Bank of Montreal 2010 Annual Report Download - page 64

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
planned for 2011. In addition, the BCBS is working with the Financial
Stability Board to address the risk of systemically important banks and
has recommended that for such banks, additional capital requirements
be adopted, such as capital surcharges and contingent capital. These
changes could affect the amount of capital that we hold to meet regula-
tory requirements.
BMO’s strong capital levels position us well to adopt both the
announced regulatory changes and IFRS accounting changes in the com-
ing years. We do not expect the announced changes in regulatory capital
requirements to materially affect our strategic or tactical direction.
Economic Capital Review
Economic capital is our internal assessment of the risks underlying BMO’s
business activities. It represents management’s estimation of the likely
magnitude of economic losses that could occur should adverse situations
arise, and allows returns to be measured on a basis that considers the
risks taken. Economic capital is calculated for various types of risk – credit,
market (trading and non-trading), operational and business – where
measures are based on a time horizon of one year. For further discussion
of these risks, refer to the Enterprise-Wide Risk Management section
on page 75. Economic capital is a key element of our risk-based capital
management and ICAAP framework.
Capital Management Activities
There were no share issuances in 2010, other than through the
bank’s Shareholder Dividend Reinvestment and Share Purchase Plan
and the exercise of stock options. We redeemed $500 million 4.00%
Series C Medium-Term Notes, Tranche 1 on January 21, 2010 and
$350 million BMO Capital Trust Securities – Series A (BMO BOaTS –
Series A) on June 30, 2010. On November 23, 2010, we announced our
intention to redeem the $400 million BMO Capital Trust Securities –
Series B (BMO BOaTS – Series B) on December 31, 2010. Further
details are provided in Notes 18 and 20 on pages 142 and 145 of
the financial statements.
On October 27, 2010, we announced our intention to renew our
normal course issuer bid, subject to the approval of OSFI and the Toronto
Stock Exchange, under which we may repurchase for cancellation up
to 15 million BMO common shares (representing approximately 2.7%
of the public float). No common shares were repurchased under our
previous normal course issuer bid, which expired on December 1, 2010.
Dividends
BMO’s target dividend payout range over the medium term is 45% to
55% of net income available to common shareholders. The target is
indicative of our confidence in our continued ability to increase earnings
and our strong capital position. BMO’s target dividend payout range
seeks to provide shareholders with stable income, while ensuring
We believe the Common Equity Ratio and the Tier 1 Capital Ratio
are the most important capital ratios under Basel III. After full imple-
mentation of announced Basel III capital deductions and RWA changes
and including the potential impact of certain key changes associated
with the adoption of IFRS, based on our analysis to date, as set out
in Transition to International Financial Reporting Standards in the Future
Changes in Accounting Policies – IFRS section on page 71, BMO’s pro-
forma October 31, 2010 Common Equity Ratio and Tier 1 Capital Ratio
would be 7.8% and 10.4%, respectively, exceeding the announced
Basel III 2019 minimum capital requirements. The pro-forma ratios are
derived using our October 31, 2010 balance sheet and are based on
our understanding of the proposed regulatory rules, which are not
yet finalized and are subject to further change. The pro-forma ratios
do not reflect management actions that may be taken to mitigate
the impact of the changes, the benefit of additional retained earnings
growth over time that could be available to meet these requirements,
or factors beyond the control of management. We believe BMO is
also well-positioned to meet the other capital requirements.
Under the above view, the bank’s regulatory common equity
would decrease by $1.5 billion from $16.5 billion to $15.0 billion as of
October 31, 2010 and its Tier 1 capital would decrease by $1.7 billion from
$21.7 billion to $20.0 billion. Regulatory common equity and Tier 1 capital
decrease relative to reported October 31, 2010 Basel II results, primarily
because of the impact of the adoption of IFRS on retained earnings, as
well as a new capital deduction for intangible assets. These factors are
partially offset by the removal of certain existing deductions from capital
and their conversion to higher levels of RWA. We have assumed existing
non-common share Tier 1 capital instruments are fully included in Tier 1
capital for purposes of this calculation. Certain of these instruments do
not meet Basel III capital requirements and are expected to be subject
to the grand fathering provisions previously noted. We expect to be
able to refinance non-common capital instruments as and when necessary
to meet applicable non-common capital requirements.
Our RWA as at October 31, 2010 would increase by $31.3 billion
from $161.2 billion to $192.5 billion, primarily due to higher counterparty
credit risk RWA ($23.4 billion) and, to a lesser extent, higher market
risk RWA and the conversion of certain existing Basel II capital deductions
to RWA ($7.9 billion), as noted above. The quantification of the change in
counterparty credit risk RWA is based on Basel III proposals developed
earlier this year. There continues to be significant ongoing discussion
concerning the approach to quantifying counterparty credit risk and,
as a result, there is considerable uncertainty regarding the final impact
on RWA. The expected introduction of central clearing agencies for
certain derivative transactions, together with management actions, are
expected to significantly mitigate the increase in counterparty credit
risk RWA noted above.
As previously noted, the regulatory treatment of capital deductions
is scheduled to change between January 1, 2013 and January 1, 2018.
Based on the same underlying assumptions as above but using the
January 1, 2013 transitional arrangements for capital deductions, the
bank’s pro-forma October 31, 2010 Common Equity Ratio and Tier 1 Capital
Ratio would be 9.0% and 10.8%, respectively, higher than the 2019
requirements. The Common Equity Ratio is higher under the 2013 transi-
tional view than under the 2018 view because the $1.5 billion goodwill
deduction is initially taken from non-common share Tier 1 capital in 2013.
Between 2013 and 2018, the goodwill deduction is scheduled to change
to a deduction from common equity, lowering the Common Equity Ratio.
The treatment of intangible assets and new Basel III deductions have a
similar impact on the 2013 to 2018 Common Equity and Tier 1 Ratios.
A number of other potential regulatory changes are still being
finalized. For example, counterparty credit risk requirements and
countercyclical capital buffer requirements have not yet been finalized
and a fundamental review of trading book capital requirements is
Credit risk remains the largest
component of economic capital
by risk type.
P&C and BMO Capital Markets
represented the two largest
components of economic
capital in 2010.
Total Economic Capital
by Operating Group
As at October 31, 2010
P&C 45%
BMO CM 44%
PCG 8%
Corp 3%
Total Economic Capital
by Risk Type
As at October 31, 2010
Market 18%
Business 4%
Credit 65%
Operational 13%
62 BMO Financial Group 193rd Annual Report 2010