Bank of Montreal 2000 Annual Report Download - page 45

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Credit Risk
Objective
Maintain a well-diversified asset portfolio within approved risk tolerance levels, and earn a
return appropriate to the risk profile of the portfolio.
Approach
Creditriskmanagementofourdiverseclientbaserequiresahighdegreeofpersonalaccountabil-
ity, clear delegation of decision-making authority, disciplined portfolio management and dynamic
loan loss management.
Credit transactions for commercial, corporate and institutional loans are first evaluated by
skilled lenders. Our credit function then provides an independent assessment of all significant
transactions, and a concurrence from this function is usually required prior to making a lending
commitment to a customer. Our independent Internal Audit group also reviews management
processes in order to ensure that established credit policies are followed. In addition, the Loan
Review unit of the Risk Management Group performs periodic reviews of significant and higher
risk transactions.
Diversification of risk within all loan and investment portfolios is a key requirement in
effective risk management, particularly in the corporate and institutional portfolios, where
concentration of risk can be a significant issue. For large credit transactions, management uses
advanced models to assess the impact of the correlation of risks before authorization of the new
exposure is provided. Exposure to specific industries is governed by limits on combination of
aggregate authorizations in portfolios.
Technological tools used as part of the portfolio management process have allowed the
Bank to refocus workloads so that more time and attention are paid to higher-risk transactions.
The prompt recognition of problem loans is stressed with material cases being transferred to
a group of specialists skilled in managing these accounts. All problem accounts are subject to
quarterly review.
Monitoring of performance and pricing of credit transactions are commensurate with
risk and are determined using Risk Adjusted Return on Capital (RAROC)
1
, as described in the
adjacent box, in addition to other methodologies. RAROC is applied to all large commercial
transactions and draws upon a number of external market data feeds, including credit ratings
and stock exchange data.
We calculate the expected loss (EL) for individual transactions (as part of the calculation of
their RAROC) and for the portfolio as a whole in order to establish a prudent annual forecast of
loan loss provisions and an appropriate level of general allowance for credit losses. We define
EL as management’s estimate, for the forthcoming year, of one year’s credit losses. The estimate
relies upon judgement, in addition to the following:
■the probability of default(s);
■the amount of outstanding exposure at the time of default(s);
■the difference between the book value and market value/realizable value of loans, if default(s)
occurred; and
■the effect of economic/industry cycles on asset quality and loan values.
EL should provide a reliable estimate of one year’s losses for both the forthcoming year and each
successive year under a normal economic cycle. These estimates are supported by the judge-
ment of experienced credit officers and by quantitative analysis of the above, where possible.
Estimates and assumptions underlying EL calculations may be supported by portfolio monitoring,
historical experience, market data and/or proxies for market data, and modeling of economic
and business-specific events. Further information on EL is provided in the box overleaf.
Bank of Montreal Group of Companies Annual Report 2000 ■21
1Defined in the glossary on page 88.
Risk Adjusted Return on
Capital (RAROC)
RAROC facilitates the comparison,
aggregation and management of
market, credit and operational
risks across the organization. This
methodology was implemented
to support risk assessment
and measurement applications.
RAROC
allows management
to view these risks on a com-
parative
basis, differentiating
by risk class.
These comparisons,
which can be performed by
transaction, client
and line
of business, enable man
agement
to better understand
sustainable
performance, actively
manage
the composition of portfolio risk,
and allocate capital to those
businesses that can most advan-
tageously deploy the capital
to maximize shareholder value.
This provides a framework
for measuringriskinrelation
to return at each level of
our activity.