Bank of Montreal 2012 Annual Report Download - page 73

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
Off-Balance Sheet Arrangements
BMO enters into a number of off-balance sheet arrangements in the
normal course of operations.
Credit Instruments
In order to meet the financial needs of our clients, we use a variety of
off-balance sheet credit instruments. These include guarantees and
standby letters of credit, which represent our obligation to make
payments to third parties on behalf of a customer if the customer is
unable to make the required payments or meet other contractual
requirements. We also write documentary and commercial letters of
credit, which represent our agreement to honour drafts presented by a
third party upon completion of specified activities. Commitments to
extend credit are off-balance sheet arrangements that represent our
commitment to customers to grant them credit in the form of loans or
other financings for specific amounts and maturities, subject to meeting
certain conditions.
There are a large number of credit instruments outstanding at any
time. Our customers are broadly diversified and we do not anticipate
events or conditions that would cause a significant number of our
customers to fail to perform in accordance with the terms of the con-
tracts. We use our credit adjudication process in deciding whether to
enter into these arrangements, just as we do when extending credit in
the form of a loan. We monitor off-balance sheet instruments to avoid
undue concentrations in any geographic region or industry.
The maximum amount payable by BMO in relation to these credit
instruments was approximately $74 billion at October 31, 2012
($76 billion in 2011). However, this amount is not representative of our
likely credit exposure or liquidity requirements for these instruments, as
it does not take into account customer behaviour, which suggests that
only a portion will utilize the facilities related to these instruments. It
also does not take into account any amounts that could be recovered
under recourse or collateralization provisions. Further information on
these instruments can be found in Note 5 on page 134 of the finan-
cial statements.
For the credit commitments outlined in the preceding paragraphs,
in the absence of an event that triggers a default, early termination by
BMO may result in a breach of contract.
Special Purpose Entities (SPEs)
Our interests in SPEs are discussed primarily on pages 65 and 66 in the
BMO-Sponsored Securitization Vehicles and Structured Investment
Vehicle sections and in Note 9 on pages 139 and 140 of the financial
statements. Under IFRS, we consolidate all of our SPEs and capital and
funding trusts, except for certain Canadian customer securitization and
structured finance vehicles.
Guarantees
Guarantees include contracts under which we may be required to make
payments to a counterparty based on changes in the value of an asset,
liability or equity security that the counterparty holds. Contracts under
which we may be required to make payments if a third party does not
perform according to the terms of a contract and contracts under which
we provide indirect guarantees of indebtedness are also considered
guarantees. In the normal course of business, we enter into a variety of
guarantees, including standby letters of credit, backstop and other
liquidity facilities and derivatives contracts or instruments (including, but
not limited to, credit default swaps and written options), as well as
indemnification agreements.
The maximum amount payable by BMO in relation to these guaran-
tees was $40 billion at October 31, 2012 ($50 billion in 2011). However,
this amount is not representative of our likely exposure, as it does not
take into account customer behaviour, which suggests that only a por-
tion of the guarantees will require payment. It also does not take into
account any amounts that could be recovered through recourse and
collateral provisions.
For a more detailed discussion of these agreements, please see
Note 7 on page 137 of the financial statements.
Critical Accounting Estimates
The most significant assets and liabilities for which we must make esti-
mates include: allowance for credit losses; consolidation of special purpose
entities; purchased loans; acquired deposits; impairment of assets other
than loans; pension and other employee future benefits; fair value of
financial instruments; goodwill and intangible assets; insurance-related
liabilities; income taxes; and contingent liabilities. We make judgments in
assessing whether substantially all risks and rewards have been transferred
in respect of transfers of financial assets and whether we control SPEs.
These judgments are discussed in Notes 8 and 9, respectively. Note 29
discusses the judgments made in determining the fair value of financial
instruments. If actual results differ from the estimates, the impact would be
recorded in future periods. We have established detailed policies and con-
trol procedures that are intended to ensure the judgments we make in
determining the estimates are well controlled, independently reviewed and
consistently applied from period to period. We believe that our estimates of
the value of BMO’s assets and liabilities are appropriate.
For a more detailed discussion of the use of estimates, please see
Note 1 on page 124 of the financial statements.
Allowance for Credit Losses
One of our key performance measures is the provision for credit losses
as a percentage of average net loans and acceptances. Over the past 10
years, for our Canadian peer group, the average annual ratio has ranged
from a high of 0.90% in 2009 to a low of 0.10% in 2004.
This ratio varies with changes in the economy and credit conditions.
If we were to apply these high and low ratios to average net loans and
acceptances in 2012, our provision for credit losses would range from
$2,227 million to $247 million. Our provision for credit losses in 2012
was $765 million.
Additional information on the process and methodology for
determining the allowance for credit losses can be found in the dis-
cussion of credit risk on page 80 as well as in Note 4 on page 131 of the
financial statements.
Purchased Loans
Significant judgment and assumptions were applied to determine the
fair value of the Marshall & Ilsley Corporation (M&I) loan portfolio. Loans
are either purchased performing loans or purchased credit impaired
loans (PCI loans), both of which are recorded at fair value at the time of
acquisition. Determining fair value involves estimating the expected
cash flows to be received and determining the discount rate applied to
the cash flows from the loan portfolio. PCI loans are those where the
timely collection of principal and interest was no longer reasonably
assured as at the date of acquisition. We regularly evaluate what we
expect to collect on PCI loans. Assessing the timing and amount of cash
flows requires significant management judgment regarding key
assumptions, including the probability of default, severity of loss, timing
of payment receipts and the valuation of collateral. All of these factors
70 BMO Financial Group 195th Annual Report 2012