Bank of Montreal 2010 Annual Report Download - page 82

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
Credit and counterparty risk exists in every lending activity that
BMO enters into, as well as in the sale of treasury and other capital
markets products, the holding of investment securities and securitization
activities. BMO’s robust and effective credit risk management begins
with our experienced and skilled professional lending and credit
risk officers, who operate in a dual control structure to authorize lending
transactions. These individuals are subject to a rigorous lender quali-
fication process and operate in a disciplined environment with clear
delegation of decision-making authority, including individually delegated
lending limits. Credit decision-making is conducted at the management
level appropriate to the size and risk of each transaction in accordance
with comprehensive corporate policies, standards and procedures
governing the conduct of credit risk activities.
Credit risk is assessed and measured using risk-based parameters:
Exposure at Default (EAD) represents an estimate of the outstanding
amount of a credit exposure at the time a default may occur. For off-
balance sheet amounts and undrawn amounts, EAD includes an estimate
of any further amounts that may be drawn at the time of default.
Loss Given Default (LGD) is the amount that may not be recovered
in the event of a default, presented as a proportion of the exposure
at default. LGD takes into consideration the amount and quality of any
collateral held.
Probability of Default (PD) represents the likelihood that a credit
obligation (loan) will not be repaid and will go into default. A PD
is assigned to each account, based on the type of facility, the product
type and customer characteristics. The credit history of the counterparty/
portfolio and the nature of the exposure are taken into account in the
determination of a PD.
Expected Loss (EL) is a measure representing the loss that is expected
to occur in the normal course of business in a given period of time.
EL is calculated as a function of Exposure at Default, Loss Given Default
and Probability of Default.
Unexpected Loss (UL) is a measure of the amount by which actual
losses may exceed expected loss in the normal course of business in
a given period of time.
Under Basel II, there are three approaches available for the computation
of credit risk: Standardized, Foundation Internal Ratings Based and
Advanced Internal Ratings Based (AIRB). We apply the AIRB Approach for
calculations of credit risk in our portfolios, while our subsidiary Harris
Bancorp Inc. currently uses the Standardized Approach. Pending approval
from OSFI, we plan to adopt the AIRB Approach for Harris Bancorp Inc.
in 2011.
Risk Rating Systems
BMO’s risk rating systems are designed to assess and measure the risk
of any exposure. The rating systems differ for the consumer and small
business portfolios and the commercial and corporate portfolios.
Consumer and Small Business
The consumer and small business portfolios are made up of a
diversified group of individual customer accounts and include residential
mortgages, personal loans, and credit card and small business loans.
These loans are managed in pools of homogeneous risk exposures. For
these pools, credit risk models and decision support systems are devel-
oped using established statistical techniques and expert systems for
underwriting and monitoring purposes. Adjudication models, behavioural
scorecards, decision trees and expert knowledge are combined to
produce optimal credit decisions in a centralized and automated environ-
ment. The characteristics of both the borrower and the loan, along with
past portfolio experience, are used to predict the credit performance of
new accounts. These metrics are used to define the overall credit risk
profile of the portfolio, predict future performance of existing accounts
for ongoing credit risk management and determine both Economic
Capital and Basel II regulatory capital. Every exposure is assigned risk
parameters, PD, LGD and EAD based on the performance of the pool, and
these assignments are updated monthly. The PD risk profile of the AIRB
Retail portfolio at October 31, 2010, was as follows:
PD risk profile PD range % of Retail EAD
Exceptionally low ≤ 0.05% 38.8
Very low > 0.05% to 0.20% 20.3
Low > 0.20% to 0.75% 23.7
Medium > 0.75% to 7.00% 15.6
High > 7.00% to 99.99% 1.3
Default 100% 0.3
Commercial and Corporate Lending
Within the commercial and corporate portfolios, we utilize an enterprise-
wide risk rating framework that is applied to all of our sovereign, bank,
corporate and commercial counterparties. This framework is consistent
with the principles of Basel II, under which minimum regulatory
capital requirements for credit risk are determined. One key element
of this framework is the assignment of appropriate borrower risk ratings
to help quantify potential credit risk. BMO’s risk rating framework
establishes counterparty risk ratings using methodologies and rating
criteria based on the specific risk characteristics of each counterparty.
The resulting rating is then mapped to a probability of default over
a one-year time horizon. As counterparties migrate between risk ratings,
the probability of default associated with the counterparty changes.
We review our loans and acceptances on an ongoing basis to assess
whether any loans should be classified as impaired and whether an
allowance or write-off should be recorded. Future losses are estimated
based on the expected proportion of the exposure that will be at risk if
a counterparty default occurs, through an analysis of transaction-specific
factors such as the nature and term of the loan, collateral held and the
seniority of our claim. For large corporate transactions, we also utilize
unexpected loss models to assess the extent and correlation of risks
before authorizing new exposures.
Credit and Counterparty Risk
Credit and counterparty risk is the potential for loss due to the
failure of a borrower, endorser, guarantor or counterparty to repay
a loan or honour another predetermined financial obligation.
This is the most significant measurable risk that BMO faces.
Material in blue-tinted font above is an integral part of the 2010 annual consolidated financial statements (see page 75).
80 BMO Financial Group 193rd Annual Report 2010