Bank of Montreal 2013 Annual Report Download - page 71

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
including assessments of our top and emerging risks, to provide senior
management and the Board of Directors with timely, actionable and
forward-looking risk reporting. This reporting includes material to facili-
tate assessments of these risks relative to our risk appetite and the
relevant limits established within our Risk Appetite Framework.
On a regular basis, reporting on risk is also provided to stake-
holders, including regulators, external rating agencies and our share-
holders, as well as to others in the investment community.
Risk-Based Capital Assessment
Two measures of risk-based capital are used by BMO: Economic Capital
and Regulatory Capital. Both are aggregate measures of the risk that we
undertake in pursuit of our financial targets. Our operating model pro-
vides for the direct management of each type of risk, as well as the
management of risks on an integrated basis. Economic Capital is our
integrated internal measure of the risk underlying BMO’s business activ-
ities. It represents management’s estimate of the magnitude of
economic losses that could occur should adverse situations arise, and
allows returns to be measured on a basis that considers the risks taken.
Economic Capital is calculated for various types of risk – credit, market
(trading and non-trading), operational and other – where measures are
based on a time horizon of one year. Measuring the economic profit-
ability of transactions or portfolios incorporates a combination of both
expected and unexpected losses to assess the extent and correlation of
risk before authorizing new exposures. Economic Capital methods and
model inputs are reviewed and/or re-calibrated on an annual basis, as
applicable. Our Economic Capital models provide a forward-looking
estimate of the difference between our maximum potential loss in
economic (or market) value and our expected loss, measured over a
specified time interval and using a defined confidence level. Both
expected and unexpected loss measures for either a transaction or
portfolio reflect current market conditions and credit quality. As the
recovery continues these measures decrease, reflecting portfolio quality
improvements, offset somewhat by increases due to growth.
Stress Testing
Stress testing is a key element of our risk and capital management frame-
works. It is inherently linked to our risk appetite and informs our strategy,
business planning and decision-making processes. We conduct stress
testing to evaluate the potential effects of low-frequency, high-severity
events on our balance sheet, earnings, and liquidity and capital positions.
Governance
Governance over the stress testing framework resides with senior
management, including the Stress Testing Steering Committee. This
committee is comprised of business, risk and finance executives and is
accountable to RMC for the oversight of BMO’s stress testing framework
and for reviewing and challenging stress test results. As a part of the
Internal Capital Adequacy Assessment Process, enterprise-wide
scenarios and stress testing results are presented to senior management
and the board, together with recommended actions that BMO could take
to manage the impact of the stress event.
Enterprise Stress Testing
Enterprise stress testing supports our internal capital adequacy assess-
ment and target-setting through the analysis of macroeconomic
scenarios that are consistently executed by business, risk and finance
groups. Scenario selection is a multi-step process that considers the
macroeconomic environment, prevailing risk concerns, the potential
impact of new or emerging risks on our risk profile, historical credit
losses and areas of potential enterprise-specific vulnerability. Scenarios
may be defined by senior management, the board or regulators. The
Economics group then translates the scenario into macroeconomic and
market variables, including but not limited to GDP growth, yield curve
estimates, unemployment rates, housing starts, real estate prices, stock
index growth and changes in corporate profits.
Our stress testing process employs a bottom-up approach. We
model the impact of a forward-looking scenario on our material risks,
income statement and balance sheet over a forecast horizon to test the
resilience of our capital. Stress test results, including mitigating actions,
are benchmarked and challenged by relevant business units and senior
management, including the Stress Testing Steering Committee.
Ad Hoc Stress Testing
Through our stress testing framework, we embed stress testing in strat-
egy, business planning and decision-making. Ad hoc stress testing is
conducted regularly by our operating and risk groups to support risk
identification, business analysis and strategic decision-making.
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, ERPM
approves credit decisions and is accountable for providing independent
oversight of the risks assumed by the operating groups. All of 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 dele-
gated 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 esti-
mate 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 measurement
of credit risk: Standardized, Foundation Internal Ratings Based and
82 BMO Financial Group 196th Annual Report 2013