Bank of Montreal 2013 Annual Report Download - page 87

MANAGEMENT’S DISCUSSION AND ANALYSIS
LGD: assigned to each credit facility extended to a borrower and meas-
ures the potential economic loss at default during downturn conditions.
LGD models are based on realized losses and calibrated to account for
potential downturn conditions (with an added margin-of-conservatism
adjustment for data uncertainty where necessary). LGD models have
been developed for each asset class using internal data that covers a
period of more than seven years (2000 to 2011), captures a full
economic cycle and is supplemented by external data, as needed.
EAD: assigned to each facility extended to a borrower and measures the
amount of a credit facility that is likely to be drawn in the event the
borrower defaults within the next 12 months assuming downturn con-
ditions. EAD is modelled using internal data that covers a period of more
than seven years (2000 to 2010) and captures a full economic cycle. The
EAD models are then calibrated to reflect downturn conditions based on
the average of historical realized drawn-down amounts over downturn
periods with a margin-of-conservatism adjustment for data uncertainty
where necessary.
MD&A
Model Back-testing
Back-testing requirements are governed under comprehensive Vali-
dation Guidelines. For probability of default, back-testing entails
comparing the rating system’s mapped probabilities of default against
actual or realized default rates for each of the obligor ratings, and
testing for statistical evidence that the realized default rates represent
sampling variability and not different populations of default data. Back-
testing the effectiveness of a risk rating system can be measured
through the evaluation of calibration and discriminatory power with
support from migration analysis. A comprehensive validation includes
various prescribed tests and analyses that measure discriminatory
power, calibration and dynamic properties. Additional tests or analyses
may be used to validate BRR/PDs. As with any analysis, judgment can
be applied in determining potentially limiting factors, such as data limi-
tations, which may impact the overall relevance of validation
approaches and/or interpretation of statistical analysis. For loss given
default, back-testing follows similar testing requirements. Annual vali-
dations are performed independently by the Model Risk Vetting group.
Strategic Risk
Strategic risk is the potential for loss due to fluctuations in the
external business environment and/or failure to properly respond to
these fluctuations due to inaction, ineffective strategies or poor
implementation of strategies.
Strategic risk arises from external risks inherent in the business environ-
ment within which BMO operates, as well as the risk of potential loss if
BMO is unable to address those external risks effectively. While external
strategic risks – including economic, political, regulatory, technological,
social and competitive risks – cannot be controlled, the likelihood and
magnitude of their impact can be mitigated through an effective
strategic risk management process.
BMO’s Strategy Group oversees our strategic planning processes
and works with the lines of business, along with risk, finance and other
corporate areas, to identify, monitor and mitigate strategic risk across
the enterprise. A rigorous strategic management process encourages a
consistent approach to the development of strategies and incorporates
financial information linked to financial commitments.
The Strategy Group works with the lines of business and key corpo-
rate stakeholders during the strategy development process to promote
consistency and adherence to strategic management standards. The
potential impacts of the changing business environment, such as broad
industry trends and the actions of competitors, are considered as part of
this process and inform strategic decisions within each of our lines of
business. Enterprise and group strategies are reviewed with the
Management Committee and the Board of Directors annually in inter-
active sessions designed to challenge assumptions and strategies in the
context of current and potential future business environments.
Performance objectives established through the strategic manage-
ment process are regularly monitored and are reported upon quarterly,
using both leading and lagging indicators of performance, so that strat-
egies can be reviewed and adjusted where necessary. Regular strategic
and financial updates are also monitored closely to identify any sig-
nificant issues.
Reputation Risk
Reputation risk is the risk of a negative impact to BMO that results
from the deterioration of BMO’s reputation. Potential negative
impacts include revenue loss, decline in client loyalty, litigation, regu-
latory sanction or additional oversight or decline in BMO’s share price.
BMO’s reputation is one of its most valuable assets. By protecting and
maintaining our reputation, we can increase shareholder value, reduce
our cost of capital and improve employee engagement.
Fostering a business culture in which integrity and ethical conduct
are core values is key to effectively protecting and maintaining
BMO’s reputation.
We believe that active, ongoing and effective management of
reputation risk is best achieved by considering reputation risk issues in
the course of strategy development, strategic and operational
implementation, and transactional or initiative decision-making. Reputa-
tion risk is also managed through our corporate governance practices,
code of conduct and risk management framework.
All employees are responsible for conducting themselves in accord-
ance with FirstPrinciples, BMO’s code of conduct, thus building and
maintaining BMO’s reputation. The Reputation Risk Management
Committee reviews significant or heightened issues of reputation risk to
BMO, including those that may arise from complex credit or structured-
finance transactions.
98 BMO Financial Group 196th Annual Report 2013