Bank of Montreal 2013 Annual Report Download - page 72

Advanced Internal Ratings Based (AIRB). Subject to a transitional floor
based on the Standardized Approach, we apply the AIRB Approach for
calculations of credit risk in our portfolios, including portfolios of our
subsidiary BMO Bankcorp, Inc. (now part of BMO Financial Corp.). The
Standardized Approach is currently being used in the acquired M&I portfo-
lio, but activities to transition to the AIRB Approach are well underway.
Risk Rating Systems
BMO’s risk rating systems are designed to assess and measure the risk
of any exposure. The rating systems differ for the consumer and small
business portfolios and the commercial and corporate portfolios.
Consumer and Small Business
The consumer and small business portfolios are made up of a diversified
group of individual customer accounts and include residential mort-
gages, personal loans, and credit card and small business loans. These
loans are managed in pools of homogeneous risk exposures. For these
pools, credit risk models and decision support systems are developed
using established statistical techniques and expert systems for under-
writing and monitoring purposes. Adjudication models, behavioural
scorecards, decision trees and expert knowledge are combined to
produce optimal credit decisions in a centralized and automated
environment. The characteristics of both the borrower and the credit
obligation, along with past portfolio experience, are used to predict the
credit performance of new accounts. These metrics are used to define
the overall credit risk profile of the portfolio, predict future performance
of existing accounts for ongoing credit risk management and determine
both Economic Capital and Basel II and Basel III regulatory capital. In
addition, our consumer and small business ratings framework is utilized
in the collective allowance process to quantify losses incurred but not
identified for the performing loan portfolio. Exposures are segmented
into homogeneous pools based on account characteristics such as credit
bureau score, delinquency history, loan-to-value (LTV) ratio and loan
balance. PDs and other credit risk parameters are then assigned to each
pool based on the characteristics of the pool and historical loss experi-
ence, and the incurred loss is quantified. In the specific allowance proc-
ess, certain significant consumer loans are individually assessed for
impairment and individually immaterial consumer loans are collectively
assessed for impairment on a pooled basis, taking into account historical
loss experience, PDs, delinquency status, bankruptcy status, product
category and type of collateral pledged. The exposure of each pool is
assigned risk parameters (PD, LGD and EAD) based on the performance
of the pool, and these assignments are reviewed and updated monthly
for changes. The PD risk profile of the AIRB Retail portfolio can be found
on page 46 of the Supplementary Financial Information.
Commercial and Corporate
Within the commercial and corporate portfolios, we utilize an enterprise-
wide risk rating framework that is applied to all of our sovereign, bank,
corporate and commercial counterparties. This framework is consistent
with the principles of Basel II and Basel III, under which minimum regu-
latory capital requirements for credit risk are determined. One key
element of this framework is the assignment of appropriate borrower
risk ratings to help quantify potential credit risk. BMO’s risk rating
framework establishes counterparty risk ratings using methodologies
and rating criteria based on the specific risk characteristics of each
counterparty. The resulting rating is then mapped to a PD over a
one-year time horizon. As counterparties migrate between risk ratings,
the PD associated with the counterparty changes. The commercial and
corporate risk rating framework is utilized in the collective allowance
process to quantify losses incurred but not identified for the performing
loan portfolio. For performing commercial and corporate accounts, risk
ratings are mapped to PDs based on historical long-run default experi-
ence for a given portfolio. Borrower risk ratings are assigned within this
framework using methodologies and rating criteria based on the specific
risk characteristics of each counterparty. As counterparties migrate
between risk ratings, the associated PDs also change, which is reflected
in the incurred loss calculation. In the specific allowance process, risk
ratings are assigned to impaired exposures in the commercial and
corporate portfolios; however, these risk ratings reflect whether or not a
loan has been classified as impaired and not the PD, since objective
evidence of impairment already exists. Specific allowances and the
related provisions for credit losses are determined at the individual
account level based on the expected recoverable amount.
As demonstrated in the table below, our internal risk rating system
corresponds in a logical manner to those of the external rating agencies.
Borrower Risk Rating Scale
Moody’s Investors
BMO
rating Description of risk Service implied equivalent Standard & Poor’s implied equivalent
Investment grade
I-1 to I-3 Undoubted to minimal Aaa to Aa3 AAA to AA-
I-4 to I-5 Modest A1 to Baa1 A+ to BBB+
I-6 to I-7 Average Baa2 to Baa3 BBB to BBB-
Non-investment grade
S-1 to S-2 Acceptable Ba1 to Ba2 BB+ to BB
S-3 to S-4 Marginal Ba3 to B1 BB- to B+
Watchlist
P-1 Deteriorating B2 B
P-2 to P-3 Watchlist B3 to Ca B- to CC
Default and impaired
D-1 to D-4 Default/default and
impaired C D
Policies and Standards
BMO’s credit risk management framework is built on governing princi-
ples defined in a series of corporate policies and standards, which flow
through to more specific guidelines and procedures. These are reviewed
on a regular basis to keep them current and consistent with BMO’s risk
appetite. The structure, limits, collateral requirements, ongoing
management, monitoring and reporting of our credit exposures are all
governed by these credit risk management principles.
Credit Risk Governance
The RRC has oversight of the management of all risks faced by the
enterprise, including credit risk. Operating practices include the ongoing
monitoring of credit risk exposures and regular portfolio and sector
reporting to the board and to senior management committees.
Performing accounts are reviewed on a regular basis, with most
commercial and corporate accounts reviewed at least annually. The
frequency of review is increased in accordance with the likelihood and
size of potential credit losses, with deteriorating higher-risk situations
referred to specialized account management groups for closer attention,
when appropriate. Corporate Audit Division reviews and tests manage-
ment processes and controls and samples credit transactions for adher-
ence to credit terms and conditions, as well as to governing policies,
standards and procedures. In addition, regular portfolio and sector
reviews are carried out, including stress testing and scenario analysis
based on current, emerging or prospective risks.
Portfolio Management
BMO’s credit risk governance policies provide for an acceptable level of
diversification. Limits are in place for several portfolio dimensions,
including industry, country, product and single-name concentrations, as
well as transaction-specific limits. At year end, our credit assets con-
sisted of a well-diversified portfolio comprised of millions of clients, the
majority of them consumers and small to medium-sized businesses.
BMO employs a number of measures to mitigate and manage credit
risk. These measures include, but are not limited to, strong underwriting
MD&A
Material in blue-tinted font above is an integral part of the 2013 annual consolidated financial statements (see page 77).
BMO Financial Group 196th Annual Report 2013 83