Bank of Montreal 2013 Annual Report Download - page 59

MANAGEMENT’S DISCUSSION AND ANALYSIS
Off-Balance Sheet Arrangements
MD&A
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 $90 billion at October 31, 2013
($74 billion in 2012). 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 and collateralization provisions. Further information on
these instruments can be found in Note 5 on page 141 of the
financial statements.
Critical Accounting Estimates
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 page 66 in the BMO-
Sponsored Securitization Vehicles and Structured Investment Vehicle
sections and in Note 9 on page 145 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, as well as indemnification
agreements).
The maximum amount payable by BMO in relation to these guaran-
tees was $31 billion at October 31, 2013 ($40 billion in 2012). 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 144 of the financial statements.
The most significant assets and liabilities for which we must make
estimates include: allowance for credit losses; purchased loans; acquired
deposits; financial instruments measured at fair value; consolidation of
special purpose entities (SPEs); pension and other employee future
benefits; impairment of securities; income taxes; goodwill and
intangible assets; insurance-related liabilities; 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, on page 145 of the financial statements. Note 29 on
page 178 of the financial statements 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 control procedures that are
intended to ensure the judgments we make in determining the esti-
mates 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 130 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 2013, our provision for credit losses would range from
$2,395 million to $266 million. Our provision for credit losses in 2013
was $589 million.
Additional information on the process and methodology for
determining the allowance for credit losses can be found in the dis-
cussion of Credit and Counterparty Risk on page 82 as well as in Note 4
on page 137 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
were identified as either purchased performing loans or purchased credit
impaired loans (PCI loans), both of which were recorded at fair value at
the time of acquisition. The determination of fair value involved
estimating the expected cash flows to be received and determining the
70 BMO Financial Group 196th Annual Report 2013