Bank of Montreal 2000 Annual Report Download - page 112

Glossary of Financial Terms
88 ■Bank of Montreal Group of Companies Annual Report 2000
Adjusted Assets
Used in the calculation of the assets-to-
capital multiple and includes on-balance
sheet assets plus standby letters of credit
and guarantees.
Allowance for Credit Losses
An amount set aside and deemed adequate
by management to absorb potential
credit-related losses in the Bank’s port-
folio of loans, acceptances, guarantees,
letters of
credit, deposits with other banks
and deriv
atives. 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 and are therefore not
reported on the balance sheet of the finan-
cial 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 instru-
ment drawn by the borrower for payment
at maturity and accepted by a bank. BAs
constitute 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.
Counterparty
The opposite side of a transaction, typically
the Bank’s corporate or commercial cus-
tomers or another financial institution.
Counterparty risk refers to the risk that the
counterparty will not be able to meet its
financial obligations 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, modification or reduction of cur-
rent 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 agreements, options
and swaps.
Earnings at Risk
Theimpactonnetincomeoverthe
following 12 months of a one-time change
in market rates/prices.
Economic Value at Risk
The impact on the value of the Bank’s
assets and liabilities of a change in market
rates/prices.
Forwards and Futures
Contractual commitments to either buy
or sell a specified currency or financial
instrument 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.
Guarantees and Standby
Letters of Credit
Primarily represent a bank’s obligation
to make payments to third parties on behalf
of its clients if its clients 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
i s only recognized as interest revenue
when management has reasonable
assurance of the timely collection of the
full amount of principal and interest.
Innovative Tier 1 Capital
The Office of the Superintendent of
Financial Institutions Canada (OSFI)
allows banks to issue instruments which
qualify as “Innovative” Tier 1 capital.
In
order to qualify, these instruments have
to be issued indirectly through a special
purpose vehicle, they have to be permanent
in nature and free of any fixed charges,
the bank has to absorb any losses and
must account for them on an equity basis.
They cannot comprise more than 15%
of net Tier 1 Capital and cannot exceed,
in aggregate, 25% of innovative and
perpetual preferred shares.
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 Economic Profit (NEP)
Cash net income available to common
shareholders less a charge for capital.
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 debt.
Net Interest Margin
Average net interest margin is the ratio
of net interest income to average assets.
Notional Amount
The amount considered as principal when
calculating interest and other payments
for derivative contracts. This amount tra-
ditionally does not change hands under
the terms of a derivative contract.
Off-Balance Sheet Financial Instruments
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. A variety of products offered
to clients can be classified as off-balance
sheet and they fall into two broad cate-
gories: (i) credit-related arrangements,
which provide clients 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
atafixedpriceeitheratafixedfuturedate
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 quota-
tion 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
expense deemed adequate by management
given the composition of a bank’s credit
portfolios, their probability of default,
the economic environment and the allow-
ance for credit losses already established.
Specific provisions are established 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 iden-
tified by OSFI that have restructured or
experienced difficulties in servicing all or
part of their external debt to commercial
banks. A general provision 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
OSFI under the framework of risk-based
capital standards developed by the Bank
for International Settlements. These
ratios are labeled Tier 1 and Tier 2. Tier 1
capitalisconsideredtobemorepermanent,
consisting of common shares together
with any qualifying non-cumulative pre-
ferred shares less unamortized goodwill.
Tier 2 capital consists of other preferred
shares, subordinated debentures and
generalallowancestocertainprescribed
limits. Assets-to-capital multiple is
adjusted assets divided by total capital.
Replacement Cost of Derivative Contracts
The cost of replacing a derivative contract
thathasapositivefairvalueatcurrent
market rates should a counterparty fail
to settle.
Return on Common Shareholders’
Equity (ROE)
This represents net income, less preferred
share dividends, expressed as a percentage
of average common shareholders’ equity.
Cash-based ROE eliminates the impact in
accounting treatment for business acqui-
sitions in Canada and the United States and
adjusts net income by adding back amor-
tization of goodwill and intangible assets.
Equity is not adjusted to exclude goodwill
and intangible assets.
Risk
Country Risk
Also known as sovereign risk, it is the risk
that economic or political change in a
coun trymayimpactrepaymentstocreditor
banks. This risk is considered higher
for certain emerging market and lesser-
developed countries specifically identified
by OSFI.
Credit Risk
The potential for loss due to the failure
of a counterparty or borrower to meet its
financial obligations. Credit risk arises
from traditional lending activity, from
settling payments between financial insti-
tutions and from providing products that
create replacement risk. Replacement
risk arises when a counterparty’s commit-
ments to us are determined by reference
to the changing values of contractual
commitments.
Foreign Exchange Risk
Possible losses resulting from exchange
rate movements. A foreign currency
devaluation, for example, could result
in losses on an overseas investment.
Interest Rate Risk
The potential impact on the bank’s earn-
ings 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
The risk of being unable to meet financial
commitments, under all circumstances,
without having to raise funds at unreason-
able prices or sell assets on a forced basis.
Market Risk
The potential for loss arising from poten-
tial adverse changes in underlying market
factors, including interest and foreign
exchange rates, equity and commodity
prices, spread and basis risk.
Operational Risk
The risk of loss resulting from a breakdown
in, for example, communications, infor-
mation or transactional processing or legal/
compliance issues, due to technology/sys-
tems or procedural failures, human errors,
disasters or criminal activity. The Bank’s
definition of operational risk consists
of two main components, operations risk
and business/event risks.
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 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,
client and line of business. This facilitates
the deployment of capital to business units
that can provide the maximum shareholder
value on the capital invested.
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. By adjusting notional values to
balance sheet (or credit) equivalents and
then applying appropriate risk-weighting
factors, risks inherent in off-balance
sheet instruments are recognized.
Securities Purchased under Resale
Agreements
A type of transaction that involves the
pur chase of a security, normally a govern-
ment 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 under Repurchase
Agreements
A type of transaction where a security
is sold with the commitment by the seller
to repurchase the security at a specified
price and time.
Securities Sold but not yet Purchased
A transaction in which the seller sells secu-
rities it does not own. The seller borrows
thesecuritiesinordertodeliverthemtothe
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 obliga-
tion to deliver securities that we did not
own at the time of sale.
Securitization
Securitizing assets involves selling finan-
cial assets to trusts or special purpose
vehicles that are independent from the
Bank;itservesasaneffectivebalancesheet
management tool by reducing or elimi-
nating the need to hold capital against
risk-weighted assets, enabling capital to
be reduced or redeployed to alternative
revenue-generating purposes, and serves
as an effective liquidity management tool
by diversifying funding sources.
Spread
The difference between two product rates,
typically an asset and a liability.
Swaps
Contractual agreements between two
parties to exchange a series of cash flows.
For interest rate swaps, counterparties
generally exchange fixed and floating rate
interestpaymentsbasedonanotionalvalue
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 cer-
tain securities (primarily loan substitute
securities) to an amount which, had it been
taxable at the statutory rate, would result in
the same after-tax net income as appears
in the financial statements. This results in
a better reflection of the pre-tax economic
yield of these assets and facilitates uniform
measurement and comparison of net
interest income.
Total Shareholder Return (TSR)
This amount is calculated as the annual-
ized 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.
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 mea-
sure of price variance, usually the standard
deviation of returns from a security or
a portfolio of securities over a specified
period of time.