Bank of Montreal 2015 Annual Report Download - page 83

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
Credit and Counterparty Risk
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.
Credit and counterparty risk underlies every lending activity that BMO enters into, and also arises in the transacting of trading and other capital
markets products, the holding of investment securities and the activities related to securitization. Credit risk is the most significant measurable risk
BMO faces. Proper management of credit risk is essential to our success, since the failure to effectively manage credit risk could have an immediate
and significant impact on our earnings, financial condition and reputation.
Credit and Counterparty Risk Governance
The objective of our credit risk management framework is to ensure all material credit risks to which the enterprise is exposed are identified,
measured, managed, monitored and reported. The RRC has oversight of the management of all risks faced by the enterprise, including the credit risk
management framework. BMO’s credit risk management framework incorporates governing principles which are defined in a series of corporate
policies and standards, and which flow through to more specific guidelines and procedures. These are reviewed on a regular basis and modified
when necessary to keep them current and consistent with BMO’s risk appetite. The structure, limits, collateral requirements, monitoring, reporting
and ongoing management of our credit exposures are all governed by these credit risk management principles.
Lending officers in the operating groups are accountable for recommending credit decisions based on the completion of appropriate due
diligence, and they assume ownership of the risks. Credit officers in ERPM approve these credit decisions and are accountable for providing an
objective assessment of the lending recommendations and independent oversight of the risks assumed by the lending officers. All of these
experienced and skilled individuals are subject to a rigorous lending qualification process and operate in a disciplined environment with clear
delegation of decision-making authority, including individually delegated lending limits, which are reviewed annually. 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. Corporate Audit Division reviews and tests management processes and
controls and samples credit transactions in order to assess adherence to credit terms and conditions, as well as to governing policies, standards and
procedures.
All credit risk exposures are subject to regular monitoring. Performing accounts are reviewed on a regular basis, with most commercial and
corporate accounts reviewed at least annually. The frequency of review increases 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, when appropriate. In addition,
regular portfolio and sector reviews are carried out, including stress testing and scenario analysis based on current, emerging or prospective risks.
Reporting is provided at least quarterly to the Board and senior management committees in order to keep them informed of developments in our
credit risk portfolios, including changes in credit risk concentrations and significant emerging credit risk issues, and to allow appropriate actions to be
taken where necessary.
Credit and Counterparty Risk Management
Collateral Management
Collateral is used for credit and/or counterparty risk mitigation purposes to minimize losses that would otherwise be incurred upon the occurrence
of a default. Depending on the type of borrower, the assets available and the structure and term of the credit obligations, collateral can take
various forms. For corporate and commercial borrowers, collateral can take the form of pledges of the assets of a business, such as accounts
receivable, inventory, machinery and real estate, or personal assets pledged in support of guarantees. On a periodic basis, collateral is subject to
regular revaluation specific to asset type.
For loans, the value of collateral is initially established at the time of origination, and the frequency of revaluation is dependent on the type of
collateral. Credit officers in ERPM provide independent oversight of collateral documentation and valuation. For collateral in the form of investor-
owned commercial real estate, a full external appraisal of the property is obtained at the time of loan origination, except where the loan is below a
specified threshold amount, in which case an internal evaluation and a site inspection are conducted. Internal evaluation methods may consider tax
assessments, purchase price, real estate listing or realtor opinion. The case for an updated appraisal is reviewed annually, with consideration given to
the borrower risk rating, existing tenants and lease contracts, as well as current market conditions. In the event a loan is classified as impaired,
depending on its size, a current external appraisal, evaluation or restricted use appraisal is obtained and updated every 12 months while the loan is
classified as impaired. For residential real estate that has a loan-to-value (LTV) ratio of less than 80%, an external property appraisal is routinely
obtained at the time of loan origination. In certain low LTV ratio cases, BMO may use an external service provided by Canada Mortgage and Housing
Corporation to assist in determining whether a full property appraisal is necessary. For high LTV ratio (greater than 80%) insured mortgages, BMO
obtains the value of the property through available means and the default insurer confirms the value.
Collateral for our trading products is primarily comprised of cash and high-quality liquid securities (U.S. and Canadian treasury securities, U.S.
agency securities and Canadian provincial government securities) that are monitored and margined on a daily basis. Collateral is obtained under the
contractual terms of standardized industry documentation. With limited exceptions, we utilize the International Swaps and Derivatives Association Inc.
(ISDA) Master Agreement with a Credit Support Annex (CSA) to document our collateralized trading relationships with our counterparties for non-
centrally cleared over-the-counter (OTC) derivatives. CSAs entitle a party to demand collateral (or other credit support) when its OTC derivatives
exposure to the other party exceeds an agreed amount (threshold). Collateral transferred can include an independent amount (initial margin) and/or
variation margin. CSAs contain, among other things, provisions setting out acceptable collateral types and how they are to be valued (discounts are
often applied to the market values), as well as thresholds, whether or not the collateral can be re-pledged by the recipient and how interest is to be
calculated.
To document our contractual trading relationships with our counterparties for repurchase transactions, we utilize master repurchase agreements
and for securities lending transactions, we utilize master securities lending agreements.
Material presented in a blue-tinted font above is an integral part of the 2015 annual consolidated financial statements (see page 86).
94 BMO Financial Group 198th Annual Report 2015