Bank of Montreal 2010 Annual Report Download - page 85

MD&A
rules under GAAP and are accorded banking book regulatory capital
treatment. For trading and underwriting portfolios covered by the
internal models approach, VaR is computed using BMO’s Trading Book
Value at Risk model. This is a Monte Carlo scenario simulation model,
and its output is used for market risk management and reporting
of exposures. The model computes one-day VaR results using a 99%
confidence level and reflects the correlations between the different
classes of market risk factors.
We use a variety of methods to verify the integrity of our risk
models, including the application of backtesting against hypothetical
losses. This process assumes there are no changes in the previous day’s
closing positions. The process then isolates the effects of each day’s price
movements against these closing positions. Models are validated by
assessing how often the calculated hypothetical losses exceed the
MVE measure over a defined period. Results of this testing confirm the
reliability of our models.
The correlations and volatility data that underpin our models are
updated monthly, so that MVE measures are reflective of current volatility.
In the fourth quarter of 2010, changes were made to the calculation
of MVE for AFS positions to better align the risk methodology to that
used for the MTM positions within the Trading Book. This change, in
addition to increased exposures in the quarter, resulted in an increase
in interest rate risk for AFS securities. In 2011, a further methodology
change is planned to include additional risk factors within the MVE
calculation. It is expected that this will lead to a further increase in the
calculated MVE. In general, the approach to the measurement of risk and
governance of AFS positions in the trading businesses will continue to
evolve in recognition of their distinct accounting treatment – i.e. the way
changes in market value are recorded in the financial statements.
Market risk exposures arising from trading and underwriting
activities are summarized in the following table.
Total Trading and Underwriting MVE Summary ($ millions)*
For the year ended October 31, 2010
(pre-tax Canadian equivalent) Year-end Average High Low
Commodity risk (0.1) (0.4) (1.4) (0.1)
Equity risk (7.5) (6.5) (15.8) (3.1)
Foreign exchange risk (0.6) (4.4) (12.5) (0.3)
Interest rate risk (mark-to-market) (7.5) (10.4) (22.5) (5.7)
Diversification 4.8 8.6 nm nm
Comprehensive risk (10.9) (13.1) (23.1) (5.9)
Interest rate risk (AFS) (7.4) (5.6) (8.8) (2.8)
Issuer risk (2.7) (2.6) (4.4) (1.6)
Total MVE (21.0) (21.3) (31.0) (15.2)
*One-day measure using a 99% confidence level.
nm – not meaningful
For the year ended October 31, 2009
(pre-tax Canadian equivalent) Year-end Average High Low
Commodity risk (0.7) (0.7) (1.7) (0.4)
Equity risk (10.2) (9.6) (16.3) (5.5)
Foreign exchange risk (0.8) (3.4) (8.2) (0.4)
Interest rate risk (mark-to-market) (18.4) (16.3) (29.1) (9.2)
Diversification 11.4 10.1 nm nm
Comprehensive risk (18.7) (19.9) (31.2) (13.4)
Interest rate risk (AFS) (7.3) (10.5) (15.8) (5.7)
Issuer risk (1.9) (3.5) (9.5) (1.3)
Total MVE (27.9) (33.9) (52.1) (24.2)
*One-day measure using a 99% confidence level.
nm – not meaningful
that could occur in any one day, because both measures are computed
at prescribed confidence levels and could be exceeded in highly volatile
market conditions. On a daily basis, exposures are aggregated by lines
of business and risk type and monitored against delegated limit levels, and
the results are reported to the appropriate stakeholders. The bank has a
robust governance process in place for the adherence to delegated market
risk limits. Amounts exceeding established limits are escalated to senior
management on a timely basis for resolution and appropriate action.
Within the Market Risk group, the Valuation Product Control group
checks whether the valuations of all trading and underwriting portfolios
within BMO are materially accurate by:
• developing and maintaining valuation adjustment/reserve policies
and procedures in accordance with regulatory requirements and GAAP;
• establishing official rate sources for valuation of mark-to-market
(MTM) portfolios; and
• providing an independent review of trading books where trader prices
are used for valuation of mark-to-market portfolios.
The Valuation Control processes include all over-the-counter (OTC)
and exchange-traded instruments that are booked within Capital Markets
Trading portfolios. These include both trading and available-for-sale
(AFS) securities. Valuation Products Control group also performs an
independent valuation of certain portfolios outside of Capital Markets
Trading Products.
Trader valuations are reviewed to determine whether they align
with an independent assessment of the market value of the portfolio.
If the valuation differences exceed the prescribed tolerance threshold,
a valuation adjustment is recorded in accordance with accounting
policy and regulatory requirements. Prior to the final month-end general
ledger close, meetings are held between staff from the line of business,
Market Risk, Capital Markets Finance and Accounting Policy groups
to review all valuation reserves and adjustments that are established
by the Market Risk group.
The Valuation Steering Committee is the senior management level
valuation committee within the bank. It meets at least quarterly to address
the more challenging valuation issues in the bank’s portfolios and acts as
a key forum for discussing Level 3 positions and their inherent uncertainty.
At a minimum, the following are considered when determining
appropriate valuation adjustment levels: Credit Valuation Adjustments
(CVA), close-out costs, uncertainty, administrative costs, liquidity and
model risk. Also, a fair value hierarchy is used to categorize the inputs
used in the valuation of securities, liabilities, derivative assets and deriv-
ative liabilities. Level 1 inputs consist of quoted market prices, Level 2
inputs consist of internal models that use observable market information
and Level 3 inputs consist of internal models without observable market
information. Details of Level 1, Level 2 and Level 3 fair value measure-
ments can be found in Note 29 on page 160 of the financial statements.
Our models are used to determine market risk Economic Capital
for each of the lines of business and to determine regulatory capital.
For capital calculation purposes, longer holding periods and/or higher
confidence levels are used than are employed in day-to-day risk
management. Prior to use, models are subject to review under the
Model Risk Corporate Standard by our Model Risk and Vetting group.
The Model Risk Corporate Standard outlines minimum requirements
for the identification, assessment, monitoring and management of
models and model risk throughout the enterprise.
We measure the market risk for trading and underwriting portfolios
that meet our criteria for trading book regulatory capital treatment
using an internal models approach, as well as the market risk for money
market portfolios that are subject to Available-for-Sale accounting
Material in blue-tinted font above is an integral part of the 2010 annual consolidated financial statements (see page 75).
BMO Financial Group 193rd Annual Report 2010 83