Bank of Montreal 2008 Annual Report Download - page 119

Notes
BMO Financial Group 191st Annual Report 2008 | 115
Note 5: Other Credit Instruments
We use other off-balance sheet credit instruments as a method of
meeting the financial needs of our customers. Summarized below are
the types of instruments that we use:
•Standby letters of credit and guarantees represent our obligation
to make payments to third parties on behalf of another party if
that party is unable to make the required payments or meet other
contractual requirements. Standby letters of credit and guarantees
include our guarantee of a subsidiary’s debt to a third party;
•Securities lending represents our credit exposure when we lend
our securities, or our customers’ securities, to third parties should
a securities borrower default on its redelivery obligation;
•Documentary and commercial letters of credit represent our agree-
ment to honour drafts presented by a third party upon completion
of specific activities; and
•Commitments to extend credit represent our commitment to
our customers to grant them credit in the form of loans or other
financings for specific amounts and maturities, subject to their
meeting certain conditions.
The contractual amount of our other credit instruments represents the
maximum undiscounted potential credit risk if the counterparty does not
perform according to the terms of the contract, before possible recoveries
under recourse and collateral provisions. Collateral requirements for
these instruments are consistent with collateral requirements for loans.
A large majority of these commitments expire without being drawn
upon. As a result, the total contractual amounts may not be represen-
tative of the funding likely to be required for these commitments.
We strive to limit credit risk by dealing only with counterparties
that we believe are creditworthy, and we manage our credit risk for
other credit instruments using the same credit risk process that is
applied to loans and other credit assets.
Summarized information related to various commitments is as follows:
(Canadian $ in millions) 2008 2007
Contract Contract
amount amount
Credit Instruments
Standby letters of credit and guarantees $ 15,270 $ 12,395
Securities lending 1,038 1,834
Documentary and commercial letters of credit 1,841 1,301
Commitments to extend credit
–Original maturity of one year and under 41,113 66,126
–Original maturity of over one year 39,995 28,372
Total $ 99,257 $ 110,028
We have an enterprise-wide approach to the identification, measurement,
monitoring and management of risks faced across the organization.
The key financial instrument risks are classified as credit and counter-
party, market, and liquidity and funding risk.
Credit and Counterparty Risk
We are exposed to credit risk from the possibility that counterparties
may default on their financial obligations to us. Credit risk arises
predominantly with respect to loans, over-the-counter derivatives
and other credit instruments. This is the most significant measurable
risk that we face. Our risk management practices and key measures
are disclosed in the text and tables identified in a blue-tinted font in
Management’s Discussion and Analysis on pages76to77ofthis
report. Additional information on loans and derivative-related credit
risk is disclosed in Notes 4 and 10, respectively.
Concentrations of Credit and Counterparty Risk
Concentrations of credit risk exist if a number of clients are engaged
in similar activities, are located in the same geographic region or have
similar economic characteristics such that their ability to meet contractual
obligations could be similarly affected by changes in economic, political
or other conditions. Concentrations of credit risk indicate a related
sensitivity of our performance to developments affecting a particular
counterparty, industry or geographic location. At year-end, our credit
assets consisted of a well-diversified portfolio comprised of millions
ofclients,themajorityofthemconsumersandsmalltomedium-sized
businesses.
From an industry viewpoint, our most significant exposure as at
year-end was to the financial institutions sector, comprising $128 billion,
of which 50% was represented by secured, short-term repo transactions.
Basel II Framework
We adopted a new capital management framework, the Basel II
Framework, effective November 1, 2007, replacing Basel I, the framework
utilized for the past 20 years. The new framework promotes the
adoption of stronger risk management practices. Under this framework,
exposure at default is used to assess credit and counterparty risk.
Exposures are classified as follows:
•Drawn loans include loans, acceptances, deposits with regulated
financial institutions, and certain securities. Exposure at default
represents the amount drawn, adding back any specific provisions
and write-offs.
•
Undrawn commitments cover all unutilized authorizations,
including those which are unconditionally cancellable. Exposure
at default for undrawn commitments is based on management’s
best estimate.
•Over-the-counter (“OTC”) derivatives are those, in the banking book
only, that attract credit risk in addition to market risk. Exposure at
default for over-the-counter derivatives is equal to the net gross
replacement cost plus any potential credit exposure amount.
•Other off-balance sheet exposures include items such as guarantees
and standby letters of credit and documentary credits. Exposure at
default for other off-balance sheet items is based on management’s
best estimate.
•Repo style transactions include repos, reverse repos and securities
lending transactions, which represent both asset and liability expo-
sures. Exposure at default for repo style transactions is the amount
drawn, adding back any write-offs.
•Adjusted exposure at default represents exposure at default that
has been redistributed to a more favourable probability of default
band or a different Basel asset class as a result of collateral.
Note 6: Risk Management