Bank of Montreal 2012 Annual Report Download - page 74

MD&A
are inherently subjective and can result in significant changes in the
cash flow estimates over the life of a loan.
The purchased performing loans are subject to the credit review
processes applied to loans we originate.
Acquired Deposits
M&I deposit liabilities were recorded at fair value at acquisition. The
determination of fair value involves estimating the expected cash flows
to be paid and determining the discount rate applied to the cash flows.
The timing and amount of cash flows involve significant management
judgment regarding the likelihood of early redemption by us and the
timing of withdrawal by the client. Discount rates were based on the
prevailing rates we were paying on similar deposits at the date of
acquisition.
Financial Instruments Measured at Fair Value
BMO records securities and derivatives at their fair value, and certain
liabilities are designated at fair value. Fair value represents our estimate
of the amount we would receive, or would have to pay in the case of a
derivative liability, in a current transaction between willing parties. We
employ a fair value hierarchy to categorize the inputs we use in valu-
ation techniques to measure fair value. The extent of our use of quoted
market prices (Level 1), internal models using observable market
information (Level 2) and internal models without observable market
information (Level 3) in the valuation of securities, derivative assets and
derivative liabilities as at October 31, 2012, as well as a sensitivity
analysis of our Level 3 financial instruments, is disclosed in Note 29 on
page 170 of the financial statements.
Valuation models use general assumptions and market data, and
therefore do not reflect the specific risks and other factors that would
affect a particular instrument’s fair value. As a result, we incorporate
certain adjustments when using internal models to establish fair values.
These fair value adjustments take into account the estimated impact of
credit risk, liquidity risk, valuation considerations, administrative costs
and closeout costs. For example, the credit risk adjustment for derivative
financial instruments incorporates credit risk into our determination of
fair values by taking into account factors such as the counterparty’s credit
rating, the duration of the instrument and changes in credit spreads.
Valuation Product Control (VPC), a group independent of the trading
lines of business, verifies the fair values at which financial instruments
are recorded. For instruments that are valued using models, VPC identi-
fies situations where valuation adjustments must be made to the model
estimates to arrive at fair value.
The methodologies used for calculating these adjustments are
reviewed on an ongoing basis to ensure that they remain appropriate.
Significant changes in methodologies are made only when we believe
that the change will result in better estimates of fair value.
Valuation Adjustments ($ millions)
As at October 31 2012 2011
Credit risk 110 134
Liquidity risk 28 21
Administrative costs 11 10
Other 360
152 225
Valuation adjustments made to model estimates to arrive at fair value
were lower in 2012. The decrease in the adjustment for credit risk was
due to narrower relative credit spreads between our counterparties
and BMO. The decrease in Other was due to better alignment between
the valuations performed by traders and the independent valuations
performed by the Valuations Product Group.
Consolidation of Special Purpose Entities
In the normal course of business, BMO enters into arrangements with
special purpose entities (SPEs). We are required to consolidate SPEs if
we determine that we control the SPEs.
We control the vehicle and therefore we consolidate its results
when the activities of the SPE are being conducted on our behalf and we
receive the benefits, when we have the decision making power or we
retain the residual or ownership risks related to the SPE or its assets.
Additional information concerning BMO’s involvement with special
purpose entities is included on pages 70 and 71 as well as in Note 9 on
page 139 of the financial statements.
Pension and Other Employee Future Benefits
BMO’s pension and other employee future benefits expense is calcu-
lated by our independent actuaries using assumptions determined by
management. If actual experience differs from the assumptions used,
pension and other employee future benefits expense could increase or
decrease in future years. The expected rate of return on plan assets is a
management estimate that significantly affects the calculation of pen-
sion expense. Our expected rate of return on plan assets is determined
using the plan’s target asset allocation and estimated rates of return for
each asset class. Estimated rates of return are based on expected
returns from fixed-income securities, which take into consideration bond
yields. An equity risk premium is then applied to estimate equity
returns. Expected returns from other asset classes are established to
reflect the risks of these asset classes relative to fixed-income and
equity assets. The impact of changes in expected rates of return on plan
assets is not significant for our other employee future benefits expense
since only small amounts of assets are held in these plans.
Pension and other employee future benefits expense and obliga-
tions are also sensitive to changes in discount rates. We determine
discount rates at each year end for our Canadian and U.S. plans using
high-quality corporate bonds with terms matching the plans’ specific
cash flows.
Additional information regarding our accounting for pension and
other employee future benefits, including a sensitivity analysis for
key assumptions, is included in Note 23 on page 160 of the finan-
cial statements.
Impairment
We have investments in securities issued or guaranteed by Canadian or
U.S. governments, corporate debt and equity securities, mortgage-
backed securities and collateralized mortgage obligations, which are
classified as available-for-sale securities or as held-to-maturity secu-
rities. We review held-to-maturity, available-for-sale and other securities
at each quarter-end reporting period to identify and evaluate invest-
ments that show indications of possible impairment. An investment is
considered impaired if there is objective evidence that the estimated
future cash flows will be reduced and the impact can be reliably meas-
ured. We consider evidence such as delinquency or default, bankruptcy,
restructuring or the absence of an active market. The decision to record
a write-down, its amount and the period in which it is recorded could
change if management’s assessment of those factors were different. We
do not record impairment write-downs on debt securities when impair-
ment is due to changes in market interest rates, since we expect to
realize the full value of these investments by holding them until
maturity or until they recover in value.
At the end of 2012, there were total unrealized losses of
$86 million on securities for which cost exceeded fair value and an
impairment write-down had not been recorded. Of this amount,
$5 million related to securities for which cost had exceeded fair value
for 12 months or more. These unrealized losses resulted from increases
in market interest rates and not from deterioration in the creditworthi-
ness of the issuer.
BMO Financial Group 195th Annual Report 2012 71