Bank of Montreal 2015 Annual Report Download - page 84

MD&A
Portfolio Management
BMO’s credit risk governance policies set an acceptable level of diversification. Limits may be used for several portfolio dimensions, including industry,
specialty segments (e.g., hedge funds and leveraged lending), country, product and single-name concentrations. At year end, our credit assets
consisted of a well-diversified portfolio comprised of millions of clients, the majority of them consumers and small to medium-sized businesses. The
diversification of our credit exposure may be supplemented by the purchase or sale of insurance through guarantees or credit default swaps.
Wrong-way Risk
Wrong-way risk occurs when exposure to a counterparty is highly correlated with the credit quality of collateral or another intended mitigant of the
risk from that counterparty. There is specific wrong-way risk, which arises when the counterparty and the market risk factors affecting that mitigant
display a high correlation, and general wrong-way risk, which arises when the credit quality of the counterparty, for non-specific reasons, is highly
correlated with macroeconomic or other factors that affect the value of the mitigant. Our procedures require that specific wrong-way risk be identified
in transactions and accounted for in the calculation of risk. Stress testing of wrong-way risk is conducted monthly and can be used to identify
existing/emerging concentrations of general wrong-way risk in our portfolios.
Credit and Counterparty Risk Measurement
We quantify credit risk at both the individual borrower or counterparty and the portfolio level. In order to limit earnings volatility, manage expected
credit losses and minimize unexpected losses, credit risk is assessed and measured using the following risk-based parameters:
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.
Loss Given Default (LGD) is the amount that may not be recovered in the event of a default, presented as a proportion of the exposure at default.
Probability of Default (PD) represents the likelihood that a borrower or counterparty will go into default over a one-year time horizon, estimated at
a high confidence level.
Expected Loss (EL) is a measure representing the loss that is expected to occur in the normal course of business in a given period of time. EL is
calculated as a function of EAD, LGD and PD.
Under OSFI rules, there are three approaches available for the measurement of credit risk: Standardized, Foundation Internal Ratings Based and
Advanced Internal Ratings Based (AIRB). Subject to a transitional floor based on the Standardized Approach, we apply the AIRB Approach for
calculations of credit risk in our portfolios, including portfolios of our subsidiary BMO Financial Corp. The Standardized Approach is currently being used
for measurements related to the acquired M&I portfolio, while we continue to execute our plan to transition this portfolio to the AIRB Approach.
Risk Rating Systems
BMO’s risk rating systems are designed to assess and measure the risk of any exposure. The rating systems differ for retail (consumer and small
business) and wholesale (corporate and commercial) portfolios.
Credit risk measures are validated and back-tested regularly – quarterly in the case of retail models and annually in the case of wholesale models.
Please refer to pages 112 and 113 for a discussion of our model risk mitigation processes.
Retail (Consumer and Small Business)
The retail portfolios are made up of a diversified group of individual customer accounts and include residential mortgages, personal loans, credit
cards and small business loans. These loans are managed in pools of homogeneous risk exposures. For these pools, decision support systems are
developed using established statistical techniques and expert systems for underwriting and monitoring purposes. Adjudication models, behavioural
scorecards, decision trees and expert knowledge are combined to produce optimal credit decisions in a centralized and automated environment.
The retail risk rating system assesses the borrower’s risk based on a narrow range of likely expected conditions, primarily more recent in nature,
including delinquency, loan-to-value ratio and loan utilization rate. Product lines within each of the retail risk areas are separately modelled so the
risk-based parameters capture the distinct nature of each product. A final segmentation then sorts each exposure within a product line into
homogeneous pools of retail risk that reflect common risk-based parameters. Each pool is assigned a unique combination of PD, LGD and EAD
parameters that captures its segment-specific credit risk.
The retail risk rating system is designed to generate estimates of the value of credit risk parameters as accurately as possible but is subject to
uncertainty. During the calibration process, adjustments are made at the parameter level for each segment to account for this uncertainty. The retail
parameters are tested quarterly and calibrated on an annual basis to incorporate additional data points in the parameter estimation process, ensuring
that the most recent experience is incorporated.
Retail Credit Probability of Default Bands by Risk Rating
Risk profile Probability of default band
Exceptionally low ≤0.05%
Very low > 0.05% to 0.20%
Low > 0.20% to 0.75%
Medium > 0.75% to 7.00%
High > 7.00% to 99.99%
Default 100%
Wholesale (Corporate, Commercial and Sovereign)
Within wholesale portfolios, we utilize an enterprise-wide risk rating framework that is applied to all of our sovereign, bank, corporate and
commercial counterparties. One key element of this framework is the assignment of appropriate borrower or counterparty risk ratings (BRRs). A suite
of general and sector-specific risk rating models have been developed within each asset class to capture the key quantitative and qualitative risk
Material presented in a blue-tinted font above is an integral part of the 2015 annual consolidated financial statements (see page 86).
BMO Financial Group 198th Annual Report 2015 95