Bank of Montreal 2008 Annual Report Download - page 73

MD&A
BMO Financial Group 191st Annual Report 2008 | 69
Critical Accounting Estimates
The Notes to BMO’s October 31, 2008 Consolidated Financial Statements
outline our significant accounting estimates. The following accounting
estimates are considered particularly important, as they require
significant judgments by management. Management has established
detailed policies and control procedures that are intended to ensure
these judgments are well controlled, independently reviewed and con-
sistently 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 particular
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 2008, our provision for credit
losses would range from a provision of $1,387 million to a net recovery
of $147 million. Our provision for credit losses in 2008 was $1,330 million.
Additional information on the process and methodology for
determining the allowance for credit losses can be found in the discussion
of credit risk on page 76 as well as in Note 4 on page 113 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 employ 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 (Level 2) and internal models
without observable market information (Level 3) in the valuation of
securities, derivative assets and derivative liabilities as at October 31, 2008
was as follows: Available- Fair
Trading for-sale value Derivative
(%) securities securities liabilities instruments
Asset Liability
Valued using quoted
market prices 99 28 95 6 3
Valued using internal models
(with observable inputs) – 67 5 91 96
Valued using internal models
(without observable inputs) 15–31
Total 100 100 100 100 100
The sensitivity analysis on our Level 3 assets is included in Note 3 on
page 110 of the financial statements.
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 instru-
ment
and changes in credit spreads.
Valuation Product Control (VPC), a group independent of the trading
lines of business, verifies the fair values at which financial instruments
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. In 2007, we changed our valuation 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) 2008 2007
Credit risk 153 50
Liquidity risk 39 20
Administrative costs 77
Other 30 2
229 79
The increase in the adjustment for credit risk was due to wider relative
credit spreads between our counterparties and BMO. The increase in
the adjustment for liquidity risk was due to widening bid/ask spreads
as liquidity in the market decreased in late 2008. Illiquid markets at
the end of 2008 also caused the increase in the other adjustments.
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
recognized in income would also be different. The interest rate used
to discount expected future cash flows is the estimate that most affects
the gain on securitization. A 10% decrease in the interest rate would
have resulted in a decrease of approximately $53 million in the amount
of the deferred purchase price recorded in available-for-sale securities
and in securitization revenues.
Additional information concerning accounting for securitizations,
including sensitivity analysis for key assumptions, is included in Note 8
on page 118 of the financial statements.
Accounting for Variable Interest Entities
In the normal course of business, BMO enters into arrangements
with variable interest entities (VIEs). VIEs include entities with equity
that is considered insufficient to finance the entity’s activities or
in which the equity holders do not have a controlling financial interest.
We are required to consolidate VIEs if the investments we hold in
these entities and/or the relationships we have with them result in
us being exposed to the majority of their expected losses, being able
to benefit from a majority of their expected residual returns, or both,
based on a calculation determined by accounting standard setters.