Bank of Montreal 2004 Annual Report Download - page 65

BMO Financial Group Annual Report 2004 61
MD&A
that our risk rating framework is consistent with the principles
of Basel II, under which future minimum regulatory capital
requirements for credit risk will be determined. The default
probabilities of individual counterparties over a one-year time
horizon are assessed using methodologies and rating criteria
tailored to the nature of the various counterparties.
A borrower
risk rating is derived from this assessment. Borrower risk ratings
rank credit default risk on a sixteen-point scale, including
two categories for accounts that have defaulted and/or are
impaired. Fixed probabilities of default are assigned to the indi-
vidual rating grades; consequently, counterparties migrate
between grades as our assessment of their probability of default
changes. The borrower risk rating scale is shown below.
Two transaction-specific factors are assessed to estimate
the severity of the loss should a counterparty default occur.
The first factor is an estimate of the likely future exposure to
the counterparty at the time of default. This expected future
exposure is determined on a case-by-case basis by examining
the specific characteristics of both the transaction and the
counterparty. The second factor is an estimate of the propor-
tion of the exposure that will be lost if a counterparty default
occurs. This factor is assessed for each transaction by the
analysis of transaction-specific factors such as collateral and
the seniority of our claim.
BMO’s Borrower Risk Rating Scale
BMO rating
Description
of risk
Moody’s
Investor Services
implied equivalent
Standard &
Poor’s implied
equivalent
I-1 Undoubted
sovereign Aaa Sovereign AAA Sovereign
I-2 Undoubted Aaa/Aa1 AAA/AA+
I-3 Minimal Aa2/Aa3 AA/AA–
I-4
Modest
A1/A2/A3 A+/A/A–
I-5 Baa1 BBB+
I-6
Average
Baa2 BBB
I-7 Baa3 BBB–
S-1
Acceptable
Ba1 BB+
S-2 Ba2 BB
S-3
Marginal
Ba3 BB–
S-4 B1 B+
P-1 Uncertain B2 B
P-2
Watch list
B3 B–
P-3 Caa/C CCC/C
D-1 Default C D
D-2 Default and
impaired C D
BMO utilizes various models to assess the extent and cor-
relation of risks before authorizing new exposures on large
corporate credit transactions. Expected loss (EL) and unex-
pected loss (UL) are calculated for large individual transactions
and for the portfolio as a whole. EL and UL are determined
using inputs that calculate the capital at risk for each of the
relevant lines of business. The estimates of EL and UL rely upon:
•management’s judgment;
•probabilities of default;
•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 occurs; and
•effects of economic and industry cycles on asset quality
and loan values.
Credit derivative products are increasingly important tools
used to enhance the management of BMO’s portfolio of credit
risk assets, primarily the corporate loan portfolio. Currently,
BMO uses single-name credit default swaps to mitigate the
credit risk related to specific client credit exposures, and uses
structured credit default swaps to mitigate identified sectoral
risk concentrations.
BMO’s provisioning approach embodies disciplined loan loss
management and evaluation, with prompt identification of
problem loans being a key risk management objective. All prob-
lem accounts are subject to close monitoring and are reviewed
no less than quarterly.
BMO employs two key credit measures:
•Gross impaired loans and acceptances as a percentage
of equity and allowances for credit losses is used to assess
the condition of a portfolio by comparing the level of
impaired loans to the capital and reserves available to
absorb loan losses.
•Provision for credit losses as a percentage of average net
loans and acceptances (including securities purchased under
resale agreements) is a measure of our credit losses occur-
ring in the year relative to the size of our portfolio. It is a
measure of credit quality experience and is monitored for
both specific and total provisions.
Page 19 includes a historical comparison of BMO’s performance
on these key measures relative to our Canadian and North
American peers. Our 2004 provision for credit losses is dis-
cussed on page 31.
Note 4 on page 91 of the financial statements and Tables 11
to 19 on pages 76 to 79 provide details of BMO’s loan portfolio,
impaired loans and provisions and allowances for credit losses.
Portfolio diversification is shown in the graph on page 50.
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 value. In 2004, we reduced our general
allowance for credit losses by $170 million to $1,010 million.