Bank of Montreal 2013 Annual Report Download - page 80

Frequency Distribution of Daily Net Revenues
November 1, 2012 to October 31, 2013 ($ millions)
Daily net revenues (pre-tax)
Frequency in number of days
13579(9) (7) (5) (3) (1) 212325272931333537
0
5
10
15
20
25
30
35
40
11 13 15 17 19
Structural Market Risk
Structural market risk is comprised of interest rate risk arising from our
banking activities (loans and deposits) and foreign exchange risk arising
from our foreign currency operations. Structural market risk is managed
in support of high-quality earnings and maximization of sustainable
product spreads. The RRC approves the market risk policy limits
governing structural market risk and regularly reviews structural market
risk positions. The Balance Sheet and Capital Management Committee
and the RMC provide senior management oversight. BMO’s Corporate
Treasury group is responsible for the ongoing management of structural
market risk across the enterprise, with independent oversight provided
by the Market Risk group.
Structural interest rate risk arises primarily from interest rate
mismatches and product embedded options. Interest rate mismatch risk
results from differences in the scheduled maturity, repricing dates or
reference rates of assets, liabilities and derivatives. Product embedded
option risk results from product features that allow customers to alter
scheduled maturity or repricing dates. Product embedded options
include loan prepayment and deposit redemption privileges and
committed rates on unadvanced mortgages. The net interest rate
mismatch, representing residual assets funded by common share-
holders’ equity, is managed to a target duration, while product
embedded options are managed to low risk levels. The net interest rate
mismatch risk is primarily managed with interest rate swaps and secu-
rities. Product embedded option risk exposures are primarily managed
through a dynamic hedging process or with purchased options.
Structural foreign exchange risk arises primarily from translation
risk related to the net investment in our U.S. operations and from trans-
action risk associated with our U.S.-dollar-denominated net income.
Translation risk represents the impact changes in foreign exchange
rates can have on BMO’s reported shareholders’ equity and capital
ratios. When the Canadian dollar appreciates relative to the U.S. dollar,
unrealized translation losses on our net investment in foreign oper-
ations, net of related hedging activities, are reported in other compre-
hensive income in shareholders’ equity. In addition, the Canadian dollar
equivalent of U.S.-dollar-denominated RWA decreases. The reverse is
true when the Canadian dollar depreciates relative to the U.S. dollar.
Consequently, we may hedge our net investment in foreign operations
to ensure translation risk does not materially impact our capital ratios.
Transaction risk represents the impact on the Canadian dollar
equivalent of BMO’s U.S.-dollar-denominated results that fluctuations in
the Canadian/U.S. dollar exchange rate may have. Exchange rate
fluctuations will affect future results measured in Canadian dollars and
the impact on those results is a function of the periods in which rev-
enues, expenses and provisions for credit losses arise. Hedging trans-
actions may be executed to partially offset the pre-tax effects of
Canadian/U.S. dollar exchange rate fluctuations. If future results are
consistent with results in 2013, each one cent increase (decrease) in
the Canadian/U.S. dollar exchange rate would be expected to increase
(decrease) adjusted net income before income taxes for the year by
$15 million in the absence of hedging transactions.
We use a variety of metrics to measure and manage interest rate
risk. These include simulations, sensitivity analysis, stress testing and gap
analysis in addition to other traditional risk metrics. The interest rate gap
position is disclosed in Note 19 on page 161 of the financial statements.
Structural interest rate sensitivity to an immediate parallel increase
or decrease of 100 and 200 basis points in the yield curve is disclosed in
the table below. This interest rate sensitivity analysis is performed and
disclosed by many financial institutions and facilitates comparison with
our peer group. Economic value interest rate sensitivity declined and
earnings interest rate sensitivity increased from the prior year primarily
due to higher short-term asset sensitivity. The asset-liability profile at
the end of the year results in a structural earnings benefit from interest
rate increases and structural earnings exposure to interest rate
decreases.
Structural Balance Sheet Interest Rate Sensitivity (1) ($ millions)*
Canadian equivalent As at October 31, 2013 As at October 31, 2012
Economic value 12-month earnings Economic value 12-month earnings
sensitivity sensitivity sensitivity sensitivity
pre-tax after tax pre-tax after tax
100 basis point increase (503.1) 95.4 (537.6) 20.1
100 basis point decrease 340.1 (90.8) 402.9 (74.6)
200 basis point increase (1,078.8) 158.1 (1,223.1) 27.2
200 basis point decrease 442.7 (113.7) 783.6 (75.1)
* Exposures are in brackets and benefits are represented by positive amounts.
(1) Interest rate sensitivities associated with BMO’s insurance businesses are not reflected in the
table above. For our insurance businesses, a 100 basis point increase in interest rates results in
an increase in earnings after tax of $81 million and an increase in economic value before tax
of $335 million ($94 million and $560 million, respectively, at October 31, 2012). A 100 basis
point decrease in interest rates results in a decrease in earnings after tax of $66 million and a
decrease in economic value before tax of $399 million ($74 million and $634 million,
respectively, at October 31, 2012). The change in interest rate sensitivities from the prior
year reflects the growth in the insurance business, lower interest rates and changes in
investment mix.
Models used to measure structural market risk project changes in
interest rates and predict how customers would likely react to the
changes. For customer loans and deposits with scheduled maturity and
repricing dates (such as mortgages and term deposits), our models
measure how customers are likely to use embedded options to alter
those scheduled terms. For customer loans and deposits without sched-
uled maturity and repricing dates (such as credit card loans and
chequing accounts), our models assume a maturity profile that considers
historical and forecasted trends in changes in the balances due. These
models have been developed using statistical analysis and are validated
through regular model vetting, back-testing processes and ongoing
dialogue with staff in the lines of business. Models used to predict
customer behaviour are also used in support of product pricing and
performance measurement. Stress testing is performed regularly to
quantify the sensitivity of the structural market risk position to these
behavioural assumptions.
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 91