Bank of Montreal 2004 Annual Report Download - page 64

BMO Financial Group Annual Report 200460
MD&A
Management’s Discussion and Analysis
Scenario analysis assists in measuring the impact of extreme,
but plausible, operational, political, economic and market events
on our operations. Scenarios may be based on historical or
hypothetical events, or a combination thereof. They are applied
to all significant risk-taking activities across the organization.
We also conduct ongoing industry stress tests designed to
stress BMO’s credit exposures to a specific industry or to sev-
eral industries that are highly correlated. These tests attempt
to gauge the effect of various scenarios on default probabilities
and loss rates in the portfolio under review. This provides
significant insight into the sensitivity of our exposures to the
underlying risk characteristics of the industries under review.
Basel II (International Convergence of Capital Measurement
and Capital Standards: A Revised Framework)
The Basel Committee on Banking Supervision finalized the
development of the “Basel II” framework in June of 2004.
Basel II provides guidelines for the calculation of regulatory
capital required to support credit and operational risk expo-
sures. The framework allows internationally active banks
to use either advanced or standardized approaches to calculate
regulatory capital associated with credit and operational risks.
The Office of the Superintendent of Financial Institutions
(OSFI), the Canadian regulator, requires internationally active
Canadian banks to adopt an advanced approach for the cal-
culation of credit risk regulatory capital. However, for the
calculation of operational risk regulatory capital, OSFI allows
banks to choose from among any of the approaches identified
in Basel II. Canadian banks will implement the framework
on October 31, 2007, following a two-year parallel run with
the existing Basel I regulatory capital rules.
BMO is implementing an Advanced Internal Ratings-Based
approach for credit risk regulatory capital calculations and
is adopting a Standardized Approach for operational risk
capital calculations. An integrated enterprise-wide program
links business requirements with the “design and build”
of technology solutions. Leadership and oversight are provided
by a steering committee comprising senior executives from
all stakeholder groups.
BMO views Basel II as an important step in the alignment
of regulatory and economic capital requirements.
Credit and counterparty risk is the potential for loss due to the failure
of a borrower, endorser, guarantor or counterparty to repay a loan
or honour another financial obligation. This is the most significant
measurable risk that BMO faces.
Credit and Counterparty Risk
BMO incurs credit and counterparty risk primarily in its lend-
ing activities (including the sale of Treasury products and other
risk management products) and, to a lesser extent, by holding
investment securities. We employ comprehensive governance
and management processes surrounding credit risk manage-
ment activities. These include:
•corporate policies, standards and procedures governing the
philosophy, principles and conduct of credit risk manage-
ment activities;
•a well-developed limit-setting and monitoring process;
•oversight by senior governance committees;
•independent Credit Risk Management units and Corporate
Audit functions within ER± and
•a rigorous lender qualification process.
BMO’s credit risk management process is well established and
effective, as evidenced by our historic low loan loss experience,
which compares favourably to our Canadian peer group. The
process involves the use of skilled and qualified professional
lenders and risk managers, clear delegation of decision-making
authority, personal accountability, specific borrower limits
and account monitoring, and dynamic portfolio management.
Credit decisions are made at a management level appropriate
to the size and risk of each transaction.
We have a well-diversified portfolio, focused on North
America and comprising credit relationships with millions
of clients, the majority of them consumers and small to
medium-sized businesses. BMO’s credit risk governance policies
ensure that an acceptable level of diversification is maintained
at all times.
Operating practices include ongoing monitoring of credit
risk exposures, regular review on an account and portfolio
basis, and frequent portfolio and sector reporting to RMC and
RRC. All borrowing accounts are reviewed regularly, with most
individual commercial and corporate accounts reviewed no less
than annually. Corporate Audit reviews management processes
as well as a representative sample of credit transactions
for adherence to sound credit risk management principles,
practices, policies and procedures. In addition, BMO carries
out regular portfolio sector reviews, including stress testing and
scenario analysis, which are based on current, emerging or
prospective risks.
For the consumer and small business portfolios, credit risk
models and decision-making methodologies are developed
using established statistical techniques and expert systems for
underwriting and monitoring purposes. Adjudication models,
behavioural scorecards, decision trees and expert knowledge
are combined to produce optimal credit decisions in an auto-
mated environment. Application characteristics and past
performance are used to predict the credit performance risk of
new accounts. Past performance is used to identify likely future
behaviour of existing accounts for ongoing credit risk manage-
ment purposes.
BMO utilizes an enterprise-wide risk rating framework that
is applied to all our sovereign, bank, corporate and commercial
counterparties. Ratings are assessed and assigned on two
separate and distinct planes: (i) individual counterparty risk
characteristics and (ii) transaction-specific factors. We believe