Bank of Montreal 2012 Annual Report Download - page 85

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
Market Risk
Market risk is the potential for adverse changes in the value of
BMO’s assets and liabilities resulting from changes in market varia-
bles such as interest rates, foreign exchange rates, equity and
commodity prices and their implied volatilities, and credit spreads,
as well as the risk of credit migration and default.
BMO incurs market risk in its trading and underwriting activities and
structural banking activities.
As part of our enterprise-wide risk management framework, we
apply extensive governance and management processes to our market
risk-taking activities. These include:
‰oversight by senior governance committees, including the Balance
Sheet and Capital Management Committee, RMC and RRC;
‰an Economic Capital process that incorporates market risk measures
(market value exposures);
‰independent valuation of trading positions and measurement of
market risk;
‰a broad set of policies and corporate standards;
‰monitoring an extensive range of risk metrics as appropriate for the
respective trading portfolios, including VaR, stress and scenario tests,
risk sensitivities and operational metrics;
‰a well-developed set of limits with appropriate monitoring, reporting
and escalation of limit breaches; and
‰a model risk management framework to control for model risk.
Primary 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 our 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 execu-
tives 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 activ-
ities on behalf of BMO are appropriately informed of BMO’s risk-taking
governance, authority structure and procedures and processes, and
are given access to and guidance on the relevant corporate policies
and standards.
Our Market Risk group also provides oversight of structural market risk,
which is managed by BMO’s Corporate Treasury group and described on
pages 85 and 86.
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/or
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 potential 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 portfolio 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 loss likely to be
experienced in the 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 migration 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.
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 estimates of portfolio risk, but have
limitations. Among the limitations of VaR is the 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,
including tests of scenarios such as the stock market crash of 1987 and
the collapse of Lehman Brothers in 2008. Ad hoc analyses are run to
examine our sensitivity to high-impact, low-probability hypothetical
scenarios. Scenarios are amended, added or deleted to better reflect
changes in underlying market conditions. The results are reported to the
lines of business, RMC and RRC on a regular basis. Stress testing is lim-
ited 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 is viewed as a definitive predictor of the
maximum amount of losses that could occur in any one day,
because both measures are computed at prescribed confidence levels
and their results 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. BMO has a robust governance
process in place to ensure adherence to delegated market risk limits.
Amounts exceeding established limits are communicated to senior
management on a timely basis for resolution and appropriate action.
Material in blue-tinted font above is an integral part of the 2012 annual consolidated financial statements (see page 75).
82 BMO Financial Group 195th Annual Report 2012