Bank of Montreal 2015 Annual Report Download - page 67

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
Critical Accounting Estimates
The most significant assets and liabilities for which we must make estimates include: allowance for credit losses; financial instruments measured at
fair value; pension and other employee future benefits; impairment of securities; income taxes and deferred tax assets; goodwill and intangible
assets; purchased loans; insurance-related liabilities; and contingent liabilities. We make judgments in assessing whether substantially all risks and
rewards have been transferred in respect of transfers of financial assets and whether we control SEs. These judgments are discussed in Notes 6 and 7,
respectively, on pages 153 and 154 of the financial statements. Note 18 on page 172 of the financial statements discusses the judgments made in
determining the fair value of financial instruments. If actual results differ from the estimates we make, the impact would be recorded in future
periods. We have established detailed policies and control procedures that are intended to ensure the judgments we make in determining the
estimates 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.
For a more detailed discussion of the use of estimates, please see Note 1 on page 140 of the financial statements.
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 10 years prior
to 2015, our average annual ratio has ranged from a high of 0.88% in 2009 to a low of 0.09% in 2006. This ratio varies with changes in the economy
and credit conditions. If we were to apply these high and low ratios to average net loans and acceptances in 2015, our provision for credit losses
would range from $288 million to $2,818 million and our allowance for credit losses would range from $1,728 million to $4,258 million. Our provision
for credit losses in 2015 was $612 million and our allowance for credit losses as at October 31, 2015 was $2,052 million. Additional information on
the process and methodology for determining the allowance for credit losses can be found in the discussion of Credit and Counterparty Risk on
page 94 as well as in Note 4 on page 148 of the financial statements.
Financial Instruments Measured at Fair Value
BMO records certain securities and derivatives at their fair value, and certain liabilities are designated at fair value. Fair value represents our estimate
of the amount we would receive, or would be required to pay in the case of a 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, 2015, as well as a sensitivity analysis of our Level 3 financial
instruments, is disclosed in Note 18 on page 172 of the financial statements.
Our valuation models use general assumptions and market data, and therefore do not reflect the specific risks and other factors that could affect
a particular instrument’s fair value. Valuation Product Control (VPC), a group independent of the trading lines of business, verifies the fair valuesat
which financial instruments are recorded. For instruments that are valued using models, VPC identifies situations where valuation adjustments must
be made to the model estimates to arrive at 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 and other items, including closeout costs.
For example, the credit risk adjustment for derivative financial instruments 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 instrument and changes in credit spreads. We also incorporate an estimate
of the implicit funding costs borne by BMO for over-the-counter derivative positions (the funding valuation adjustment).
The methodologies used for calculating these adjustments are reviewed on an ongoing basis to ensure that they remain appropriate. Significant
changes in methodologies are made only when we believe that the change will result in better estimates of fair value.
Valuation Adjustments
(Canadian $ in millions)
As at October 31 2015 2014
Credit risk 100 53
Funding risk 60 39
Liquidity risk 57 59
Other –2
Total 217 153
Valuation adjustments increased in 2015, primarily driven by the widening of credit spreads, lower interest rates, and the appreciation of the
U.S. dollar.
Pension and Other Employee Future Benefits
Our pension and other employee future benefits expense is calculated by our independent actuaries using assumptions determined by management.
If actual experience differs from the assumptions used, the difference is recognized in other comprehensive income.
Pension and other employee future benefits expense and the related obligations are sensitive to changes in discount rates. We determine
discount rates at each year end for all our plans using high-quality corporate bonds with terms matching the plans’ specific cash flows.
Additional information regarding our accounting for pension and other employee future benefits, including a sensitivity analysis for key
assumptions, is included in Note 23 on page 184 of the financial statements.
78 BMO Financial Group 198th Annual Report 2015