Bank of Montreal 2012 Annual Report Download - page 83

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
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.
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 activ-
ities. BMO’s robust credit risk management framework is aligned with
the three-lines-of-defence approach to managing risk. As the first line of
defence, operating groups are accountable for recommending credit
decisions based on the completion of appropriate due diligence, and
they assume ownership of the risk. As the second line of defence,
ER&PM approves credit decisions and is accountable for providing
independent oversight of the risks assumed by the operating groups.
These experienced and skilled individuals are subject to a rigorous
lending qualification 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 EAD, LGD and PD.
Under Basel II, there are three approaches available for the measure-
ment of credit risk: Standardized, Foundation Internal Ratings Based and
Advanced Internal Ratings Based (AIRB). Subject to a transitional floor
based on the Standardized Approach, we apply the AIRB Approach for
calculations of credit risk in our portfolios, including portfolios of our
subsidiary BMO Bankcorp, Inc. (now part of BMO Financial Corp.). The
Standardized Approach is currently being used in the acquired M&I
business, and plans to transition to the AIRB Approach have been sub-
mitted to OSFI and are pending approval.
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 mort-
gages, 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 developed
using established statistical techniques and expert systems for under-
writing and monitoring purposes. Adjudication models, behavioural
scorecards, decision trees and expert knowledge are combined to
produce optimal credit decisions in a centralized and automated
environment. The characteristics of both the borrower and the credit
obligation, 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. The exposure of
each pool is assigned risk parameters (PD, LGD and EAD) based on the
performance of the pool, and these assignments are reviewed and
updated monthly for changes. The PD risk profile of the AIRB Retail
portfolio at October 31, 2012, was as follows:
PD risk profile PD range % of Retail EAD
Exceptionally low ≤0.05% 16.7
Very low > 0.05% to 0.20% 44.7
Low > 0.20% to 0.75% 21.0
Medium > 0.75% to 7.0% 15.5
High > 7.0% to 99.9% 1.5
Default 100% 0.6
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 estab-
lishes 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.
Material in blue-tinted font above is an integral part of the 2012 annual consolidated financial statements (see page 75).
80 BMO Financial Group 195th Annual Report 2012