the year.
Performance Review:
Portfolio Diversification
We have a well-diversified portfolio of lending relation-
ships with millions of clients, of which the majority are
consumers and small to medium-sized businesses. The
portfolio also continues to be free from undue concen-
trations in terms of country exposure and type of lending,
a
s indicated in the charts below.
The provision for credit losses as a percentage of aver-
age loans and acceptances for 1999 was 0.22% com-
pared to 0.09% for 1998. The increase reflects the fact
that the provision in 1998 was unusually low as a result
of non-recurring benefits related to collection activity on
commercial real estate loans.
Gross impaired loans and acceptances as a percentage
of equity and allowance for credit losses was 8.53%
compared to 6.66% at the end of 1998. The increase was
primarily due to higher levels of gross impaired loans
due to
weaknesses in the energy sector. These measures
are
discussed further on page 33.
Commercial
Individuals
Designated LDCs
Corporate and
Institutional
(% of loan portfolio)
36.7
18.1
0.1
Market
Diversification
45.1
Canada
United States
Mexico
Other countries
Designated LDCs
(% of loan portfolio)
38.6
0.3
5.8
Geographic
Diversification
0.1
55.2