Bank of Montreal 2010 Annual Report Download - page 63

MD&A
Our Total Capital Ratio was 15.91% at October 31, 2010, up from
14.87% in 2009. Both our Tier 1 and Total Capital Ratios remain well
above the current minimum capital ratios stipulated by the Office of the
Superintendent of Financial Institutions Canada (OSFI) of 7% and 10%,
respectively, for a well-capitalized financial institution. BMO’s Assets-to-
Capital Multiple was 14.5 at October 31, 2010, up from 14.1 in 2009. The
multiple remains well below the current maximum permitted by OSFI.
As noted in the Provisions for Income Taxes section, we hedge
the foreign exchange risk arising from our net investment in our
U.S. operations by funding the net investment in U.S. dollars. This
strategy reduces the impact on our capital ratios of changes in foreign
exchange rates, as the effect of foreign currency adjustments to Tier 1
capital arising from changes in the value of the Canadian dollar is
partially offset by the change in the Canadian-dollar equivalent of
U.S.-dollar-denominated RWA.
BMO conducts business through a variety of corporate structures,
including subsidiaries and joint ventures. All of our subsidiaries must
meet the regulatory and legislative requirements of the jurisdictions in
which they operate. A framework is in place to ensure that subsidiaries
and their parent entities have access to capital and funding to support
their ongoing operations under both normal and stressed conditions.
Potential Impacts of Proposed Regulatory Capital
Changes and Conversion to IFRS
Over the past two years, global regulators have proposed reforms that
are
intended to strengthen the banking sector regulatory capital and
liquidity
frameworks and strengthen the resilience of individual banking
institutions in periods of stress. Collectively, these new global standards
are referred to as “Basel III”. Based on regulatory guidance provided
to date, the key building blocks of Basel III from a regulatory capital
perspective include:
• raising the quality of capital that banks are required to hold to ensure
banks are better able to absorb losses on both a going-concern and
liquidation basis;
• increasing risk capital requirements, particularly for market risk,
securitizations and counterparty credit risk;
• introducing new regulatory capital ratios – the Common Equity Ratio
and the Leverage Ratio – to complement the existing Tier 1 Capital
Ratio and Total Capital Ratio; and
• increasing minimum capital requirements.
The Basel III rules are expected to be implemented in a phased approach.
The final requirements and transition period applicable to BMO will be
established by OSFI. Market risk and securitization exposure RWA
changes are expected to be implemented in fiscal 2012. Counterparty
credit risk and other RWA changes are scheduled to be implemented on
January 1, 2013, and new capital deductions are scheduled to be phased in
at 20% per year beginning on January 1, 2014 and ending January 1, 2018.
New minimum regulatory capital ratio requirements are scheduled to
be implemented over a transition period that runs from January 1, 2013
to January 1, 2019, or earlier, depending on local regulatory requirements.
The minimum capital ratio requirements will include a capital con ser-
vation buffer that can absorb losses during periods of stress. If a bank
operates within the buffer, restrictions on earnings distributions (e.g.
dividends, equity repurchases, and discretionary compensation) would
likely ensue, with the degree of such restrictions varying with the
position within the buffer range. Moreover, subject to the discretion of
the bank supervisory or regulatory authorities, a countercyclical capital
buffer requirement ranging from 0% to 2.5% of RWA could also be
imposed on banking organizations when it is deemed that excess
aggregate credit growth has resulted in a build-up of systemic risk.
This countercyclical capital buffer, when in effect, would serve as an
additional buffer that supplements the capital conservation buffer.
Under Basel III, two new regulatory capital metrics are expected
to be introduced:
The Common Equity Ratio is defined as common equity
less required capital deductions, divided by risk-weighted assets.
This ratio is also referred to as the Tier 1 Common Ratio.
The Leverage Ratio is defined as Tier 1 capital divided by on-
balance sheet assets and specified off-balance sheet items net of
specified deductions.
Non-common share Tier 1 and Tier 2 capital instruments must meet
new requirements to qualify as regulatory capital under Basel III. Existing
instruments that do not meet these new requirements are expected
to be subject to grandfathering provisions and phased out over a 10-year
period beginning January 1, 2013. Using a base equal to the amount
of such instruments outstanding on January 1, 2013, their recognition
is expected to be capped at 90% from January 1, 2013, with the cap
reducing by 10 percentage points in each subsequent year. In addition,
instruments with an incentive to be redeemed are expected to be
phased out at their effective maturity date. Under the proposed rules,
a large majority of the bank’s existing innovative Tier 1 capital (BMO
Capital Trust Securities and BMO Tier 1 Notes) and Tier 2 subordinated
debt instruments are not expected to qualify as regulatory capital
once the rules are fully implemented. We expect the regulatory capital
treatment of the bank’s other non-common share capital instruments
and related grandfathering treatment to be determined after the Basel
Committee on Banking Supervision (BCBS) finalizes its position on
contingent capital in fiscal 2011.
The proposed final minimum capital ratio requirements under
Basel III are higher than current Canadian requirements as established
by OSFI under Basel II and are summarized in the following table.
Regulatory Requirements (%)
Common Tier 1 Total
Equity Capital Capital Leverage
Ratio Ratio Ratio Ratio
(2)
Basel III – January 1, 2013 requirements
Stated minimum requirements (1) 3.5 4.5 8.0 3.0
Plus: Capital Conservation
buffer requirements 0.0 0.0 0.0 na
Effective minimum requirements (1) 3.5 4.5 8.0 3.0
Basel III – January 1, 2019 requirements
Stated minimum requirements (1) 4.5 6.0 8.0 3.0
Plus: Capital Conservation
buffer requirements 2.5 2.5 2.5 na
Effective minimum requirements (1) 7.0 8.5 10.5 3.0
OSFI Basel II – Current requirements na 7.0 10.0 na (3)
(1) The final requirements and transition periods will be established by OSFI.
(2) A 3% minimum leverage ratio has been proposed by the BCBS. It will be subject to analysis
during a four-year parallel run test period, beginning January 1, 2013. Depending upon
the results of the parallel run testing, there could be subsequent adjustments, which are
targeted to be finalized in 2017, with the final leverage ratio requirement
effective
January 1, 2018.
(3) OSFI currently monitors the Assets-to-Capital Multiple, which is based on total capital.
The proposed Basel III leverage ratio is based on Tier 1 capital.
na – not applicable
BMO Financial Group 193rd Annual Report 2010 61