Bank of Montreal 1998 Annual Report Download - page 100

92
BANK OF MONTREAL GROUP OF COMPANIES
GLOSSARY OF FINANCIAL TERMS
Allowance for Credit Losses
An amount set aside and deemed adequate
by management to absorb potential
credit-related losses in a bank’s portfolio
of loans, acceptances, guarantees, letters
of credit, deposits with other banks and
derivatives. Allowances for credit losses
can be specific or general and are accounted
for as deductions from the related assets
in the financial statements.
Assets under Administration
and under Management
Assets administered and/or managed by
a financial institution that are beneficially
owned by clients or investors and are
therefore not reported on the balance sheet
of the financial institution.
Average Earning Assets
This amount represents the daily or monthly
average balance over a one-year period of
deposits with other banks, loans and securities.
Bankers’ Acceptance (BA)
A bill of exchange or negotiable instrument
drawn by the borrower for payment at
maturity and accepted by a bank. BAs consti-
tute a guarantee of payment by the bank
and can be traded in the money market. The
bank earns a “stamping fee” for providing
this guarantee.
Basis Point
One one-hundredth of a percentage point.
Collateralized Bond Obligation
Debt instrument supported by pool of high-
yield or investment grade bonds.
Counterparty
The opposite side of any transaction, typically
a bank’s corporate or commercial customers
or another financial institution. Counterparty
risk refers to the risk that the counterparty
will not be able to meet its financial obliga-
tions under the terms of the contract or
transaction it has entered into.
Derivatives
A derivative is a contract whose value is
“
derived” from interest rates, foreign exchange
rates, or equity or commodity prices. Use
of derivatives allows for the transfer, modifi-
cation or reduction of current or expected
risks from changes in interest rates, foreign
exchange rates, and equity and commodity
prices. See also individual definitions
of forwards and futures, forward rate agree-
ments, options and swaps.
Duration
A measure of the average time interval
required for an expected stream of cash
flows to repay the original investment,
i.e., shorter duration means faster recovery
of the original investment.
Earnings at Risk
Earnings at Risk is the impact on net income
over the following 12 months of a one time
change in market rates/prices.
Economic Value-at-Risk
Economic Value-at-Risk is the impact on the
value of our assets and liabilities of a change
in market rates/prices.
Forwards and Futures
Contractual agreements to either buy or sell
a specified currency or financial instru-
ment on a specified future date at a specified
price. Forwards are customized contracts
transacted in the over-the-counter market.
Futures are transacted in standardized
amounts on regulated exchanges and are
subject to daily cash margining.
Forward Rate Agreement (FRA)
A type of derivative obliging two parties
to make a cash settlement at a future date for
the difference between a contracted rate of
interest and the current market rate, based on
a notional amount. An FRA can act as a
hedge against future movements in market
interest rates.
Group of Seven
This international group, also known as G-7,
comprises the seven leading industrial
democracies, namely Britain, Canada, France,
Germany, Italy, Japan and the United States.
The group was established in 1986 to co-
ordinate economic and monetary policy.
Guarantees and Standby Letters of Credit
Primarily represent a bank’s obligation to
make payments to third parties on behalf of
its customers if its customers are unable to
make the required payments or meet other
contractual requirements.
Hedge
A risk management technique used to
neutralize/manage interest rate or foreign
currency exchange exposures arising
from normal banking operations.
Impaired Loans
Loans are classified as impaired when, in the
opinion of management, there is no longer
reasonable assurance of the timely collection
of principal and interest. Interest on impaired
loans is only recognized as interest revenue
when management has reasonable assurance
of the timely collection of the full amount
of principal and interest.
Margining
Margins for futures contracts are money
or securities used as an initial deposit as
assurance that the contract will be fulfilled.
Margining refers to adjustments made to the
initial deposit as market movement causes
the fair value of the instrument to fluctuate,
possibly requiring additional deposits to
be placed with the exchange.
Mark-to-Market
Valuation at market rates, as of the balance
sheet date, of securities and derivatives held
for trading purposes.
Net Interest Income
The difference between what a bank earns
on assets such as loans and securities and
what it pays on liabilities such as deposits and
subordinated debentures.
Net Interest Margin (Spread)
Average net interest margin is the ratio of net
interest income to average assets. This is also
referred to as spread.
Notional Amount
The amount considered as principal when
calculating interest and other payments
for derivative contracts. This amount tradi-
tionally does not change hands under the
terms of a derivative contract.
Off-Balance Sheet Financial Instrument
An asset or liability that is not recorded
on the balance sheet, but has the potential to
produce positive or negative cash flows in
the future if a contingent event occurs. A
variety of products offered to customers can
be classified as off-balance sheet and they
fall into two broad categories: (i) credit-related
arrangements, which provide customers
with liquidity protection, and (ii) derivatives.
Options
Contractual agreements that convey the right,
but not the obligation, to either buy or sell a
specific amount of a financial instrument at a
fixed price either at a fixed future date or at
any time within a fixed future period.
Over-the-Counter (OTC)
Trading that occurs outside of organized
or regulated securities exchanges, carried out
by broker-dealers who communicate with
one another by telephone and quotation
terminals. Prices on OTC instruments are
negotiated between buying and selling
brokers. Certain OTC instruments are traded
in accordance with rules prescribed by self-
regulating bodies.
Provision for Credit Losses
A charge to income which represents an
appropriate expense given the composition
of our credit portfolios, their probability
of default, the economic environment
and the allowance for credit losses already
established. Specific provisions are estab-
lished to reduce the book value of specific
assets (primarily loans) to establish the
amount expected to be recovered on the
loans. A country risk provision is established
for loans to and securities of countries
identified by OSFI that have restructured or
experienced difficulties in servicing all
or part of their external debt to commercial
banks. A general allowance for loan losses
is established in recognition of the fact that
not all of the impairment in a loan portfolio
can be specifically identified on a loan-by-
loan basis.
Regulatory Capital Ratios
The percentage of risk-weighted assets
supported by capital, as defined by the Office
of the Superintendent of Financial Insti-
tutions Canada (OSFI) under the framework
of risk-based capital standards developed
by the Bank for International Settlements.
These ratios are labelled Tier 1 and Tier 2.
Tier 1 capital is considered to be more
permanent in nature, consisting of common
shares together with any qualifying non-
cumulative preferred shares less unamortized
goodwill. Tier 2 capital consists of other
preferred shares, subordinated debentures
and general allowances.
Replacement Cost of Derivative Contracts
The cost of replacing a derivative contract
that has a positive fair value at current market
rates should a counterparty fail to settle.
Repurchase Agreement (Repo)
A type of transaction where a security is sold
with the commitment by the seller to repur-
chase the security at a specified price and time.
Return on Common Shareholders’
Investment (ROI)
This amount is calculated as the annualized
total return on an investment in our common
shares made at the beginning of a designated
period, usually one or five years. Total return
on common shares includes the effect of
a change in the share price and assumes that
dividends received on common shares are
reinvested in additional common shares.
Return on Equity (ROE)
This represents net income, less preferred
share dividends, expressed as a percentage of
average common shareholders’ equity.
Reverse Repurchase Agreement
(Reverse Repo)
See Securities Purchased under Resale
Agreements.
Risk
Country Risk
Also known as sovereign risk, it is the risk
that economic or political change in a coun-
try may impact repayments to creditor banks.
This risk is considered higher for certain
emerging market and lesser-developed coun-
tries specifically identified by OSFI.
Credit Risk
The possibility that a loss may be incurred
in the event that borrowers or counterparties
to financial instruments transacted with a
bank will be unable to discharge their obliga-
tions under the instruments.
Foreign Exchange Risk
Foreign exchange risk refers to possible
losses resulting from exchange rate move-
ments. A foreign currency devaluation,
for example, could result in losses on an
overseas investment.
Interest Rate Risk
Interest rate risk is the potential impact on a
bank’s earnings and economic value due to
changes in interest rates. Rising interest rates
could, for example, increase funding costs
and reduce the net interest margin earned on
a fixed yield mortgage portfolio.
Liquidity Risk
Refers to potential demands on a bank for
cash resulting from commitments to extend
credit, deposit maturities and many other
transactions.
Market Risk
Market risk is the risk of loss that results from
changes in interest rates, foreign exchange
rates, equity and commodity prices, spread
and basis risk and the implied volatility of
these rates and prices.
Operational Risk
The potential loss, including adverse impact
on reputation, resulting from a breakdown
in communications, information or transac-
tion processing or legal/compliance issues,
due to systems or procedural failures, error,
natural disasters or criminal activity. This
risk represents a bank’s potential exposure to
unexpected loss as a result of pursuing busi-
ness objectives.
Replacement Risk
The risk that a financial contract will need to
be replaced in the open market at a cost to
the bank/enterprise.
Risk-Weighted Assets
Used in the calculation of risk-based capital
ratios. The face amount of assets is discounted
using predetermined risk-weighting factors
in order to reflect a comparable risk per dollar
among all types of assets. Adjusting notional
values to balance sheet (or credit) equivalents
and then applying appropriate risk-weighting
factors also recognizes the risk inherent in
off-balance sheet instruments.
Risk Adjusted Return On Capital (RAROC)
A measurement tool that enables manage-
ment to allocate capital, and the related cost
of capital, in respect of credit, market and
operational risk by type of transaction,
customer and line of business. This facilitates
the deployment of capital to business units
that can provide the maximum shareholder
value on the capital invested.
Securities Purchased under
Resale Agreements
A type of transaction that involves the
purchase of a security, normally a government
bond, with the commitment by the buyer
to resell the security to the original seller at
a specified price on a specified date in
the future.
Securities Sold Short
A transaction in which the seller sells secu-
rities it does not own. The seller borrows
the securities in order to deliver them to the
purchaser. At a later date, the seller buys
identical securities in the market to replace
the borrowed securities. On the balance sheet,
this category represents our obligation to
deliver securities that we did not own at the
time of sale.
Swaps
Contractual agreements between two
parties to exchange a series of cash flows.
For interest rate swaps, counterparties
generally exchange fixed and floating rate
interest payments based on a notional
value in a single currency. For cross-currency
interest rate swaps, principal amounts and
fixed and floating rate interest payments are
exchanged in different currencies.
Taxable Equivalent Basis
(TEB) Adjustment
An addition to interest income to gross
up the tax-exempt income earned on certain
securities (primarily loan substitute securi-
ties) to an amount which, had it been taxable
at the statutory rate, would result in the
same after-tax net income that appears in the
financial statements. This results in a better
reflection of the pre-tax economic yield of
these assets and facilitates uniform measure-
ment and comparison of net interest income.
Value at Risk (VaR)
VaR measures the adverse impact on the
value of a portfolio, over a specified time
period, of potential changes in market rates
and prices. VaR is usually measured at a 99%
confidence interval and assumes that changes
in rates and prices are correlated.
Volatility
A term which generally refers to a measure of
price variance, usually the standard deviation
of returns from a security or a portfolio
of securities over a specified period of time.