Bank of Montreal 1999 Annual Report Download - page 46

Download and view the complete annual report

Please find page 46 of the 1999 Bank of Montreal annual report below. You can navigate through the pages in the report by either clicking on the pages listed below, or by using the keyword search tool below to find specific information within the annual report.

Page out of 112

  • 1
  • 2
  • 3
  • 4
  • 5
  • 6
  • 7
  • 8
  • 9
  • 10
  • 11
  • 12
  • 13
  • 14
  • 15
  • 16
  • 17
  • 18
  • 19
  • 20
  • 21
  • 22
  • 23
  • 24
  • 25
  • 26
  • 27
  • 28
  • 29
  • 30
  • 31
  • 32
  • 33
  • 34
  • 35
  • 36
  • 37
  • 38
  • 39
  • 40
  • 41
  • 42
  • 43
  • 44
  • 45
  • 46
  • 47
  • 48
  • 49
  • 50
  • 51
  • 52
  • 53
  • 54
  • 55
  • 56
  • 57
  • 58
  • 59
  • 60
  • 61
  • 62
  • 63
  • 64
  • 65
  • 66
  • 67
  • 68
  • 69
  • 70
  • 71
  • 72
  • 73
  • 74
  • 75
  • 76
  • 77
  • 78
  • 79
  • 80
  • 81
  • 82
  • 83
  • 84
  • 85
  • 86
  • 87
  • 88
  • 89
  • 90
  • 91
  • 92
  • 93
  • 94
  • 95
  • 96
  • 97
  • 98
  • 99
  • 100
  • 101
  • 102
  • 103
  • 104
  • 105
  • 106
  • 107
  • 108
  • 109
  • 110
  • 111
  • 112

Enterprise-Wide Risk Management
40 Bank of Montreal Group of Companies 1999 Annual Report
Market Risk
Strategy:
To identify, measure, monitor and control all market
risk-taking activities, ensuring that exposures remain
within approved risk tolerance levels and that the eco-
nomic profit from market risk activities is acceptable.
Approach:
We have established a Board-approved corporate stan-
dard for market risk tolerance, within which our market
risk activities are conducted. For non-trading risks in the
Canadian, U.S. and international portfolios, market risk
is controlled by actively managing the asset and liability
mix, either directly through the balance sheet or with
off-balance sheet derivative instruments†. Our measures
also focus on off-balance sheet exposure gaps, interest
rate exposure gaps and sensitivity to rate changes. The
methodologies for trading risk measurement include
Value at Risk†(VaR) and market risk capital against the
Bank for International Settlements (BIS) standards.
We use derivative instruments for both hedging and
trading purposes, which is discussed in note 21 to the
consolidated
financial statements. We also offer deriva-
tive products to clients for their own risk management
and investment purposes. The use of these products
generates two primary risks, credit/replacement risk
and market risk.
Interest Rate Risk Management
Interest rate risk is our primary non-trading market risk.
We use two primary risk models to determine the sensi-
tivity of our non-trading portfolios to adverse interest rate
changes. A 100 basis point
†
increase model calculates the
impact on earnings and the value of our assets and lia-
bilities of a one-time 100 basis point increase across all
portfolios. This model is used by most financial institu-
tions and hence facilitates comparability with our peers.
Our second measure is the rising interest rate risk
model, which is used internally as a more sophisticated
measure of risk. This model calculates the impact on
earnings over the next 12 months, and on the value of our
assets and liabilities, of a one-time increase in rates. It
reflects the maximum expected rate change in each port-
folio
during the estimated period required to close our
positions in that portfolio. Management considers this a
more accurate reflection of our risk. These instruments
areshort-terminnatureandwewouldnormallybeableto
close them before a full 100 basis point increase occurred.
Trading Risk Management
During the year we successfully completed implementa-
tion of our Integrated Value at Risk (I-VaR) methodology
for foreign exchange and interest rate risk trading port-
folios. We received approval from our primary regulator
(OSFI) to use this as an internal model for regulatory
capital purposes effective April 30, 1999.
The implementation of this project significantly im-
proves our ability to measure and evaluate risk, while pro-
viding
netting and correlation benefits within portfolios.
VaR methodologies for trading portfolios that incur
equity and commodity risk are currently in development.
Overall Market Risk Sensitivity
Our market risk sensitivity model uses the same core
principles as the rising interest rate risk model, but in
addition to rising interest rate risk, it incorporates the
impact of all adverse market rate/price changes within
the different time periods required to close each of our
portfolios. The model also views each portfolio separately
and hence can be more conservative.
Measures:
Earnings at Risk
†
, Economic Value at Risk
†and
Inte-
grated Value at Risk are the primary measures for ana-
lyzing market risk. These measures calculate the impact
on earnings and economic value of a one-time change
in market rates/prices. This calculation is based on the
estimated maximum adverse market rate/price change
that would be expected to occur within the estimated
time period required to neutralize the risks in a portfo-
lio, and is applied to our positions at the period end. Our
estimates are based upon statistical historical analysis
using a 97.5% confidence level, except for interest rate
and foreign exchange trading portfolios, which are based
upon a one-day 99% confident VaR measure. The calcula-
tions
exclude the effect of actions that we might take to
reduce risk, actions that clients might take in response
to changing rates/prices, and correlations between
portfolios. The box below details the components of the
Balance Sheet which may create market risk.
Balance Sheet Components
Structural: Canadian and U.S. retail and commercial and
Canadian corporate instruments
Money market: Bank placements and acceptances, and interna-
tional loans and investments
Trading: Instruments designated as trading and marked-to-market.
†Defined in the glossary on page 104.