Bank of Montreal 2007 Annual Report Download - page 65

MD&A
BMO Financial Group 190th Annual Report 2007 61
rate sensitivities can be found in the Enterprise-Wide Risk Management
section on pages 65 to 73 of this MD&A.
Further information on how we determine the fair value of financial
instruments is included in the Financial Instruments Measured at Fair
Value discussion in the Critical Accounting Estimates section of the MD&A
that follows.
Critical Accounting Estimates
The Notes to BMO’s October 31, 2007 Consolidated Financial Statements
outline our significant accounting estimates. The following accounting
estimates are considered particularly important, as they require signifi-
cant judgments by management. Management has established detailed
policies and control procedures that are intended to ensure these
judgments are well controlled, independently reviewed and consistently
applied from period to period. We believe that our estimates of the
value of BMO’s assets and liabilities are appropriate.
Allowance for Credit Losses
The allowance for credit losses adjusts the value of credit assets to
reflect their estimated realizable value. In assessing their estimated
realizable value, we must rely on estimates and exercise judgment
regarding matters for which the ultimate outcome is unknown. These
include economic factors, developments affecting companies in par-
ticular industries and specific issues with respect to single borrowers.
Changes in circumstances may cause future assessments of credit
risk to be materially different from current assessments, which could
require an increase or decrease in the allowance for credit losses.
One of our key performance measures is the provision for credit
losses as a percentage of average net loans and acceptances (including
securities borrowed or purchased under resale agreements). Over the
past 10 years, the ratio has ranged from a high of 0.66% in 2001 to a low
of (0.07%) in 2004. This ratio varies with changes in the economy and
credit conditions. If we applied these high and low ratios to average net
loans and acceptances (including securities borrowed or purchased under
resale agreements) in 2007, our provision for credit losses would range
from a provision of $1,346 million to a net recovery of $143 million.
Our provision for credit losses in 2007 was $353 million.
Additional information on the process and methodology for
determining the allowance for credit losses can be found in the discus-
sion of credit risk on page 67 as well as in Note 4 on page 101 of the
financial statements.
Financial Instruments Measured at Fair Value
BMO records securities and derivatives at their fair value. Fair value
represents our estimate of the proceeds we would receive, or would
have to pay in the case of a derivative liability, in a current transaction
between willing parties.
We use a fair value hierarchy to categorize the inputs we use in
valuation techniques to measure fair value. The extent of our use of
quoted market prices (Level 1), internal models using observable market
information as inputs (Level 2) and internal models without observable
market information (Level 3) in the valuation of securities, derivative
assets and derivative liabilities at October 31, 2007 was as follows:
Derivative instruments
Available-for-sale Trading
securities securities Asset Liability
Valued using quoted
market prices 59% 93% 8% 8%
Valued using internal models
(with observable inputs) 35 – 91 91
Valued using internal models
(without observable inputs) 6711
Total 100% 100% 100% 100%
The fair values of most securities and exchange-traded derivatives are
determined on a Level 1 basis, from quoted market prices. The majority
of over-the-counter derivatives are valued using multi-contributor prices
or models that utilize observable market data (Level 2). For example,
the fair value of interest rate swaps is determined using yield curves
developed from observable market interest rates. A small percentage
of over-the-counter derivatives and securities are valued based upon
inputs that are not observable or cannot be corroborated by market data
(Level 3). For example, the fair value of a long-dated cross-currency
swap may be determined using forward curve assumptions that can only
be extrapolated from available market information. See page 68 for
Market Risk discussion. Included in Level 3 for trading securities is the
asset-backed commercial paper issued by non-bank-sponsored conduits
and one BMO-sponsored conduit. Included in Level 3 for available-for-sale
securities is our investment in the capital notes and senior notes of our
BMO-sponsored SIVs. We determined the fair value of these securities
using a variety of valuation techniques, including discounted cash flows,
fair value of the underlying assets and proxy securities.
Valuation models use general assumptions and market data and
therefore do not reflect the specific risks and other factors that would
affect a particular instrument’s fair value. As a result, we incorporate
certain adjustments when using internal models to establish fair values.
These fair value adjustments take into account the estimated impact of
credit risk, liquidity risk, valuation considerations, administrative costs
and closeout costs. For example, the credit risk adjustment incorporates
credit risk into our determination of fair values by taking into account
factors such as the counterparty’s credit rating, the duration of the
instrument and changes in credit spreads.
A group independent of the trading lines of business, Valuation
Product Control (VPC), verifies the fair values at which financial instru-
ments are recorded. For instruments that are valued using models, VPC
identifies situations where adjustments must be made to the model
estimates to arrive at fair value. During the year, we changed our valua-
tion process to incorporate a more appropriate market-based valuation
methodology for the commodities portfolio.
The methodologies used for calculating these adjustments are
reviewed on an ongoing basis to ensure that they remain appropriate.
Significant changes in methodologies are rare and are made only when
we feel that the change will result in better estimates of fair value.
Valuation Adjustments
As at October 31 ($ millions) 2007 2006
Credit risk 50 33
Liquidity risk 20 42
Administrative costs 77
Other 29
79 91
The increase in the adjustment for credit risk was due to wider credit
spreads and refinements to the calculation to reflect more market-based
inputs. The reduction in the valuation adjustment for liquidity risk
was primarily due to lower holdings of commodities derivatives.
Accounting for Securitizations
When loans are securitized, we record a gain or loss on sale. In deter-
mining the gain or loss, management must estimate the net present
value of expected future cash flows by relying on estimates of the
amount of interest and fees that will be collected on the securitized
assets, the yield to be paid to investors, the portion of the securitized
assets that will be repaid before their scheduled maturity, credit
losses, the fair value cost of servicing and the rate at which to discount
these estimated future cash flows. Actual cash flows may differ
significantly from those estimated by management. If management’s
estimate of future cash flows were different, our gain on securitization