Bank of Montreal 2004 Annual Report Download - page 57

BMO Financial Group Annual Report 2004 53
MD&A
BMO enters into a number of off-balance sheet arrangements
in the normal course of operations. The discussion that
follows addresses the more significant types of off-balance
sheet arrangements.
Credit Instruments
In order to meet the financing needs of our clients, we use a
variety of off-balance sheet credit instruments. These include
guarantees and standby letters of credit, which represent our
obligation to make payments to third parties on behalf of a
customer if the customer is unable to make the required pay-
ment or meet other contractual requirements. We also engage
in securities lending where we lend either our securities or
our customers’ securities to third parties. This exposes us to
credit risk as a result of the possibility of the third party not
returning the securities as agreed. We also write documentary
and commercial letters of credit, which represent our agreement
to honour drafts presented by a third party upon completion
of specified activities. Commitments to extend credit are
off-balance sheet arrangements that represent our commitment
to customers to grant them credit in the form of loans or other
financings for specific amounts and maturities, subject to
meeting certain conditions.
There are a significant number of instruments outstanding
at any time. Our customers are broadly diversified and we do
not anticipate events or conditions that would lead a significant
number of our customers to fail to perform in accordance
with the terms of the contracts. We use our credit adjudication
process in deciding whether to enter into these agreements, just
as we do when extending credit in the form of a loan. We moni-
tor off-balance sheet instruments to ensure that there are no
undue concentrations in any geographic region or industry.
The maximum amounts payable by BMO in relation to these
instruments was approximately $100 billion as at October 31,
2004. However, this amount is not representative of our likely
credit exposure or liquidity requirements for these instruments
as it does not take into account any amounts that could possibly
be recovered under recourse or collateralization provisions. In
addition, a large majority of these commitments expire without
being drawn upon. Further information on these instruments
can be found in Note 5 on page 93 of the financial statements.
Derivatives
Derivative financial instruments are contracts that require the
exchange of, or provide the opportunity to exchange, cash flows
determined by applying certain rates, indices or changes
therein to notional contract amounts.
We structure and market derivative products to customers
to enable them to transfer, modify or reduce current or
expected risks. We may also take proprietary trading positions
in various capital markets instruments and derivatives that,
taken together, are designed to profit from anticipated changes
in market factors. We also use derivatives as hedges of our
own positions.
We enter into derivatives contracts with many different
counterparties. Information on the split between financial
institutions and other counterparties, by derivative type,
is disclosed on page 102 of the financial statements. The
geographic locations in which our counterparties operate
are detailed on page 101 of the financial statements.
The amount that we are required to pay, if any, under a
derivative contract depends on the nature of the derivative.
For instance, if we enter into an interest rate swap that requires
us to pay a fixed interest rate and the counterparty to pay
a floating interest rate, the amount that we would be required
to pay would depend on the difference between the fixed
and floating rates. If the floating rate is higher than the fixed
rate, the counterparty would be required to pay us the differ-
ence between the floating and fixed rates applied to the
notional amount of the swap. However, if the fixed rate exceeds
the floating rate, we would be required to pay the counterparty
the difference.
In most cases, we act as an intermediary. As a result, for
each derivative liability we usually have an offsetting derivative
asset. Therefore, at any point in time our net derivative assets,
together with associated capital markets instruments, are
not significant.
Trading derivatives are fully recognized on our Consolidated
Balance Sheet at their fair values. These trading derivatives
represent over 95% of our total outstanding derivatives.
Only our hedging derivatives represent off-balance sheet
items, since these derivatives are not recorded at fair value on
our Consolidated Balance Sheet. We follow accrual accounting
for these derivatives, since they are expected to be highly effec-
tive in hedging certain risks associated with on-balance sheet
financial instruments or future cash flows. Any ineffectiveness
in a hedging derivative is recognized in income over the term
of the derivative contract. The fair value of our hedging deriva-
tives was an asset of $867 million and a liability of $462 million
at October 31, 2004.
Variable Interest Entities (VIEs)
Customer Securitization Vehicles
Customer securitization vehicles (referred to as multi-seller
conduits) assist our customers with the securitization of their
assets to provide them with alternate sources of funding. These
vehicles provide clients with access to liquidity in the commer-
cial paper markets by allowing them to sell their assets into
these vehicles, which then issue commercial paper to investors
to fund the purchases. The customer continues to service the
transferred assets and is first to absorb any losses on the assets.
We earn fees for providing structuring advice related to the
securitizations as well as administrative fees for supporting
the ongoing operations of the vehicles. For the year ended
October 31, 2004, these fees were approximately $96 million.
Off-Balance Sheet Arrangements