Bank of Montreal 2010 Annual Report Download - page 84

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
loans, loss rates are based on historical loss experience for the different
portfolios. Model results are then considered, along with the level of the
existing allowance and management’s judgment regarding portfolio
quality, business mix, and economic and credit market conditions, to
determine the appropriate adjustment to the allowance.
BMO incurs market risk in its trading and underwriting activities and
structural banking activities.
As part of our enterprise-wide risk management framework, we
employ extensive governance and management processes surrounding
market risk-taking activities. These include:
• oversight by senior governance committees, including the Trading
Products Risk Committee, Balance Sheet Management Committee,
Risk Management Committee and Risk Review Committee;
•
an Economic Capital plan process that incorporates market risk measures
(market value exposures, stress testing);
• a process for the effective valuation of trading positions and measure-
ment of market risk;
• development of appropriate policies and corporate standards;
• a well-developed limit-setting and monitoring process;
• controls over processes and models used; and
• a framework of scenario and stress tests for worst-case events.
High-level market risk measures for structural market risk include
Earnings Volatility (EV) and Market Value Exposure (MVE). These
positions are summarized in the table on page 85. The primary measure
for market risk in trading and underwriting activities is MVE.
BMO’s Market Risk group provides independent oversight of trading and
underwriting portfolios with the goal of ensuring:
•
market risk of trading and underwriting activities is measured and
modelled in compliance with corporate policies and standards;
• risk profiles of our trading and underwriting activities
are maintained
within our risk appetite, and are monitored and reported
to traders,
management, senior executives and board committees;
•
proactive identification and reporting to management, senior executives
and board committees of specific exposures or other factors that
expose BMO to unusual, unexpected, inappropriate or otherwise not
fully identified or quantified risks associated with market or traded
credit exposures; and
•
all individuals authorized to execute trading and underwriting activities
on behalf of BMO are appropriately informed of BMO’s risk-taking
governance, authority structure, procedures and processes by being
given access to and guidance on the relevant corporate policies
and standards.
BMO’s Market Risk group also provides oversight of Structural Market
Risk managed by Corporate Treasury.
Market risk is the potential for a negative impact on the balance
sheet and/or income statement resulting from adverse changes in
the value of financial instruments as a result of changes in certain
market variables. These variables include interest rates, foreign
exchange rates, equity and commodity prices and their implied
volatilities, as well as credit spreads, credit migration and default.
Trading and Underwriting Market Risk
To capture the multi-dimensional aspects of market risk effectively,
a number of metrics are used, including VaR, stress testing, option
sensitivities, position concentrations, market and notional values and
revenue losses.
VaR and stress testing are portfolio estimates of risk but have
limitations. Among the limitations of VaR are its assumption that all
positions can be liquidated within the assigned one-day holding period
(ten-day holding period for regulatory calculations), which may not
be the case in illiquid market conditions, and that historical data can be
used as a proxy to predict future market events. Scenario analysis and
probabilistic stress testing are performed daily to determine the impact
of unusual and/or unexpected market changes on our portfolios. As well,
historical and event stresses are tested on a weekly basis. Scenarios
are amended, added or deleted to better reflect changes in underlying
market conditions. The results are reported to the lines of business,
Trading Products Risk Committee, Risk Management Committee and Risk
Review Committee on a regular basis. Stress testing is limited by the
number of scenarios that can be run, and by the fact that not all downside
scenarios can be predicted and effectively modelled. Neither VaR nor
stress testing are viewed as predictors of the maximum amount of losses
balances. For business loans, these historical loss rates are associated
with the underlying risk rating of the borrower, which is assigned at the
time of loan origination, monitored on an ongoing basis and adjusted to
reflect changes in underlying credit risk. These loss rates are further
refined with regard to industry sectors and credit products. For consumer
Earnings Volatility (EV) is a measure of the adverse impact
of potential changes in market parameters on the projected
12-month after-tax net income of a portfolio of assets, liabilities
and off-balance sheet positions, measured at a 99% confidence
level over a specified holding period.
Market Value Exposure (MVE) is a measure of the adverse
impact of changes in market parameters on the market value
of a portfolio of assets, liabilities and off-balance sheet positions,
measured at a 99% confidence level over a specified holding
period. The holding period considers current market conditions
and composition of the portfolios to determine how long it
would take to neutralize the market risk without adversely
affecting market prices. For trading and underwriting activities,
MVE is comprised of Value at Risk and Issuer Risk.
Value at Risk (VaR) is measured for specific classes of risk in
BMO’s trading and underwriting activities: interest rate, foreign
exchange rate, equity and commodity prices and their implied
volatilities. This measure calculates the maximum likely loss
from portfolios, measured at a 99% confidence level over a
specified holding period.
Issuer Risk arises in BMO’s trading and underwriting portfolios,
and measures the adverse impact of credit spread, credit migra-
tion and default risks on the market value of fixed-income
instruments and similar securities. Issuer risk is measured at a
99% confidence level over a specified holding period.
Market Risk
Material in blue-tinted font above is an integral part of the 2010 annual consolidated financial statements (see page 75).
82 BMO Financial Group 193rd Annual Report 2010