Bank of Montreal 2007 Annual Report Download - page 71

Credit and Counterparty Risk
BMO incurs credit and counterparty risk primarily in its lending activities,
including the sale of treasury and other capital markets products and,
to a lesser extent, in its holding of investment securities. Effective credit
risk management begins with BMO’s experienced and skilled profes-
sional lending and credit risk officers, who together operate in a dual
control structure to authorize transactions that expose the enterprise to
credit risk. These individuals are subject to a rigorous lender qualifica-
tion process, and operate in a disciplined environment with clear
delegation of decision-making authority, including individually dele-
gated lending limits. Credit decision-making is conducted at the
management level appropriate to the size and risk of each transaction
in accordance with comprehensive corporate policies, standards and pro-
cedures governing the conduct of credit risk activities.
Operating practices include the ongoing monitoring of credit risk
exposures and regular portfolio and sector reporting to the Board and
senior management committees. Performing accounts are reviewed on
a regular basis, with most commercial and corporate accounts reviewed
at least annually. The frequency of reviews is increased in accordance
with the likelihood and size of potential credit losses, with deteriorating
higher-risk situations referred to specialized account management
groups for closer attention where appropriate. Corporate Audit Division
reviews and tests management processes and controls and samples
credit transactions for adherence to credit terms and conditions, and to
governing policies, standards and procedures. In addition, BMO carries
out regular portfolio sector reviews, including stress testing and scenario
analysis based on current, emerging or prospective risks.
For the consumer and small business portfolios, credit risk models
and decision systems are developed using established statistical
techniques and expert systems for underwriting and monitoring pur-
poses. Adjudication models, behavioural scorecards, decision trees and
expert knowledge are combined to produce optimal credit decisions in
to strengthen the soundness and stability of the international banking
system, promote the adoption of stronger risk management practices
and develop more risk-sensitive capital requirements. The Framework
allows banking enterprises to choose from three increasingly risk-
sensitive approaches to the calculation of credit and operational risk
regulatory capital requirements, as outlined in the graphic below, and
promotes the use of an enterprise’s own internal estimates.
an automated environment. The characteristics of both the borrower
and the loan, along with past portfolio experience, are used to predict
the credit performance of new accounts. Past performance is also used,
as appropriate, to predict the likely future behaviour of existing
accounts for ongoing credit risk management.
For the commercial and corporate portfolios, BMO utilizes an
enterprise-wide risk rating framework that applies to all its sovereign,
bank, corporate and commercial counterparties. This framework is
consistent with the principles of Basel II, under which future minimum
regulatory capital requirements for credit risk will be determined.
One key element of this framework is the assignment of appropriate
borrower risk ratings to help quantify potential credit risk.
Under BMO’s risk rating framework, a counterparty’s risk rating is
assessed using methodologies and rating criteria tailored to the specific
risk characteristics of the counterparty, and the resulting rating is then
mapped to a predetermined default probability over a one-year time
horizon. As counterparties migrate between risk ratings, their probability
of default changes. Losses are estimated based on the expected proportion
of the exposure that will be at risk if a counterparty default occurs,
through an analysis of transaction-specific factors such as the nature and
terms of the loan, collateral held and the seniority of our claim. For large
corporate transactions, we also utilize unexpected loss models to assess
the extent and correlation of risks before authorizing new exposures.
We employ a disciplined approach to provisioning and loan loss
evaluation, with prompt identification of problem loans being a key risk
The Basel II Framework introduced the concept of “three pillars” for the
reporting and monitoring of risk-based regulatory capital. BMO continues
to work towards meeting all of the applicable requirements of the
Basel II Framework.
The First Pillar
The first pillar outlines new methodologies to be used in the
determination of the minimum capital requirements for credit risk
and operational risk.
IRB Advanced
Advanced Measurement
Standardized
Basic Indicator
Increasing level
of sophistication
and risk sensitivity
IRB Foundation
Standardized
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 predetermined financial obligation. This
is the most significant measurable risk that BMO faces.
Credit Risk
Operational Risk
The Second Pillar
One of the fundamental principles of the second pillar is that banks
should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital
levels. This process includes addressing all material risks, including risks
not captured within the first pillar. Another important principle of the
second pillar is that regulators are to evaluate banks’ internal capital
adequacy assessments. Banks are expected to maintain capital ratios
that exceed the minimum regulatory ratios. Building on the work that
we are doing to implement the first pillar, we are reviewing our process
for assessing overall capital adequacy in relation to our risk profile.
The Third Pillar
The third pillar delineates the market disclosures required from banks, in
order that the market may have better information in regards to the
overall risk position of a bank. BMO will be implementing disclosure
that complies with the Basel II Framework throughout fiscal 2008.
BMO views Basel II as an important step in the alignment of regulatory
and economic capital requirements. We have an integrated enterprise-
wide program for managing the implementation of Basel II. Leadership
and oversight for Basel II activities are provided by an Executive Steering
Committee.
BMO has filed an application with our regulator, OSFI, to apply the
most advanced approach (AIRB) for Credit Risk on our portfolio, except
for our subsidiary Harris Bankcorp, Inc., where we have requested a
waiver to apply the Standardized Approach. The approval decision from
the regulator is pending. We have adopted the Standardized Approach
for Operational Risk.
MD&A
BMO Financial Group 190th Annual Report 2007 67