Bank of Montreal 2010 Annual Report Download - page 124

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Notes
122 BMO Financial Group 193rd Annual Report 2010
Note 5: Other Credit Instruments
Note 6: Risk Management
Impaired Loans
Our average gross impaired loans and acceptances were $3,255 million
for the year ended October 31, 2010 ($2,850 million in 2009). Our average
impaired loans, net of the specific allowance, were $2,589 million for
the year ended October 31, 2010 ($2,325 million in 2009).
During the years ended October 31, 2010, 2009 and 2008,
we would have recorded additional interest income of $111 million,
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 presented in a blue-tinted font in Management’s
Discussion and Analysis on pages 80 to 81 of this 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
con tractual 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 port-
folio representing millions of clients, the majority of them consumers
and small to medium-sized businesses.
From an industry viewpoint, our most significant exposure as at
year-end was to the individual consumers, captured in the “individual
sector”, comprising $136.8 billion.
Basel II Framework
We use the Basel II Framework for our capital management framework.
The framework uses exposure at default 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 (“EAD”)
represents an estimate of the outstanding amount of a credit exposure
at the time a default may occur. For off-balance sheet amounts and
undrawn amounts, EAD includes an estimate of any further amounts
that may be drawn at the time of default.
• 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 our proprietary
accounts that attract credit risk in addition to market risk. Exposure
at default for OTC 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 exposures.
Exposure at default for repo style transactions is the total amount
drawn, adding back any write-offs.
• Adjusted EAD represents exposures that have been redistributed to
a more favourable probability of default band or a different Basel asset
class as a result of applying credit risk mitigation.
$119 million and $102 million, respectively, if we had not classified
any loans as impaired.
Cash interest income of $2 million was recognized on impaired
loans during the year ended October 31, 2010 ($nil in 2009 and 2008).
During the year ended October 31, 2010, we recorded a loss of
$4 million (loss of $24 million in 2009) on the sale of impaired loans.
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 representa-
tive 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) 2010 2009
Contractual Contractual
amount amount
Credit Instruments
Standby letters of credit and guarantees 10,163 11,384
Securities lending 2,094 445
Documentary and commercial letters of credit 1,272 1,422
Commitments to extend credit
– Original maturity of one year and under 22,393 28,438
– Original maturity of over one year 29,078 31,626
Total 65,000 73,315