Bank of Montreal 2007 Annual Report Download - page 72

Management’s Discussion and Analysis
68 BMO Financial Group 190th Annual Report 2007
MD&A
management objective. BMO maintains both specific and general
allowances for credit losses, the sum of which must always be sufficient
to reduce the book value of credit assets to their estimated realizable
value. Specific allowances reduce the aggregate carrying value of credit
assets where there is evidence of deterioration in credit quality.
We maintain a general allowance in order to cover any impair-
ment in the existing portfolio that cannot yet be associated with
specific loans. Our approach to establishing and maintaining the general
allowance is based on the guideline issued by our regulator, OSFI.
The general allowance is reviewed on a quarterly basis and a number
of factors are considered when determining the appropriate level of the
general allowance. This includes a general allowance model that applies
historical expected and unexpected loss rates, based on probabilities
of default and loss given default factors, to current balances. For business
loans, these historical loss rates are associated with the underlying risk
rating of the borrower which is assigned at the time of loan origination,
monitored on an ongoing basis, and adjusted to reflect changes in
underlying credit risk. These loss rates are further refined with regard
to industry sectors and credit products. For consumer loans, these loss
rates are based on historical loss experience for the different portfolios.
Model results are then considered along with the level of the existing
allowance and management’s judgment regarding portfolio quality,
business mix, and economic and credit market conditions.
We use credit derivative products to enhance the management
of our portfolio of credit risk assets, in particular our corporate loan book.
In 2007, we were active in the use of single-name credit default swaps
to mitigate the credit risk related to specific client credit exposures.
BMO’s credit risk governance policies ensure that an acceptable
level of diversification is maintained at all times. The use of industry
structural risk factor limits ensures diversification of risk in the commer-
cial and corporate lending portfolios, and allows us to closely monitor
sectors of concern as required. At year-end, our credit assets consisted
of a well-diversified portfolio comprised of millions of clients, the
majority of them consumers and small to medium-sized businesses.
Our credit risk management processes are both well-established
and effective: In 14 of the past 15 years, BMO’s specific credit losses
as a percentage of loans and acceptances, including securities borrowed
or purchased under resale agreements, were lower than the average
of our Canadian peer group. Over this 15-year period, BMO’s average loss
rate was 28 basis points, compared with an average of 47 basis points
for our largest peers. These favourable results were achieved in consumer
loans, as well as corporate and commercial loans.
Provisions for credit losses are discussed on page 39. Note 4
on page 101 of the financial statements and Tables 11 to 19 on pages 84
to 87 provide details of BMO’s loan portfolio, impaired loans and provi-
sions and allowances for credit losses.
Market Risk
BMO incurs market risk in its trading and underwriting activities and
structural banking activities.
As part of our enterprise-wide risk management framework,
we employ comprehensive governance and management processes
surrounding market risk-taking activities. These include:
•oversight by senior governance committees, including Market Risk
Committee (MRC), Balance Sheet Management Committee (BSMC),
RMC and RRC;
•independent market risk oversight functions;
•processes for the valuation of trading positions and the measurement
of market risks, which are linked to the allocation of Economic Capital;
•a well-developed limit-setting and monitoring process;
•effective controls over processes and models used; and
•a framework of scenario and stress tests for worst-case events.
BMO’s primary market risk measures are Market Value Exposure (MVE)
and Earnings Volatility (EV). The aggregate market value and earnings
volatility exposures at October 31, 2007 are summarized in the following
table. Total MVE has decreased over the past year largely as a result
of lower modelled structural interest rate volatility. Interest rate volatility
is derived from 10 years of historical data that in fiscal 2007 excludes
the high volatility associated with fiscal 1997. Total EV has decreased
relative to last year, mainly due to reduced exposure in the commodity
portfolios coupled with reduced interest rate exposure in the mark-to-
market and accrual accounted money market portfolios.
Aggregate MVE and EV for Trading and Underwriting
and Structural Positions ($ millions)*
As at October 31, 2007 Market value 12-month
(After-tax Canadian equivalent) exposure earnings volatility
2007 2006 2007 2006
Trading and Underwriting (18.2) (23.4) (12.6) (17.5)
Structural (249.9) (267.0) (24.2) (24.1)
Total (268.1) (290.4) (36.8) (41.6)
*Measured at a 99% confidence interval.
Market risk is the potential for a negative impact on the balance
sheet and/or income statement resulting from adverse changes in
the value of financial instruments as a result of changes in certain
market variables. These variables include interest rates, foreign
exchange rates, equity and commodity prices and their implied
volatilities, as well as credit spreads, credit migration and default.
Market Value Exposure (MVE) is a measure of the adverse impact
of changes in market parameters on the market value of a port-
folio of assets, liabilities and off-balance sheet positions, measured
at a 99% confidence level over a specified holding period. The
holding period considers current market conditions and composition
of the portfolios to determine how long it would take to neutralize
the market risk without adversely affecting market prices. For
trading and underwriting activities, MVE is comprised of Value at
Risk and Issuer Risk.
Earnings Volatility (EV) is a measure of the adverse impact
of potential changes in market parameters on the projected
12-month after-tax net income of a portfolio of assets, liabilities
and off-balance sheet positions, measured at a 99% confidence
level over a specified holding period.
Value at Risk (VaR) is measured for specific classes of risk
in BMO’s trading and underwriting activities: interest rate, foreign
exchange rate, equity and commodity prices and their implied
volatilities. This measure calculates the maximum likely loss from
portfolios, over a specified holding period, measured at a 99%
confidence level.
Issuer Risk arises in BMO’s trading and underwriting portfolios,
and measures the adverse impact of credit spread, credit migration
and default risks on the market value of fixed income instruments
and similar securities. Issuer risk is measured at a 99% confidence
level over
a specified holding period.