Bank of Montreal 2015 Annual Report Download - page 93

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
Structural interest rate risk is measured using simulations, earnings sensitivity and economic value sensitivity analysis, stress testing and gap
analysis, in addition to other traditional risk metrics.
Earnings Sensitivity is a measure of the impact of potential changes in interest rates on the projected 12-month after-tax net income of a
portfolio of assets, liabilities and off-balance sheet positions in response to prescribed parallel interest rate movements.
Economic Value Sensitivity is a measure of the impact of potential changes in interest rates on the market value of a portfolio of assets,
liabilities and off-balance sheet positions in response to prescribed parallel interest rate movements.
The models used to measure structural interest rate risk project changes in interest rates and predict how customers would likely react to these
changes. For customer loans and deposits with scheduled maturity and repricing dates (such as mortgages and term deposits), our models measure
the extent to which customers are likely to use embedded options to alter those scheduled terms. For customer loans and deposits without scheduled
maturity and repricing dates (such as credit card loans and chequing accounts), we measure our exposure using models that adjust for elasticity in
product pricing and reflect historical and forecasted trends in balances. Structural market risk models by their nature have inherent uncertainty as they
reflect potential anticipated pricing and customer behaviours which may differ from actual experience. The models have been developed using
statistical analysis and are validated and periodically updated through regular model vetting, back-testing processes and ongoing dialogue with the
lines of business. Models developed to predict customer behaviour are also used in support of product pricing.
Structural interest rate earnings and economic value sensitivity to an immediate parallel increase or decrease of 100 and 200 basis points in the
yield curve are disclosed in the following table. The interest rate gap position is disclosed in Note 20 on page 180 of the financial statements.
During the year, we updated our approach to quantify the potential impact of changing interest rates on structural earnings and value
sensitivities. The new approach reflects a more refined estimate of expected deposit pricing as interest rates change. There were no other significant
changes in our structural market risk management framework during the year.
Structural economic value sensitivity to rising rates primarily reflects a lower market value for fixed-rate loans. Structural economic value
sensitivity to falling rates primarily reflects the reduced ability to price deposits lower in the low-rate environment. Structural earnings exposure to
falling interest rates primarily reflects the risk of fixed and floating rate loans repricing at lower rates and the more limited ability to reduce deposit
pricing as rates fall. The asset-liability profile at the end of the year resulted in a structural earnings benefit from interest rate increases and structural
earnings exposure to interest rate decreases. The realized earnings impact may differ from that shown depending on a number of factors, including
customer and competitor actions and the pace at which interest rates change.
Structural Balance Sheet Interest Rate Sensitivity (1) (2) (3) (4) (5)
As at October 31, 2015 As at October 31, 2014
(Canadian $ in millions)
Economic value
sensitivity
(Pre-tax)
Earnings sensitivity
over the next
12 months
(After tax)
Economic value
sensitivity
(Pre-tax)
Earnings sensitivity
over the next
12 months
(After tax)
100 basis point increase (647.6) 143.5 (715.1) 64.7
100 basis point decrease 107.3 (62.0) 405.2 (62.6)
200 basis point increase (1,722.3) 185.4 (1,579.4) 85.8
200 basis point decrease (288.5) (87.8) 320.5 (68.1)
(1) We enhanced our approach to quantify the potential impact of changing interest rates on structural earnings and value sensitivities in 2015. Positions as at October 31, 2014 have not been restated to
the new approach.
(2) Earnings and value sensitivities to falling interest rates assume Canadian and U.S. central banks do not decrease overnight interest rates below nil. The scenarios with decreasing interest rates therefore
limit the decrease in Canadian and U.S. short-term interest rates to 50 basis points (100 basis points in 2014) and 25 basis points, respectively, for shorter terms in 2015 and 2014. Longer-term interest
rates do not decrease below the assumed level of short-term interest rates.
(3) Certain non-trading AFS holdings are managed under the bank’s trading risk framework.
(4) Losses are in brackets and benefits are presented as positive numbers.
(5) For BMO’s Insurance businesses, a 100 basis point increase in interest rates at October 31, 2015, results in an increase in earnings after tax of $66 million and an increase in economic value before
tax of $511 million ($71 million and $385 million, respectively, at October 31, 2014). A 100 basis point decrease in interest rates at October 31, 2015, results in a decrease in earnings after tax of
$63 million and a decrease in economic value before tax of $414 million ($63 million and $414 million, respectively, at October 31, 2014). These impacts are not reflected in the table above.
Foreign Exchange Risk
Structural foreign exchange risk arises primarily from translation risk related to the net investment in our U.S. operations and from transaction risk
associated with our U.S.-dollar-denominated net income.
Translation risk represents the impact that changes in foreign exchange rates can have on BMO’s reported shareholders’ equity and capital
ratios. When the Canadian dollar appreciates relative to the U.S. dollar, unrealized translation losses on our net investment in foreign operations,
net of related book value hedging activities, are reported in other comprehensive income in shareholders’ equity. In addition, the Canadian dollar
equivalent of U.S.-dollar-denominated risk-weighted assets and regulatory capital deductions decreases. The reverse is true when the Canadian dollar
depreciates relative to the U.S. dollar. Consequently, we may adjust the hedge of our net investment in foreign operations such that translation risk is
not expected to materially impact our capital ratios.
Transaction risk represents the impact that fluctuations in the Canadian/U.S. dollar exchange rate may have on the Canadian dollar equivalent of
BMO’s U.S.-dollar-denominated results. Exchange rate fluctuations will affect future results measured in Canadian dollars and the impact on those
results is a function of the periods during which revenues, expenses and provisions for credit losses arise. Hedging positions may be taken to partially
offset the pre-tax effects of Canadian/U.S. dollar exchange rate fluctuations. If future results are consistent with results in 2015, each one cent
increase (decrease) in the Canadian/U.S. dollar exchange rate would be expected to increase (decrease) adjusted net income before income taxes for
the year by $10 million, in the absence of hedging transactions. Refer to the Foreign Exchange section on page 37 for a more complete discussion of
the effects of changes in exchange rates on the bank’s results.
Material presented in a blue-tinted font above is an integral part of the 2015 annual consolidated financial statements (see page 86).
104 BMO Financial Group 198th Annual Report 2015