Bank of Montreal 2013 Annual Report Download - page 51

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
The AIRB Approach is the most advanced of the approaches for
determining credit risk capital requirements. It utilizes sophisticated
techniques to measure RWA at the exposure level based on sound risk
management principles, including consideration of estimates of the
probability of default, the likely loss given default and exposure at
default, term to maturity and the type of Basel Asset Class exposure.
These risk parameters are determined using historical portfolio data
supplemented by benchmarking, and are updated periodically. Vali-
dation procedures related to these parameters are in place and are
enhanced periodically in order to appropriately quantify and differ-
entiate risks so they reflect changes in economic and credit conditions.
Under the Standardized Approach, operational risk capital require-
ments are based on the size and type of our lines of business. As
defined under Basel rules adopted by the Office of the Superintendent of
Financial Institutions Canada (OSFI), gross income serves as a proxy for
the size of the line of business and as an indicator of operational risk.
Gross income is segmented into eight regulatory business lines by
business type, and each segment amount is multiplied by a
corresponding factor prescribed by the Basel framework to determine its
operational risk capital requirement. The table that follows provides a
breakdown of our RWA by risk type.
Risk-Weighted Assets ($ millions)
2013 2012
As at October 31 (Basel III) (Basel II)
Credit risk 179,289 171,955
Market risk 9,154 7,598
Operational risk 26,651 25,677
Total RWA 215,094 205,230
2013 Regulatory Capital Review
Effective the first quarter of 2013, regulatory capital requirements for
BMO are determined on a Basel III basis. In 2013, the minimum Basel III
capital ratios proposed by the Basel Committee on Banking Supervision
(BCBS) were a 3.5% Common Equity Tier 1 (CET1) Ratio, 4.5% Tier 1
Capital Ratio and 8% Total Capital Ratio, such ratios being calculated
using a five-year transitional phase-in of regulatory adjustments and a
nine-year transitional phase-out of instruments that no longer qualify as
regulatory capital under the Basel III rules. However, guidance issued by
OSFI (also referred to as the “all-in” requirements) required Canadian
deposit-taking institutions to meet the 2019 Basel III capital require-
ments in 2013, other than the phase-out of non-qualifying capital
instruments, and expected them to attain a target Basel III CET1 Ratio of
at least 7% (4.5% minimum plus 2.5% Capital Conservation Buffer) by
January 31, 2013.
BCBS has released a framework for the determination of additional
capital requirements for domestic systemically important banks (D-SIBs).
In March 2013, OSFI issued guidance designating the six largest Cana-
dian banks, including BMO, as D-SIBs. The D-SIBs will be subject to
continued enhanced supervision and disclosure and, commencing on
January 1, 2016, will be required to hold an additional 1% CET1 capital
buffer as part of an increased Capital Conservation Buffer. No Canadian
banks are currently considered to be globally systemically important.
The fully implemented Basel III requirements and the OSFI “all-in”
Basel III requirements are summarized in the following table.
Regulatory Requirements (% of Risk-Weighted Assets)
Common
Equity
Tier 1
Ratio (1)
Tier 1
Capital
Ratio
Total
Capital
Ratio
Leverage
Ratio (3)
Basel III – Stated 2019 minimum
requirements
Plus: Capital Conservation Buffer (2)
(effective January 1, 2013)
4.5
2.5
6.0
2.5
8.0
2.5
3.0
na
Plus: D-SIB Common Equity capital buffer
(effective January 1, 2016) 1.0 1.0 1.0 na
OSFI Basel III effective requirements (4) 8.0 9.5 11.5 3.0
(1) The minimum 4.5% CET1 Ratio requirement is augmented by the 2.5% Capital Conservation
Buffer that can absorb losses during periods of stress. The Capital Conservation Buffer for
BMO will increase to 3.5% CET1 due to the addition of the D-SIB buffer. If a bank’s capital
ratios fall within the range of this buffer, restrictions on discretionary distributions of
earnings (such as dividends, equity repurchases and discretionary compensation) would
ensue, with the degree of such restrictions varying according to the position of the bank’s
ratios within the buffer range.
(2) The Capital Conservation Buffer does not include the counter-cyclical capital buffer of up to
2.5% of CET1, which may be required on a national basis by supervisors if they perceive
credit growth resulting in systemic risk. If imposed, this additional buffer is effectively
combined with the Capital Conservation Buffer.
(3) A 3% minimum Leverage Ratio has been proposed by the BCBS. It will be subject to
monitoring and analysis during a four-year parallel run test period, which began on
January 1, 2013. Depending upon the results of the parallel run testing, there could be
subsequent adjustments, which are targeted to be finalized in 2017, with the final Leverage
Ratio requirement effective January 1, 2018. OSFI currently monitors bank leverage using the
Assets-to-Capital Multiple, which is based on total capital. The proposed Basel III Leverage
Ratio is based on Tier 1 capital.
(4) OSFI’s Basel III “effective requirements” are the capital requirements systemically important
Canadian banks must meet in 2016 to avoid being subject to restrictions on discretionary
distributions of earnings.
na – not applicable
Common equity is the most permanent form of capital. Under Basel III,
CET1 is comprised of common shareholders’ equity less deductions for
goodwill, intangible assets, pension assets, certain deferred tax assets
and certain other items. Additional Tier 1 capital primarily consists of
preferred shares and innovative hybrid instruments, less certain regu-
latory deductions. Tier 1 capital is comprised of CET1 and Additional
Tier 1 capital.
Our Basel III CET1 and Tier 1 capital were $21.2 billion and
$24.6 billion, respectively, at October 31, 2013, up from the pro-forma
estimates of $19.3 billion and $23.2 billion, respectively, at October 31,
2012. Basel III CET1 capital increased due to retained earnings growth,
increases to accumulated other comprehensive income, the issuance of
common shares through the Shareholder Dividend Reinvestment and
Share Purchase Plan (DRIP) and the exercise of stock options, partially
offset by the purchase and cancellation of shares under BMO’s share
repurchase program and payment of dividends. Pro-forma estimates of
Basel III capital amounts and ratios have not been updated to reflect the
Basel III rules set out in OSFI’s Capital Adequacy Requirements Guideline
released in December 2012. The increase in Tier 1 capital from the
October 31, 2012 pro-forma estimate, was attributable to the growth in
CET1 capital, partially offset by the redemption of preferred shares, as
outlined below in the Capital Management Activities section.
Total capital includes Tier 1 and Tier 2 capital. Tier 2 capital is
primarily comprised of subordinated debentures and a portion of the
collective allowance for credit losses, less certain regulatory deductions.
Basel III Total capital was $29.5 billion at October 31, 2013, up from the
pro-forma estimate of $28.5 billion at October 31, 2012, attributable to
the growth in Tier 1 capital mentioned above, partially offset by the
phase-out of Tier 2 instruments that no longer qualify as capital under
Basel III, as mentioned above and further explained below.
The Basel III Common Equity Tier 1 Ratio reflects Basel III CET1
capital divided by RWA.
The Basel III Tier 1 Capital Ratio reflects Basel III Tier 1 capital
divided by RWA.
The Basel III Total Capital Ratio reflects Basel III Total capital divided
by RWA.
62 BMO Financial Group 196th Annual Report 2013