Bank of Montreal 1998 Annual Report Download - page 54

(refer to table on page 52). We also do not currently have any impaired loans to hedge funds,
another market sector that experienced problems in 1998, and after a detailed review of all
such accounts we do not consider that our limited outstandings in this sector of the market
exhibit any material risk of loss.
Similar comments apply to the position at the end of 1997 when net impaired loans were
negative $358 million, resulting from a decrease in gross impaired loans of $610 million, or
43.7%, and the build-up of the general allowance to $775 million. This improvement was
also due mainly to the favourable economic environment in our major markets and our
improved monitoring methods to detect deterioration in the quality of corporate loans.
MARKET RISK
Approach:
Market risk is controlled by actively managing the asset and liability mix, either directly
through the balance sheet or with off-balance sheet
†
derivative products.We measure, monitor
and control market risk using various techniques, including gap reporting, stress testing,
simulation and sensitivity analysis.
Interest rate risk is our primary market risk and is discussed in more detail below. The
amount of foreign exchange risk arising from both customer-initiated transactions and trading
activities undertaken on our behalf is not a material part of our overall market risk. Structural
(non-trading) foreign exchange positions in the balance sheet are for the most part match
funded (with assets and liabilities funded in the same currency), with the exception of our
investment in Bancomer. We generally offset commodity and equity exposures to ensure
that our exposure to adverse price movements is minimal.
Interest Rate Risk Sensitivity
We use two primary risk models to determine the sensitivity of our portfolios to adverse
interest rate changes. A 100 Basis Point Increase model calculates the impact on earnings and
the value of our assets and liabilities of a one-time 100 basis point increase across all port-
folios. This model is used by most financial institutions and hence facilitates comparability
with our peers. The Rising Interest Rate Risk model is used internally as a more sophisti-
cated measure of our risk. This model calculates the impact on earnings over the next
12 months and on the value of our assets and liabilities of a one-time increase in rates
reflecting the maximum expected rate change in each portfolio during the estimated period
required to close our positions in that portfolio. Management considers this a more accurate
46
BANK OF MONTREAL GROUP OF COMPANIES
ENTERPRISE-WIDE RISK MANAGEMENT
VALUE AT RISK†
A key focus this year was the continuing implementation of Value at Risk (VaR) methodologies for
our trading portfolios. VaR measures the adverse impact on our portfolios of potential changes in
market rates and prices while incorporating correlations across all markets. VaR is also the basis for
calculating market risk capital in accordance with Bank for International Settlements (BIS) and OSFI
requirements. The objective of this project is to implement an infrastructure to satisfy our needs
for better measurement and evaluation of risk, including capital at risk, and to better satisfy regulatory
requirements. A three-pronged approach has been adopted to meet the regulatory requirements
for Capital Adequacy Reporting (CAR) mandated by OSFI, as follows:
■The Standard Model, CAR, being a standardized approach for all trading activities, is complete;
■
We received OSFI approval to apply the model of the Foreign Exchange VaR to all affected units
effective October 31, 1998; and
■
Implementation of Integrated VaR for all traded foreign exchange and interest rate products,
representing our significant sources of trading risk, is continuing. When this is completed in fiscal
1999 it will replace the Standard Model for those trading activities. Commodity and equity risks,
which do not represent as significant a level of risk, will be dealt with following the completion of
Integrated VaR.
STRATEGY:
To identify, measure, monitor
and control all market risk-taking
activities to protect both our
earnings and the value of our
assets against potential adverse
changes in market rates.
MEASURES:
Earnings at Risk†and Economic
Value-at-Risk†are the primary
measures for analyzing market
risk. These measures calculate
the impact on net income over
the next 12 months of a one-
time increase in market rates or
prices and the impact on the
value of our assets and liabilities
of adverse changes in market
rates or prices over the period
that would be required to
eliminate open positions.
BALANCE SHEET
COMPONENTS:
Structural: Canadian and U.S.
retail and commercial and
Canadian corporate instruments.
Money market: Bank place-
ments and acceptances,
and international loans and
investments.
Trading: Instruments designated
as trading and marked-to-market.
OUTLOOK
The provision for credit losses as a percentage of average loans and acceptances was unusually low
in 1998, benefiting from the extended growth phase of the economic cycle and a high level of
recoveries and reversals as well as strong asset quality management. In 1999 we expect this ratio to
increase, with slower economic growth and lower levels of recoveries and reversals.
†Defined in the Glossary on page 92