Bank of Montreal 2008 Annual Report Download - page 80

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
76 | BMO Financial Group 191st Annual Report 2008
of this framework is the assignment of appropriate borrower risk ratings
to help quantify potential credit risk.
BMO’s risk rating framework establishes a counterparty’s risk
rating using methodologies and rating criteria based on the specific
risk characteristics of the counterparty. The resulting rating is then
mapped to a probability of default over a one-year time horizon.
As counterparties migrate between risk ratings, the probability of
their default changes. We review our loans and acceptances on an
ongoing basis to assess whether any loans should be classified as
impaired and whether an allowance or write-off should be recorded
(other than consumer instalment and credit card loans, which are
written off when certain conditions exist, as discussed under Impaired
Loans in Note 4 on page 113 of the financial statements). Future
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.
Below is a segmentation of the Wholesale portfolio by risk rating.
Borrower Risk Rating Scale
Moody’s Investor % of
BMO Services implied Standard & Poor’s Wholesale
rating Description of risk equivalent implied equivalent outstanding
Investment grade As at October 31, 2008
I-1 Undoubted/
Sovereign Aaa Sovereign AAA Sovereign 15.9
I-2 Undoubted Aaa/Aa1 AAA/AA+ 6.1
I-3 Minimal Aa2/Aa3 AA/AA– 11.3
I-4 Modest A1/A2/A3 A+/A/A– 6.8
I-5 Modest Baa1 BBB+ 2.8
I-6 Average Baa2 BBB 14.7
I-7 Average Baa3 BBB– 8.5
66.1
Non-investment grade
S-1 Acceptable Ba1 BB+ 10.2
S-2 Acceptable Ba2 BB 8.0
S-3 Marginal Ba3 BB – 6.2
S-4 Marginal B1 B+ 5.2
29.6
Watch list
P-1 Uncertain B2 B 1.4
P-2 Watch list B3 B– 1.4
P-3 Watch list Caa/C CCC/C 0.2
3.0
D-1 and Default C D
D-2 Default and 1.3
Impaired C D
1.3
i
SEE PG 73
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 and Counterparty Risk
Credit and counterparty risk exists in every lending activity that BMO
enters into, as well as in the sale of treasury and other capital markets
products and the holding of investment securities. Effective credit
risk management begins with BMO’s experienced and skilled professional
lending and credit risk officers, who operate in a dual control structure
to authorize transactions that expose the enterprise to credit risk.
These individuals are subject to a rigorous lender qualification process
and operate in a disciplined environment with clear delegation of
decision-making authority, including individually delegated 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 procedures
governing the conduct of credit risk activities.
Policies and Standards
BMO’s lending principles are laid out in a series of corporate policies,
standards, guidelines, directives and procedures, all of which are
reviewed on a regular basis to keep them current and appropriate
to our risk appetite. The structure, limits, collateral requirements,
ongoing management, monitoring and reporting of our credit exposures
are all governed by these lending principles.
Credit Risk Governance
The Risk Review Committee of the Board of Directors ultimately oversees
the management of all risks faced by the enterprise, including credit
risk. 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 all commercial and corporate accounts
reviewed at least annually. The credit review process ensures that an
appropriate structure, including covenant monitoring, is in place for
each account. 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, as well
as 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.
Risk Rating Practices
Consumer and Small Business
The consumer and small business portfolio is made up of a diversified
group of individual customers and includes residential mortgages,
personal loans, credit cards and small business loans. These are managed
as pools of homogeneous risk exposures. For these pools, credit risk
models and decision support systems are developed using established
statistical techniques and expert systems for underwriting and
monitoring purposes. Adjudication models, behavioural scorecards,
decision trees and expert knowledge are combined to produce
optimal credit decisions in a centralized and 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 performance of existing accounts for ongoing
credit risk management.
Commercial and Corporate Lending
Within the commercial and corporate portfolios, we utilize an enterprise-
wide risk rating framework that applies to all of our sovereign, bank,
corporate and commercial counterparties. This framework is consistent
with the principles of Basel II, under which minimum regulatory
capital requirements for credit risk are determined. One key element