Bank of Montreal 2003 Annual Report Download - page 52

Management’s Discussion and Analysis of Operations and Financial Condition
BMO Financial Group 186th Annual Report 200348
rules under generally accepted accounting principles. For these
activities, VaR measures the magnitude of BMO’s market risk.
In addition to our VaR models and measures, issuer risk is
measured daily at a 99% confidence level, over specifically
determined holding periods, for the respective portfolios.
Various VaR models are used to determine market risk capital
at risk for each of the lines of business, and are also used to
determine regulatory capital under the standards of the 1998
▪amounts of outstanding exposures at the time of default;
▪differences between the book value and the market value or
realizable value of loans, if default occurred; and
▪effects of economic and industry cycles on asset quality and
loan values.
EL and UL are inputs that determine the capital at risk (CaR) for
each of the relevant lines of business. Credit CaR measures, like
all CaR measures, are based on a confidence level of 99.95% and
a holding period of one year.
BMO maintains specific allowances and general allowances
for credit losses. The specific allowances reduce the aggregate
carrying value of credit assets that bear evidence of deteriora-
tion in credit quality to their estimated realizable amounts. The
general allowance is maintained in order to absorb any impair-
ment in the existing portfolio that cannot yet be associated with
specific credit assets. The sum of these allowances must always
be sufficient to reduce the book value of credit assets to their
estimated realizable values.
A number of factors are considered when assessing the
amount and adequacy of the general allowance. A statistical
analysis of past performance is undertaken to derive the mean
(EL) and volatility (UL) of loss experience. This analysis cal-
cu lates historical average loss for each homogeneous portfolio
segment, while other models estimate loss for portfolios of
corporate credit assets that can be referenced to market data.
Estimates of EL and UL are used to forecast loan loss provisions
and in establishing an appropriate level of general allowance.
Finally, management’s professional judgment regarding port-
folio quality, business mix and economic and credit market
conditions is considered. Our approach is also based on Guide-
line C-5, “General Allowance for Credit Risk,” issued by the
Office of the Superintendent of Financial Institutions Canada.
BMO incurs market risk in its trading and underwriting activities
and structural banking activities.
As part of our enterprise-wide risk management framework, we
employ comprehensive governance and management processes
surrounding market risk-taking activities. These include:
▪oversight by senior governance committees, including Market
Risk Committee, RMC and RRC;
▪independent market risk oversight functions;
▪
effective processes to measure market risks linked to the
allocation of economic capital and the valuation of positions;
▪a well-developed limit-setting and monitoring process;
▪effective controls over processes and models used; and
▪
a framework of scenario and stress tests for worst-case events.
BMO’s primary market risk measures are Market Value Exposure
(MVE) and Earnings Volatility (EV). The aggregate market value
and earnings volatility exposures at October 31, 2003 are sum-
marized in the following table. MVE has increased modestly
relative to last year, primarily due to growth in common share-
holders’ equity in the structural balance sheet. EV has increased
over the past year, primarily due to increased short-term positions
in trading and underwriting accrual portfolios.
Aggregate MVE and EV Exposure for Trading and Underwriting
and Structural Positions ($ millions)*
As at October 31 Market value 12-month
(After-tax Canadian equivalent) exposure earnings volatility
2003 2002 2003 2002
Trading and underwriting 18.0 14.6 33.4 19.9
Structural 311.6 282.5 24.8 21.0
Total 329.6 297.1 58.2 40.9
*Measured at a 99% confidence level.
Trading and Underwriting Market Risk
BMO’s trading and underwriting activities include portfolios
that are marked to market daily, as well as some portfolios (such
as money market assets) that are subject to accrual accounting
Market Risk
Market Value Exposure (MVE) is a measure of the adverse impact of
changes in market parameters on the market value of a portfolio of
assets, liabilities and off-balance sheet positions, measured at a 99%
confidence level over a specified holding period. The holding period
considers current market conditions and composition of the portfolios to
determine how long it would take to neutralize the market risk without
adversely affecting market prices. For trading and underwriting activities,
MVE is comprised of VaR and Issuer Risk.
Earnings Volatility (EV) is a measure of the adverse impact of potential
changes in market parameters on the projected 12-month after-tax net
income of a portfolio of assets, liabilities and off-balance sheet positions,
measured at a 99% confidence level.
Value at Risk (VaR) is measured for specific classes of risk in BMO’s
trading and underwriting activities: interest rate, currency, equity and
commodity prices and implied volatilities. This measure calculates the
maximum likely loss from portfolios, over an appropriate holding period,
measured at a 99% confidence level.
Issuer risk arises in BMO’s trading and underwriting portfolios, and
measures the adverse impact of credit spread, credit migration and default
risks on the market value of non-sovereign fixed income instruments and
similar securities. Issuer risk MVE is usually measured at a 99% confidence
level over an appropriate holding period.
Market risk is the potential for a negative impact on the balance sheet
and/or income statement resulting from adverse changes in the value of
financial instruments as a result of changes in certain market variables.
These variables include interest rates, foreign exchange rates, equity or
commodity prices and their implied volatilities, as well as credit spreads,
credit migration and default.