Bank of Montreal 2007 Annual Report Download - page 76

Management’s Discussion and Analysis
72 BMO Financial Group 190th Annual Report 2007
MD&A
Operational Risk
Operational risk is inherent in all business activities. Operational risk
can never be entirely eliminated; however, shareholder value can be
preserved and enhanced by managing, mitigating and, in some cases,
insuring against operational risk.
To achieve this goal, BMO has developed an Operational Risk
Management Framework (ORMF), which includes identification, meas-
urement, management, monitoring, Economic Capital attribution and
risk control and mitigation elements. A variety of underlying processes
and controls have been developed as part of this framework. These
include risk and control self-assessments, business contingency plans,
event management, change management, outsourcing management
and acquisition and integration management.
BMO’s operational risk governance structure includes the Operational
Risk Committee (ORC), a sub-committee of Risk Management Committee
(RMC). ORC has oversight responsibility for operational risk strategy
and governance. It provides advice and guidance to the lines of business
on operational risk assessments, measurement and mitigation, and
related monitoring and change initiatives.
BMO’s intention is to make operational risk, like all other risks,
transparent throughout the enterprise. Therefore, this framework
includes regular reporting of relevant operational risk management
activities and processes to senior line and corporate management, ORC,
RMC and the Board of Directors. Operational risk events that occur
within the Credit, Market or Liquidity Risk frameworks are managed
within their respective framework.
Each line of business is responsible for using the aforementioned
framework processes and control programs to manage its operational
risk within the guidance provided by corporate policy and standards. To
ensure that all operational risks to which a line of business is exposed
are adequately managed, specialized functions are also involved in the
management of risks as appropriate, including Finance, Taxation, Legal,
Compliance, Privacy, Human Resources and Technology and Operations.
BMO has established an Enterprise Operational Risk Management
group that develops the ORMF, codifies the ORMF within corporate
policy, oversees the risk assessment methodology and defines the
reporting requirements.
BMO purchases insurance in such amounts and in such areas
as will provide protection against unexpected material loss and
when insurance is required by law, regulatory requirement or con-
tractual agreement.
Under Basel II methodologies, BMO is implementing the
Standardized Approach (TSA) for the calculation of operational risk
regulatory capital requirements enterprise-wide. TSA processes
and capital measures have been implemented at both the consolidated
bank and applicable legal entity levels. BMO will not use partial
applications of the Basic or Advanced Measurement Approach.
Operational risk is the potential for loss resulting from inade-
quate or failed internal processes or systems, human interactions
or external events, but excludes business risk.
Business Risk
Business Risk due to Operational Failure
Business risk due to operational failure is the risk of losses or reductions
in revenue arising from the indirect effects of operational risks, includ-
ing reputation risk. In 2006, it was reclassified to the Business Risk
category to align operational risk capital measures with the Basel II
Standardized Approach. BMO attributes economic capital for this risk
to the business units using a scenario-based model and reports this
capital as a component of business economic capital.
Business Risk due to Earnings Volatility
Business risk due to earnings volatility measures the risk that volumes
will decrease or margins will shrink with no opportunity being available
to offset the revenue declines with a reduction in costs. BMO faces
many risks that are similar to those faced by non-financial firms, princi-
pally that our profitability, and hence value, may be eroded by changes
in the business environment or by failures of strategy or execution.
Sources of these risks include volatile economic market activity, chang-
ing client expectations, adverse business developments and relatively
ineffective responses to industry changes. Risks to BMO’s margins
and volumes are categorized as business risk due to earnings volatility.
In line with our standard practice of regularly evaluating methodologies,
our business risk methodologies will be reviewed during fiscal 2008.
Business risk is the risk associated with specific business
activities of a company as they might affect the earnings of
that company. BMO recognizes two distinct types of business risk:
business risk due to operational failure and business risk due
to earnings volatility.