Bank of Montreal 2010 Annual Report Download - page 70

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
The Notes to BMO’s October 31, 2010 Consolidated Financial Statements
outline our significant accounting estimates. The following accounting
estimates are considered particularly important, as they require signifi-
cant judgments by management. Management has established detailed
policies and control procedures that are intended to ensure these
judgments are well controlled, independently reviewed and consistently
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 loans 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 circum-
stances 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. Over
the past 10 years, for our Canadian peer group, the average annual ratio
has ranged from a high of 1.24% in 2002 to a low of 0.17% in 2004.
Critical Accounting Estimates
BMO enters into a number of off-balance sheet arrangements in the
normal course of operations. Our arrangements with certain variable
interest entities are addressed on pages 64 to 66 and 68 to 69 of
this MD&A. The discussion that follows addresses our remaining
off-balance sheet arrangements.
Credit Instruments
In order to meet the financial needs of our clients, we use a variety
of off-balance sheet credit instruments. These include guarantees and
standby letters of credit, which represent our obligation to make pay-
ments to third parties on behalf of a customer if the customer is unable
to make the required payments or meet other contractual requirements.
We also write documentary and commercial letters of credit, which
represent our agreement to honour drafts presented by a third party
upon completion of specified activities. Commitments to extend
credit are off-balance sheet arrangements that represent our commit-
ment to customers to grant them credit in the form of loans or other
financings for specific amounts and maturities, subject to meeting
certain conditions.
There are a large number of credit instruments outstanding at
any time. Our customers are broadly diversified and we do not anticipate
events or conditions that would cause a significant number of our cus-
tomers to fail to perform in accordance with the terms of the contracts.
We use our credit adjudication process in deciding whether to enter into
these arrangements, just as we do when extending credit in the form
of a loan. We monitor off-balance sheet instruments to avoid undue
concentrations in any geographic region or industry.
The maximum amount payable by BMO in relation to these
credit instruments was approximately $65 billion at October 31, 2010
($73 billion in 2009). However, this amount is not representative of
our likely credit exposure or liquidity requirements for these instruments
as it does not take into account customer behaviour, which suggests
only a portion will utilize the facility. It also does not take into account
any amounts that could be recovered under recourse or collateralization
provisions. Further information on these instruments can be found in
Note 5 on page 122 of the financial statements.
For the credit commitments outlined in the preceding paragraphs,
in the absence of an event that triggers a default, early termination
by BMO may result in a breach of contract.
Variable Interest Entities (VIEs)
Our interests in VIEs are discussed primarily on pages 64 to 66 in the
BMO-Sponsored Securitization Vehicles and Structured Investment
Vehicles sections and on pages 68 to 69 in the Accounting for Variable
Interest Entities section. Capital and funding trusts are discussed below.
Capital and Funding Trusts
BMO Subordinated Notes Trust (SN Trust) issued $800 million of BMO
Trust Subordinated Notes (SN Trust Notes) in 2007, the proceeds of
which were used to purchase a senior deposit note from BMO. We hold
all of the outstanding voting trust units in SN Trust and expect to do
so at all times while the SN Trust Notes are outstanding. We are not
required to consolidate SN Trust. BMO does not expect to terminate
SN Trust while the SN Trust Notes are outstanding, unless SN Trust has
sufficient funds to pay the redemption price on the SN Trust Notes
and only with the approval of OSFI. We provide a $30 million credit
facility to SN Trust, of which $5 million had been drawn at October 31,
2010 ($5 million in 2009). We guarantee payment of the principal,
interest, redemption price, if any, and any other amounts on the
SN Trust Notes on a subordinated basis.
During 2009, BMO Capital Trust II (Trust II) was created to raise
capital, through the issuance of $450 million of BMO Tier 1 Notes –
Series A. Trust II used the proceeds of the offering to purchase a senior
deposit note from BMO. We are not required to consolidate Trust II.
Guarantees
Guarantees include contracts under which we may be required to
make payments to a counterparty based on changes in the value of an
asset, liability or equity security that the counterparty holds. Contracts
under which we may be required to make payments if a third party
does not perform according to the terms of a contract and contracts
under which we provide indirect guarantees of indebtedness are also
considered guarantees. In the normal course of business, we enter
into a variety of guarantees, including standby letters of credit, backstop
and other liquidity facilities and derivatives contracts or instruments
(including, but not limited to, credit default swaps and written options),
as well as indemnification agreements.
The maximum amount payable was $65 billion at October 31, 2010
($82 billion in 2009). However, this amount is not representative of our
likely exposure, as it does not take into account customer behaviour,
which suggests that only a portion of the guarantees will require
payment. It also does not take into account any amounts that could
be recovered through recourse and collateral provisions.
For a more detailed discussion of these agreements, please see
Note 7 on page 125 of the financial statements.
Off-Balance Sheet Arrangements
68 BMO Financial Group 193rd Annual Report 2010