Bank of Montreal 2013 Annual Report Download - page 60

discount rate to be applied to the cash flows from the loan portfolio. In
determining the possible discount rates, we considered various factors,
including our cost to raise funds in the current market, the risk premium
associated with the loans and the cost to service the portfolios. PCI loans
are those where the timely collection of principal and interest was no
longer reasonably assured as at the date of acquisition. We regularly
evaluate what we expect to collect on PCI loans. Changes in expected
cash flows could result in the recognition of impairment or a recovery
through the provision for credit losses. Assessing the timing and amount
of cash flows requires significant management judgment regarding key
assumptions, including the probability of default, severity of loss, timing
of payment receipts and valuation of collateral. All of these factors are
inherently subjective and can result in significant changes in the cash
flow estimates over the term 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 the date of acquis-
ition. The determination of fair value involved estimating the expected
cash flows to be paid and determining the discount rate to be applied to
the cash flows. Estimating the timing and amount of cash flows requires
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 certain 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 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, 2013, as well as a sensitivity
analysis of our Level 3 financial instruments, is disclosed in Note 29 on
page 178 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, administrative costs and other items including
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 2013 2012
Credit risk 49 110
Liquidity risk 48 28
Administrative costs 11 11
Other 3 3
111 152
Valuation adjustments made to model estimates to arrive at fair value
were lower in 2013 than in 2012. The decrease in the adjustment for
credit risk was primarily due to significantly higher swap rates in Canada
and the United States, coupled with narrower relative credit spreads
between our counterparties and BMO. The increase in liquidity risk was
due to larger independent valuation adjustments from VPC.
Consolidation of Special Purpose Entities
In the normal course of business, BMO enters into arrangements with
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 SPEs is
included on page 66 as well as in Note 9 on page 145 of the financial
statements.
Pension and Other Employee Future Benefits
Our pension and other employee future benefits expense is calculated
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 167 of the
financial statements.
MD&A
BMO Financial Group 196th Annual Report 2013 71