Not just any bank. BMO Financial Group 197th Annual Report 2014 BMO at a Glance Financiaal Snapsshot AsAs ata ot at or or forfo the yeaear ended October 3111 (((Canadian $ inin milmi lilions, except as noteed) Reported 1 Adjusted 1,2 2014 2013 2014014 2013 3 Revenue (p 36) Provision for cred r credit losses (p 40) p 40) Non-interterest expense (p 41) Net innncome ncome (p 33) (p 33) EaEarrrnings per share – d diluted ed ($) (p 33) RetReturn on equity (p(p 34) er eOperattinin erati attini gg leeveveraraage (p 41) l III Com l I Com ommoon Equity Basel Tieerr r 1 Ra oRaRatitioo p 334) (p Net I Income by ggSege eggegment gment Ca adia ana ana annaadia Canadian P&C (pp p 4p 45) UU U.S. P&C P&C (p 48)))) (p 48) WeWeWeWe Wealth Manna nagememen ntn (p 51) OOOOBMOOOMO O Capit O CaCap O Capit tapital MaMar al Marrkerke etkeeke ets eMarrke (p (p 54) 3 CoCorp C Corpo oo orate Ste SSeServicce o cesce (p 57))) 7))57) t t NetNet et t income me e (p(p 33)) 6,166,6 6 7 6,718 88 555556561 10,922121 4,333 16.411141411 14.0%% (2.77)% 1616 063 16 0,0636 16,718 15,372 22 58587 10,,226 44,195 6.17 14.4.4.9%4...9%4...9% (0.1)0.1)))0.1)1)1)% 561 10,761 4,45 4,453 6.59.596 14144.4.4%% (1.6)% 1.6)%1.6)% 3573535 99 9,755 4,223 6.21 15.0%5.0% (0.3)% %%%%110.1%% 9.9%9% 100100.100.1% 9.9% 2,014 014 64486 855788558 1,0 9079 (( 3)3)193 1,81,812 2,022 2,02 22 81,1,88 82222 5815 08330 0 4 4 1,,040444 4 ((72) 66996 4888484 1,0 ,080 (((1(((1(((((111(1(1(1 (19193193193)3)3) 631 666 857575788 11,, ,0046 4466 (1(1333 ) 4,334,33333333 4,195 ,453 4,4,4,453 4,453 4,453 444,2,24,4,2222224,2 4 244 22232332222223232223 1 3, BBM On NovNovemevememove embmbmber 1, 2013, BBM 3, , , BBBMOBMMMO ado emve ardsrdsrds BBoBBoBoBoBoard. RR Accooccoo g Standard g S ard ccounountti ing thm wiiwittittitttht onononformrm wwwiwiwiwithithtwittttthth thhh th h on to con reclasassifi ed to to rrerec several alal new ananw an opted aaad ad amaaad ad amaaad ad and annanddndnnddndnnddndnnn an teed ed sever o ed al susuults for fis al 2 esesuults for fi Re. RResR 1313 ssca scal 2 isscall 2013 reseesprpprep s ppr s current yyyeyyeea curren enttnt y e ththe ccurre nt yyeeayyeaar’sear s ar’s p prprp prese amen uununnnuouunu nded acco nting pronoou menmemeunce e nnnnnnnnnnnnt nttts iss eceemceemeunce menmemeunce d accou d accoo coco oounouooou ounu y the ntstts iss ddd by thby the nnnnnnnnntnnntnnnts issuuedd nnnnnnnt nting pg ro nting pron pronnou pronou emen beeenbe be be beeehave aa aaccoccordirdinglng yygly.y. Cy. Cly. C aaaa ee en restated d een dd eee d ad ad aa r pppriprioprior-yea n on o innninnnaiaiainnnnnnn other ea ear data a ly. g Certa 2222 2 and 43. tiontt ion. S ion. n. tiottt S p g See pages pagpa es 42 42 sentat entat entat 2 3.3. Internati natioooonal ata has beeen en eee ddiiis re disss reareree diis A ll ltltltlts ar lttt areare non-GAG djuste d resuu Ad nd ar AAAAAAAAAP aP aP aand are nd ar ts ar ltlt djusted teded edd d red r AdAd Adjust t d resu ddd rese u d resu 2 cee eee onoonn a GAGA rformanncecece erreeerer sesses per nt sssses tt asttt anagegg Man rrrforrrrrfor rrr ttt sse s pepe emenment ent sssiness pee s gggggg o uus oi ongoiin iingng bu of underlyingg ggggying ance.e. rformance. eeeer og ogggggggggg og og oggggggggg oonoonoo ngoigoin nde derlying erlyingg lltsts.s. es e res eeeees resul emememmenmmmmennen entnnt t tnt seeeseseeeeee t asaass nt assss s sessss sess ssesss how managnageee w mana gegeeegeeeeee thtn ttn tt eded ined scussed scusse se scusseeeeded ttt ttt ththettthehttth d in t in t ss aas s a GAAP b baP baba basis nn nnntin e P Preese se e. P ennnnn NNe NNe NNee N ddandanaanan gggggggggng AAPGAAGA AA AAP Mea a asuure s ses ssess s n ppppagaggge 322 e 32.. . 32. seectcsectio ooonnonnnnn n n sectio NNoNon-GAGAGG MeaMe ea aeasure asure ssesresere seeee ses nnnnnn annn d on an nn an ddjuadadju djust sted bas annddasis a co derddeders bss b nnnnnnnann on an n a aadj stedstedst ss s onononssididdidd dd d s botothh h to bbee oooooooo ooooooo and nd cocococooooooo sulults sultsultsss g resu onos o bn s bbn on bobbbn bbn b bbotboth both base ee e des rre eadersrss s wrs wwiwititwwiwiithitittthh athh aaathhh d es pr dddovroovo idovovovidoro h th too e assese e usefeful ul in the assesseses oofof tandiding of tan a ba betett a bette bbettetter under undderserstat sseeessessessment Corrpo ices v vicess s s, inccc s, inc clcclc cludiudididiniini ginnnn vv oratratee Se Servrvrv rat orate S Co Corpora 3 ng Techh gng Techh hhhhnhnhh hnology hno and nd Ope ndandd d Opera ogy and Opera annd ooonoononoonnttatatitiiaatioioio s.snsnonns.nnnn eaa BankBBaananknk of MMMontreaal aaal b alal l B eents lists ththhehehhe e inhe hhhh sst stststatateme ththheh n sndnds nnbranb n iie ii iinterc c i corporararat zati atioation’s meems mem ooororgorgaann zaniza relreel lrellationships atioonships ationships te rrr ratrateatee re rrrrerrrerre bermb mb beb ber coo ooamoamomoaps apss pp BMOBM on pn p Note 28 oon nciacial l iFFiFiFin iFinanc p. No ououGroG ouGrouroGro p. Np NNo 171 6 76 o76 agpapa age 17 6 6 of ttt ote 28 on oot Noot 8 on al GGGrG l Gl G nci ppppupuuu p ies as BM ompampaaaa comcocoomoocoo ieieieiiienie FiMOMOMO FiMOOO FFiFi MO papaanana ieeeiei iiies. ntntntrea rea subsidiari iri sub itst eaaaeaaa eereaeeeaeaeaealal an al an l aand it caiicaicficfififi icant sususub ititss signi cant sub d iits sig nifnif nd nd id nt ok o of Mo f Mo ontMon annBan onon Ba ooong Ba ong Ba nnn ofof Moknnknnnn ok ooonk onn ok okknnnnaanaa s the oooo ethe cial nancial e financi nanci Not Just Any Bank Business Review IFC BMO at a Glance 2 10 Chairman’s Message 11 CEO’s Message 17 Senior Leadership Team 18 Corporate Governance 20 Board of Directors Financial Review 22 Reasons to Invest in BMO 23 CFO’s Foreword to the Financial Review Financial Performance and Condition at a Glance 24 121 Independent Auditors’ Report of Registered Public Accounting Firm 122 Report of Independent Registered Public Accounting Firm 123 Consolidated Financial Statements 128 Notes to Consolidated Financial 26 Management’s Discussion and Statements Analysis 106 Supplemental Information 120 Statement of Management’s Responsibility for Financial Information Resources and Directories 190 Glossary of Financial Terms 192 Where to Find More Information IBC Shareholder Information Real life doesn’t follow a script. Neither do we. What matters is making the right choices. Being part of something that’s growing. And staying a few steps ahead in a world of constant change. We get it. And we’re here to help. How we work. Set big goals. Keep aiming higher. At BMO’s annual Technology and Operations Leadership Conference, more than 300 senior leaders came together to collaborate on accelerating change for customers – through digital and physical channels, data and processes – while maintaining discipline in the areas of operational excellence and risk. “It’s a great opportunity for employees to come together and talk about taking our work to the next level,” says Jason Rhule, Mobility Specialist, Digital Workspace, pictured here with Jacquelyn van Kampen of MakeLab. We help people figure out today while planning for tomorrow. It’s about building confidence and trust – consistently and authentically. And it’s about embracing change. Welcoming disruption that inspires new ways of thinking. It’s 46,000 people pulling together and living what we believe. Seeing what’s possible – and taking it even further. This is what we do. 2 BMO Financial Group 197th Annual Report 2014 2 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 3 BMO Financial Group 197th Annual Report 2014 3 Everyone contributes. Here’s where we fit in. Following the publication of a BMO – The Boston Consulting Group report, Building a New Momentum in Montreal, BMO initiated the I see mtl movement in partnership with the Board of Trade of Metropolitan Montreal to reignite confidence in the city’s future. L. Jacques Ménard, chairman of BMO Nesbitt Burns and BMO’s Quebec president, is spearheading the drive to engage citizens and community, business and institutional leaders in a range of renewal initiatives: “The commitment to action by project leaders has exceeded all our expectations. With so many people mobilized to build the Montreal of tomorrow, revitalization is well underway.” In a healthy society, everyone expects a lot of each other. Business is more than a series of transactions. It’s a set of beliefs – the steps that guide you past the easy thing to the right thing. Responsibility isn’t just following the rules. It’s working to keep the system fair and accountable, while leading by example. 4 BMO Financial Group 197th Annual Report 2014 4 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 5 BMO Financial Group 197th Annual Report 2014 5 We serve individuals, businesses, governments and corporate customers across Canada and the United States. Our significant presence in North America is bolstered by operations in select global markets, including Europe and Asia, allowing us to provide our customers in North America with access to economies and markets around the world, and our customers in other countries with access to North America. The real thing. Times change. Values don’t. In a complicated, fast-moving world, honesty matters. So does integrity. And empathy, grounded in respect. This is how performance should be measured. Not by numbers alone, but by the values they reflect. And this is where our confidence comes from. The conviction, after nearly 200 years, that success is driven by our passion for helping others succeed – and that by working together, we’re building a better future. 6 BMO Financial Group 197th Annual Report 2014 6 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 7 BMO Financial Group 197th Annual Report 2014 7 A promise to help. That’s what it comes down to. United Alloy, Inc., a 15-year-old company specializing in metal fabrication and powder painting, employs more than 150 people in Janesville, Wisconsin – a town that was hit hard when a major auto plant closed in 2009. “With the bank’s help, we’ve added 135,000 square feet of manufacturing space,” says United Alloy founder Tom Baer, a BMO customer for three decades. “Our sales have more than doubled since 2011, and we expect them to double again in the next five years.” People’s lives and financial decisions are totally interconnected. Understanding how they’re linked requires more than ticking a few boxes. It’s a conversation. And it starts with listening. Customers want answers to the questions that matter. They want processes that make things simpler, and technologies that help them get where they need to go next. Helping is second nature for us. It’s the promise that drives everything we do. Because we know that people take money personally. And so do we. 8 BMO Financial Group 197th Annual Report 2014 8 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 9 BMO Financial Group 197th Annual Report 2014 9 Chairman’s Message Chief Executive Officer’s Message A Year of Clear Progress Taking Possibility Further The Board of Directors is pleased with BMO’s results, and confident about the year ahead. J. Robert S. Prichard Chairman of the Board William A. Downe Chief Executive Officer, BMO Financial Group Your bank has had another good year, with financial results that reinforce our confidence in the strategy we are pursuing. The core businesses of the bank continued to show strong growth, and all of us – the Board of Directors, our employees and our customers – are optimistic about the year ahead. We note, in particular, that the new businesses we have acquired in recent years – in U.S. Personal and Commercial Banking and in global Wealth Management – are already contributing to the bank’s performance and show great promise for the future. The introduction of the revitalized brand in the closing months of the year has captured the imagination of employees and customers alike. We’re here to help resonates with all of us in the ever-more-complex world of financial services. It nicely complements the bank’s culture of service, where our employees’ dedication and commitment to customers continue to be driving forces in our performance. I thank our employees for all they have done so well in the past year. On your behalf, I also want to acknowledge the efforts of the senior management team and the excellent leadership of our CEO, Bill Downe. Together, they have set clear strategic priorities for the bank, and delivered against them – more than doubling our annual earnings in the past five years and generating substantial returns for shareholders. and Bruce brought deep expertise and outstanding business judgment to the board. Both of them led board committees with great distinction and effectiveness, and they deserve much of the credit for BMO’s enviable record of excellence in corporate governance. We thank them for their leadership and exceptional service, which have made a lasting contribution to the strength of the bank. We will miss them. Achieving success in the current economic and financial environment is challenging. The industry is highly competitive and fast-changing – and uncertainty is inherent. While the global economy continues to improve, new risks are beginning to materialize. We are very conscious of these risks, and your Board of Directors considers risk assessment and risk management to be among its principal responsibilities. We remain confident that our measured approach and strong processes will allow us to make the most of the opportunities ahead as we continue to grow and strengthen the bank. And these opportunities are many. We look forward to working with Bill Downe and the leadership team to capitalize on them, while managing risk well, embracing innovation and paying close attention to our productivity performance. As your representatives, we thank all our shareholders for your continuing confidence in BMO and the direction we are headed. It is a privilege to serve you. This coming year will see the retirement from the board of two long-serving and exemplary directors: Bob Astley, who joined the board in 2004, and Bruce Mitchell, who joined in 1999. Bob J. Robert S. Prichard Each year we use this introductory section of our annual report to summarize the accomplishments of the past 12 months, which are detailed in the Management’s Discussion and Analysis (MD&A) that follows. We also use these pages to present a clear point of view about the world in which we live, the things we believe really matter and what we think it all means for our business. Whether you’re a customer, a shareholder, an employee or a stakeholder in the broader community, we want you to understand the strategy of the bank, the action plan that supports that strategy and its relevance to the issues that we understand matter to you. This consistent performance has been driven by a disciplined growth strategy and guided by a set of clear strategic priorities. But it also reflects something more – a difference in how people across this organization think, act and work together. Corporate culture is difficult to capture in a checklist or a questionnaire, but it is a topic directly related to trust – the most valuable capital a bank maintains. It is revealed in the beliefs that a company has committed to uphold and in the actions of the people who work there. And it is mirrored in the aspiration to grow revenue and profit in a way that respects all stakeholders. As the Chairman has captured in his message, 2014 was a year of tremendous progress in moving forward the agenda of the bank. We reported strong financial results and continued to build on the momentum in each of our operating businesses. In the year, BMO Financial Group generated $4.5 billion in adjusted net income, declared $2 billion in dividends and increased retained earnings by $2.2 billion, strengthening the balance sheet to finish the year with a Common Equity Tier 1 Ratio of 10.1%. We also completed the $1.3 billion acquisition of F&C Asset Management plc, moving BMO into the global top 50 in institutional money management. Our total shareholder return for the year was 17.1%. Since 2009, we have increased adjusted earnings per share by over 60% to $6.59 and increased book value per share from $32 to $48. The primacy of the customer isn’t optional In last year’s annual report we made the point that expectations are changing, in real time, across virtually every area of contemporary society. And we looked at how BMO is evolving to meet the emerging expectations of our stakeholders. The forces we discussed a year ago continue to affect all industries. Changes in consumer behaviour – driven most notably by the confluence of mobile networks, rapid digitization, customer analytics and cloud-based computing – are transforming the competitive landscape, prompting reviews of long-held business models and, naturally, inviting new entrants. We’re seeing all of this in banking. 10 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 11 Chief Executive Officer’s Message In a world where information is so readily exchanged, who you are and what you stand for is visible to everyone. The way forward can only be guided by a coherent view of how we’re going to act. The past 12 months sharpened our explanation of what’s unique about BMO’s response to a changing world. It meant defining how to meaningfully serve customers while fulfilling our larger responsibilities – and here we’ve established a clear perspective. It also meant balancing ambition with inclusiveness and the values that endure, and using that experience to create competitive advantage. Finally, it was about maintaining the conviction to direct all dimensions of our business – our talent, capabilities, capital and reputation – toward the ultimate goal of helping customers succeed. These efforts have led us to elevate the brand of the bank around what we know: that money is personal. It holds that customers want to make better decisions with better information and have confidence in the decisions they make. But they also want to feel understood. For a brand to be valuable, it must provide a consistent experience, defined by a common set of ideals, across every customer touch point. The pages that precede this letter outline exactly what we think those ideals are. The primacy of the customer is our focus. Nothing is more vital to us. We build our business around what we think is most important, because in a world where information is so readily exchanged, who you are and what you stand for are visible to everyone. The way forward can only be guided by a coherent view of how we’re going to act. Adjusted Revenue ($ Billions) Adjusted Net Income ($ Billions) Adjusted ROE (%) Basel III Common Equity Tier 1 Ratio (%) 14.9 15.4 16.7 4.1 4.2 4.5 15.5 15.0 14.4 8.7 9.9 10.1 2012 2013 2014 2012 2013 2014 2012 2013 2014 2012* 2013 2014 * 2012 CET1 Ratio is on a pro-forma basis. Predicting what’s in store The accelerating pace of change is not news – it’s the everyday reality that frames how we conduct our business. We have built that fact into our planning. It’s what allows us to take action in the face of uncertainty while acknowledging that the future will be difficult to reliably predict. Advances in computing, networked communications and the digitization of everything are transforming the lives of consumers, as well as the knowledge and skills that people need to be successful in their work. This is creating both extraordinary opportunity and unprecedented challenges for businesses, including our own. The breadth and velocity of these changes, admittedly, will be disruptive. The competitive playing field is being reshaped by a growing number of new entrants, while incumbents are revisiting models that have long been taken for granted. In this way, disruption is acting as a catalyst for positive change: it reveals areas of potential and inspires innovation along alternative vectors, even as we reinvest in proven models. And while such a rapid evolution also brings uncertainty, the one truth we can count on is that the customer – empowered by digital platforms, mobile technologies and social networks – will dictate how banking is going to work. The customer remains at the centre of the five strategic priorities that guide our bank (see sidebar). As we continue our efforts to drive productivity, leverage our North American platform and support our customers where they operate, including key global markets such as China – all while maintaining a prudent approach to risk – every decision we make points back to our fundamental promise to the people with whom we do business. We continue to take the longer view over short-term tactics and in this context are evolving the way we operate. Protecting customer records and information, and ensuring accuracy and system availability; marshalling technology’s ability to provide improved customer experiences at lower cost; enhancing our use of Our strategic priorities 1 Achieve industry-leading customer loyalty by delivering on our brand promise. 2 3 4 5 Enhance productivity to drive performance and shareholder value. Leverage our consolidated North American platform to deliver quality earnings growth. Expand strategically in select global markets to create future growth. Ensure our strength in risk management underpins everything we do for our customers. 12 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 13 Chief Executive Officer’s Message technology to manage the bank better, automate processes and reduce costs to drive competitive advantage – these are strategic competencies we work on every single day. Likewise, we are managing a great deal more data than before – and our first job is to protect our customers and their ever-growing trail of digital information. Our bank is strong in all of these areas and has the necessary capabilities to lead the way. And like our customers, we can’t help but be enthused by new technologies. In 2014, the next release of BMO’s top-rated mobile banking app reinforced our position as an industry leader. The volume of sales transactions that our customers conduct online is now equivalent to more than 120 retail branches. We’re also providing bite-sized financial management right on customers’ mobile devices, as we anticipate the questions that often arise in the moment. The next wave of mobile capabilities is already having an impact on consumers’ lives. Receiving travel alerts at the airport; tracking personal health and fitness on the move; being told that the item you viewed online is available when you walk into a store – such innovations are now par for the course. They are everywhere you look. While companies launched in the digital era create products and services that are remarkably convenient, many are still largely unregulated. It is a fact that some customers are ready and willing to pay with a smartphone instead of a plastic card at the checkout counter and transfer money through social media. These capabilities will inevitably become part of nearly every bank’s product mix – ours included. But they are not everything. The relevance of human interaction has actually increased. Our industry just reached a tipping point this year: retail transaction volume for transactions such as transfers and In the coming year, we’ll continue that momentum: • Testing touchless ABMs in the U.S. that allow customers to type in their transaction details on a smartphone app and then scan a Quick Response code on the ABM screen to conduct the transaction, replacing the need for a card. • Testing video ABMs that offer direct access to bankers anytime for additional information and help. • Launching Apple Pay for customers of BMO Harris Bank, enabling them to pay for purchases using their iPhones in a secure and contactless transaction that doesn’t require sharing their debit and credit card numbers with merchants. • Experimenting with MasterPass™ by MasterCard®, which lets customers easily check out online purchases – a shop-and-click experience that stores all of their payment and shipping information in one convenient and secure place. Diversified business mix with retail focus 38% Canadian P&C Banking 22% BMO Capital Markets 22% Wealth Management 18% U.S. P&C Banking 2014 Revenue by Operating Group1 (C$) Over 75% of revenue from retail businesses1 All of these experiences have to be frictionless. We’re very familiar with that, too. 1 Excludes Corporate Services revenue bill payments was higher through digital channels than ABMs in Canada – something that has been true in the U.S. for some time. But the vast majority of customers still prefer to drop by a branch to open an account or arrange a mortgage – and for now, this is independent of age or geography. In the end, keeping pace with human change means a lot of things. Fundamentally, it’s a question of embracing progress, but not without thinking about its implications. As a bank, we will continue to make the required trade- offs and let go of the parts that are less relevant to stakeholders. And we will continue to insist on behaviours that lead to high trust. Because it’s what we have always done. Measuring our performance BMO’s performance in fiscal 2014 confirms the value of this work and can be measured in financial terms. Results from our four principal business groups reflect the momentum flowing from investments we have been making over the past several years as we execute the bank’s customer- focused strategy: Canadian Personal and Commercial Banking had a record year, with over $2 billion in earnings and operating leverage of 2%. Our largest business continued to deliver good balance sheet growth and improved efficiency. U.S. Personal and Commercial Banking finished fiscal 2014 with good momentum and growth, demonstrating improved revenue and earnings trends in the second half. Commercial lending continues to be strong, the small- business segment is moving forward and retail banking is coming to life. Wealth Management has been the fastest-growing operating group in the bank over the past five years, growing from 17% of the bank’s operating group revenue to 22% in that period. BMO’s expanded global asset management business continues to innovate and diversify across its distinctive product offering. It’s a question of embracing progress, but not without thinking about its implications. Capital Markets generated over $1 billion in earnings, with a strong ROE of 19%. We’ve made good progress in growing Corporate & Investment Banking, improving the balance with sales and trading, and enhancing our business across an integrated North American platform with an increased contribution from the U.S. The results we’re seeing today reflect the consistent performance of the 46,000 people who work here and the overall soundness of our strategy. Four years ago, we made a decision to strengthen BMO’s continental advantage as a North American bank, with a footprint spanning strong regional economies. We’re realizing the full value of our investment through continued earnings growth. Progress in the most recent fiscal year can be credited to decisions made two and three years ago. We can’t ignore continuing adjustment in markets across the world but remain confident in the capacity of the system to adjust and innovate – and in our ability to remain relevant and profitable in all market conditions, good or bad. The bank’s progress is sustainable, because our commitment to generate a fair return for shareholders is in balance with the need to provide high-quality products at an optimal price, and to invest in a talented, well-trained workforce. As digital sales continue to grow, we are defining a path to improve relative efficiency and, at the same time, a differentiated position in customer loyalty. In all of our decision-making, we weigh what is necessary against what is possible, determining where financial performance intersects with social responsibility. 14 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 15 Chief Executive Officer’s Message We are here to help With a larger sense of responsibility comes the recognition that if we embrace and promote change, we must also play a role in addressing its broader consequences. The digital revolution is opening up unprecedented avenues of opportunity. It is also radically altering the very nature of work. The evolution of BMO’s brand promise states clearly what we expect of ourselves as we deliver on what customers expect of our bank: to be highly regarded by those who know us – with industry-leading loyalty – and to offer a welcome alternative for prospective customers. We share the essential optimism that characterizes our society and the confident belief in tomorrow that drives its architects, innovators and entrepreneurs. And while BMO’s brand may seem like a promise made strictly to our customers, it is in fact a promise to all stakeholders intended to successfully capture the issues that are important to them. Ultimately, we want to be a company whose shares you will confidently hold for a very long time, for the same reason that customers reward us with their loyalty – because we understand that money is personal, and a bank should be, too. William A. Downe Chief Executive Officer, BMO Financial Group Our strategic footprint BMO’s strategic footprint spans strong regional economies. Our three operating groups serve individuals, businesses, governments and corporate customers right across Canada and in six U.S. Midwest states – Illinois, Indiana, Wisconsin, Minnesota, Missouri and Kansas – as well as in other select locations in the United States. Our significant presence in North America is bolstered by operations in select global markets, including Europe and Asia, allowing us to provide our customers in North America with access to economies and markets around the world, and our customers in other countries with access to North America. YT NT BC AB WA OR CA UT AZ NU SK MB ON MN WI NE CO KS MO IL IN VA TX GA FL A key area of focus in 2014 was the evolution of BMO’s brand. Headed by Chief Operating Officer Frank Techar, this initiative set the stage for a company-wide conversation, bringing together thousands of employees – through workshops and vibrant, unfiltered online discussions – to help answer the question: How do we effectively demonstrate our brand to our customers? Together, our employees developed a clear set of actions and behaviours that bring our brand to life. Senior Leadership Team Jean-Michel Arès Chief Technology & Operations Officer, BMO Financial Group Christopher Begy U.S. Country Head & Chief Executive Officer, BMO Financial Corp. William Downe Chief Executive Officer, BMO Financial Group Simon Fish General Counsel, BMO Financial Group Thomas Flynn Chief Financial Officer, BMO Financial Group Cameron Fowler Group Head, Canadian Personal and Commercial Banking, BMO Financial Group Mark Furlong Group Head, U.S. Personal and Commercial Banking and Chief Executive Officer, BMO Harris Bank N.A. Carol Neal Chief Auditor, BMO Financial Group Gilles Ouellette Group Head, Wealth Management Surjit Rajpal Chief Risk Officer, BMO Financial Group Joanna Rotenberg Chief Marketing Officer and Head of Strategy, BMO Financial Group Richard Rudderham Chief Human Resources Officer, BMO Financial Group Connie Stefankiewicz Head, North American Channel Strategy and Solutions, BMO Financial Group Frank Techar Chief Operating Officer, BMO Financial Group Darryl White* Group Head, BMO Capital Markets * Effective November 1, 2014. NL QC NY MA NB PE NS Core footprint Other locations: U.S. Personal and Commercial Banking Core footprint Wealth Management Other locations: U.S. Personal and Commercial Banking BMO Capital Markets Wealth Management BMO Capital Markets 16 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 17 Corporate Governance Good corporate governance matters to our shareholders, our customers, our employees, our communities – and to us. We strive to meet rigor- ous standards of corporate governance, following the best practices in our industry and meeting or going beyond regulatory requirements. Our board oversees our business The board operates independently of management Our Board of Directors supervises how we manage our business and affairs. Its members have sophisticated expertise and a range of perspectives. The board makes decisions based on BMO’s strategies, core values, and the best information available. Its decisions emphasize long- term performance over short-term gain. The Globe and Mail’s Board Games 2014 annual review of corporate governance practices in Canada ranked BMO first overall among the 247 companies and income trusts in the S&P/ TSX Composite Index. The Chairman of the Board and our directors, other than the Chief Executive Officer, operate independently of management. Board meetings include time for the independent directors to meet without management or non-independent directors present. To reflect our customers and our values, our board is diverse The diverse backgrounds of our directors connect us with our customers, our markets and our employees. We believe this diversity also means we make better decisions. Our Board Diversity Policy received a 2013 Diversity in Governance Award presented by the Canadian Board Diversity Council. We compensate our directors and executives in ways that encourage good decisions in the organization to the Audit and Conduct Review Committee of the board. Our model for compensating directors and executives follows best practices for good governance. We use a pay-for-performance model that includes clawbacks and discourages unreasonable risk-taking. Directors and executives must own shares, to align their interests with those of other shareholders. We do not allow directors and employees to hedge their investments in our shares, securities or related financial instruments. We maintain a strong focus on ethical conduct BMO’s Code of Business Conduct and Ethics provides ethical guidance for the organization and is rooted in our core values. Every year, all directors and employees are required to declare that they have read, understood, complied with and will continue to comply with the code. The code is approved by our Board of Directors. The Chief Ethics Officer is responsible for ensuring that awareness and understanding of ethical business principles are embedded in all aspects of our business, and regularly reports on the state of ethical conduct An ethical culture requires an environment where concerns can be raised without fear of retaliation. We provide various means for raising concerns, including the ability to report them on an anonymous basis. All reports are investigated, and breaches of the code are dealt with swiftly and decisively. Our board and management stay connected with our shareholders We engage and inform our shareholders through our annual meeting of shareholders, annual report, management proxy circular, annual information form, sustainability report, corporate responsibility report, quarterly reports, news releases, earnings conference calls, industry conferences and other meetings from time to time. Our website provides extensive information about the board, its mandate, the board committees and their charters, and our directors. 18 BMO Financial Group 197th Annual Report 2014 18 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 19 BMO Financial Group 197th Annual Report 2014 19 Board of Directors1 To promote alignment of our strategic goals across all our businesses, each director sits on at least one board committee and the Chief Executive Officer is invited to all committee meetings. We review the membership of all committees annually. www.bmo.com/corporategovernance Financial Review Dr. Martha C. Piper, O.C., O.B.C. Corporate Director, former President and Vice-Chancellor, The University of British Columbia Board/Committees: Governance and Nominating (Chair), Human Resources Other public boards: Shoppers Drug Mart Corporation, TransAlta Corporation Director since: 2006 J. Robert S. Prichard, O.C., O.Ont. Chairman of the Board, BMO Financial Group, and Chair of Torys LLP Board/Committees: Governance and Nominating, Human Resources, Risk Review, The Pension Fund Society of the Bank of Montreal Other public boards: George Weston Limited, Onex Corporation Director since: 2000 Don M. Wilson III Corporate Director Board/Committees: Governance and Nominating, Human Resources, Risk Review (Chair) Director since: 2008 1 As at October 31, 2014. Robert M. Astley Former President and Chief Executive Officer, Clarica Life Insurance Company, and former President, Sun Life Financial Canada Board/Committees: Human Resources, Risk Review, The Pension Fund Society of the Bank of Montreal Director since: 2004 Janice M. Babiak Former Managing Partner, Ernst & Young Board/Committees: Audit and Conduct Review, Risk Review Other public boards: Experian PLC, Walgreens Co. Director since: 2012 Sophie Brochu President and Chief Executive Officer, Gaz Métro Board/Committees: Audit and Conduct Review Other public boards: BCE Inc. Director since: 2011 George A. Cope President and Chief Executive Officer, Bell Canada and BCE Inc. Board/Committees: Human Resources Other public boards: BCE Inc. Director since: 2006 Christine A. Edwards Capital Partner, Winston & Strawn Board/Committees: Governance and Nominating, Risk Review, The Pension Fund Society of the Bank of Montreal (Chair) Director since: 2010 Ronald H. Farmer Managing Director, Mosaic Capital Partners Board/Committees: Audit and Conduct Review, Governance and Nominating, Human Resources (Chair) Other public boards: Valeant Pharmaceuticals International Inc. Director since: 2003 Eric R. La Flèche President and Chief Executive Officer, Metro Inc. Board/Committees: Risk Review Other public boards: Metro Inc. Director since: 2012 Bruce H. Mitchell President and Chief Executive Officer, Permian Industries Limited Board/Committees: Audit and Conduct Review, The Pension Fund Society of the Bank of Montreal Director since: 1999 William A. Downe Chief Executive Officer, BMO Financial Group Board/Committees: Attends all committee meetings as an invitee Other public boards: ManpowerGroup Director since: 2007 Philip S. Orsino, O.C., F.C.A. President and Chief Executive Officer, Brightwaters Strategic Solutions Inc. Board/Committees: Audit and Conduct Review (Chair), Governance and Nominating Director since: 1999 Honorary Directors Stephen E. Bachand, Ponte Vedra Beach, FL, USA Ralph M. Barford, Toronto, ON Matthew W. Barrett, O.C., LL.D., Oakville, ON David R. Beatty, O.B.E., Toronto, ON Peter J.G. Bentley, O.C., O.B.C., LL.D., Vancouver, BC Robert Chevrier, F.C.A., Montreal, QC Tony Comper, C.M., LL.D., Toronto, ON C. William Daniel, O.C., LL.D., Toronto, ON Louis A. Desrochers, C.M., c.r., A.O.E., Edmonton, AB A. John Ellis, O.C., LL.D., O.R.S., Vancouver, BC John F. Fraser, O.C., LL.D., O.R.S., Winnipeg, MB David A. Galloway, Toronto, ON Richard M. Ivey, C.C., Q.C., Toronto, ON Betty Kennedy, O.C., LL.D., Campbellville, ON Harold N. Kvisle, Calgary, AB Eva Lee Kwok, Vancouver, BC J. Blair MacAulay, Oakville, ON Ronald N. Mannix, O.C., Calgary, AB Robert H. McKercher, Q.C., Saskatoon, SK Eric H. Molson, Montreal, QC Jerry E.A. Nickerson, North Sydney, NS Jeremy H. Reitman, Montreal, QC Lucien G. Rolland, O.C., Montreal, QC Joseph L. Rotman, O.C., LL.D., Toronto, ON Guylaine Saucier, F.C.P.A., F.C.A., C.M., Montreal, QC Nancy C. Southern, Calgary, AB Robert M. Astley Janice M. Babiak Sophie Brochu George A. Cope William A. Downe Christine A. Edwards Ronald H. Farmer Eric R. La Flèche Bruce H. Mitchell Philip S. Orsino Dr. Martha C. Piper J. Robert S. Prichard Don M. Wilson III 20 BMO Financial Group 197th Annual Report 2014 Financial Review 22 Reasons to Invest in BMO 23 24 CFO’s Foreword to the Financial Review Financial Performance and Condition at a Glance Management’s Discussion and Analysis 26 106 Supplemental Information 120 Statement of Management’s Responsibility 121 for Financial Information Independent Auditors’ Report of Registered Public Accounting Firm 122 Report of Independent Registered Public Accounting Firm Consolidated Financial Statements 123 128 Notes to Consolidated Financial Statements Resources and Directories 190 Glossary of Financial Terms 192 Where to Find More Information IBC Shareholder Information BMO Financial Group 197th Annual Report 2014 21 Reasons to Invest in BMO CFO’s Foreword to the Financial Review We are committed to telling our financial story clearly and thoroughly with high standards of governance and transparency. Thomas E. Flynn Chief Financial Officer, BMO Financial Group BMO’s results in 2014 reflect good operating group performance and the momentum we have demonstrated over a number of consecutive quarters. BMO delivered record net income of $4.3 billion this year. On an adjusted basis, net income was up 5% to $4.5 billion. During the year, we grew adjusted EPS by 6%, announced two dividend increases, completed the acquisition of F&C Asset Management plc and strengthened our capital position. We continue to generate attractive returns for BMO’s shareholders. Our one-year and five-year total shareholder returns were 17.1% and 15.5%, respectively. We have a long-standing commitment to ensuring that investors receive timely and informative reporting on our financial results. In Management’s Discussion and Analysis (MD&A), we examine our results and performance in detail. We are committed to telling our financial story clearly and thoroughly with high standards of governance and transparency. Our disclosures have been expanded over the past two years, reflecting in part recommendations issued by the Enhanced Disclosure Task Force (EDTF) of the Financial Stability Board. We support the recommendations of the EDTF and trust that the additional disclosures will be informative. We have an advantaged business mix, geographic diversification and a customer vision that continues to provide attractive opportunities for growth: • Our proven strength in commercial banking across our North American platform positions us well in the current economic environment. • Our largest business, Canadian Personal and Commercial Banking, had a record year with earnings of over $2 billion and 2% positive operating leverage. • We have an award-winning wealth franchise with growth opportunities in North America and in select global markets. • Against the backdrop of an improving U.S. economy, we expect continued growth from the investments we have made in our U.S. businesses. • We are focused on improving efficiency through our core operations and technology integration. Looking forward, we intend to build on our success this year, continuing to manage our business responsibly while executing on our strategic priorities to deliver on our commitments to all of our stakeholders. · Clear opportunities for growth across North America · Large North American commercial banking business · Good momentum in our well-established Canadian Personal and Commercial Banking business · Award-winning wealth franchise with strong growth opportunities · Operating leverage across our U.S. businesses · Strong capital position and an attractive dividend yield · Focus on efficiency through core operations and technology integration · Industry-leading customer loyalty and a focus on customer experience · Committed to the highest standards of business ethics and corporate governance 22 BMO Financial Group 197th Annual Report 2014 22 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 23 Thomas E. Flynn Financial Performance and Condition at a Glance Our Performance (Note 1) Peer Group Performance Our Performance (Note 1) Peer Group Performance Total Shareholder Return (TSR) • BMO shareholders have earned a strong average annual return of 16.7% over the past three years, above the 9.3% return on the S&P/TSX Composite Index. • The one-year TSR of 17.1% and the five-year average annual return of 15.5% both outperformed the comparable Canadian indices. P 31 16.7 11.5 10.8 Graph shows average annual three-year TSR. 2012 2013 2014 Earnings per Share (EPS) Growth • Adjusted EPS grew $0.38 or 6% to $6.59, reflecting higher P 33 earnings. Reported EPS grew $0.24 or 4% to $6.41. • On an adjusted basis, higher revenues exceeded incremental costs in 2014. There were higher provisions for credit losses, primarily due to lower recoveries, as well as lower securities gains and a lower effective tax rate. 26 17 1 4 4 6 TSR (%) • The Canadian peer group three-year average annual TSR was 18.0%. The one-year TSR was 18.8% and the five-year average annual TSR was 15.1%. • The North American peer group three-year average annual TSR was 26.0%, above the Canadian peer group average. The North American peer group one-year TSR of 18.0% and five-year average annual TSR of 13.5% were both below the corresponding Canadian peer group averages. EPS Growth (%) • The Canadian peer group average EPS growth was 8%, with all but one bank in the peer group reporting increases in EPS. • Average EPS growth for the North American peer group was 12%, driven by lower provisions for credit losses for the majority of our U.S. peer banks. All EPS measures are stated on a diluted basis. 2012 2013 2014 North American peer group data is not to scale. Return on Equity (ROE) • Adjusted ROE was 14.4% and reported ROE was 14.0% in 2014, compared with 15.0% and 14.9%, respectively, in 2013. There was growth in both earnings and adjusted earnings available to common shareholders. There was also an increase in average common shareholders’ equity as a result of increased capital expectations for banks internationally. • BMO has achieved an ROE of 13% or better in 24 of the past 25 years. Revenue Growth • Adjusted revenue increased $1,346 million or 9% in 2014 to $16,718 million. Reported revenue increased $655 million or 4% to $16,718 million. The increase was mainly due to revenue growth in Canadian P&C, Wealth Management and BMO Capital Markets. P 34 P 36 P 41 Efficiency Ratio (Expense-to-Revenue Ratio) • The adjusted efficiency ratio was 64.4%, an increase of 90 basis points from 2013. The reported efficiency ratio increased 160 basis points to 65.3%, as revenue growth was more than offset by expense growth, in part due to the impact of the stronger U.S. dollar and the acquired F&C business. • The adjusted efficiency ratio excluding PBCAE* improved to 59.1% in 2014, compared with 60.4% in 2013. 15.9 15.5 14.9 15.0 14.0 14.4 ROE (%) • The Canadian peer group average ROE of 17.3% was lower than the average return of 18.4% in 2013, as ROE declined for all but one bank in the peer group. • Average ROE for the North American peer group was 12.2%, relatively unchanged from 2013. 2012 2013 2014 14 8 9 4 3 1 2012 2013 2014 63.6 63.3 63.7 63.5 65.3 64.4 Revenue Growth (%) • Revenue growth for the Canadian peer group averaged 9%, significantly higher than the average growth of 4% in 2013. • Average revenue growth for the North American peer group was 1%, a decline from 3% in 2013, with all but one of our U.S. peers reporting flat or lower revenues. Effi ciency Ratio (%) • The Canadian peer group average efficiency ratio was 59.5%, up slightly from 59.3% in 2013 as growth in expenses exceeded growth in revenue. • The average efficiency ratio for the North American peer group was 62.6%, relatively unchanged from the group’s average ratio of 62.7% in 2013, and worse than the average of our Canadian peer group. P 40, 86 Credit Losses • Provisions for credit losses (PCL) totalled $561 million, up from $357 million in 2013 on an adjusted basis and down from $587 million in 2013 on a reported basis. The increase in adjusted PCL was due to a significant reduction in recoveries on the purchased credit impaired loan portfolio and the impact of provisions on the purchased performing loan portfolio, offset in part by reduced provisions in Canadian P&C and U.S. P&C. • PCL as a percentage of average net loans and acceptances improved to 19 basis points from 22 basis points on a reported basis a year ago. This positive ratio trend reflects lower new provisions across both our consumer and commercial loan portfolios, compared to 2013. P 86 Impaired Loans • Gross impaired loans and acceptances (GIL) decreased to $2,048 million from $2,544 million in 2013, and represented 0.67% of gross loans and acceptances, compared with 0.91% a year ago. • Formations of new impaired loans and acceptances, a key driver of provisions for credit losses, totalled $2,142 million, down from $2,449 million in 2013, reflecting decreases in the formations in both our consumer and commercial portfolios. 0.31 0.22 0.19 2012 2013 2014 1.17 0.91 0.67 Capital Adequacy • BMO’s Common Equity Tier 1 (CET1) Ratio is strong and exceeds regulatory requirements. • Our CET1 Ratio was 10.1%, up from 9.9% in 2013, primarily due to higher capital, partially offset by the impact of the F&C acquisition and a moderate increase in risk-weighted assets. 2012 2013 2014 P 34, 64 9.9 10.1 8.7 *2012 CET1 Ratio is on a pro-forma basis. 2012* 2013 2014 Provision for Credit Losses as a % of Average Net Loans and Acceptances • The Canadian peer group average PCL represented 31 basis points of average net loans and acceptances, down slightly from 33 basis points in 2013. • The North American peer group average PCL represented 26 basis points, down from 36 basis points in 2013, and lower than the average PCL for the Canadian peer group. Gross Impaired Loans and Acceptances as a % of Gross Loans and Acceptances • The Canadian peer group average ratio of GIL as a percentage of gross loans and acceptances was 0.59% in 2014, down slightly from 0.60% in 2013. • The average ratio for our North American peer group improved from 1.77% a year ago to 1.40% in 2014, but continues to be higher than the average for the Canadian peer group. Capital Adequacy • The Canadian peer group average Basel III CET1 Ratio was 9.9% in 2014, compared with an average CET1 Ratio of 9.2% a year ago. • The basis for computing capital adequacy ratios in Canada and the United States is not completely comparable. P 100 Credit Rating • Credit ratings for BMO’s long-term debt, as assessed by the four major rating agencies, are listed below and all four ratings are considered to indicate high-grade, high-quality issues. In June 2014, Moody’s affirmed its long-term ratings and changed its outlook to “negative” from “stable” on the supported senior debt and uninsured deposit ratings of BMO and six other large Canadian banks in light of previously announced plans by the Canadian federal government to implement a bail-in regime for domestic systemically important banks. In August 2014, S&P affirmed its long-term and short-term issuer credit ratings of BMO and revised its outlook for BMO and other Canadian banks to “negative” from “stable”, reflecting the possible impact of a bail-in policy proposal from the Canadian federal government. Credit Rating • The Canadian peer group median credit ratings were unchanged from 2013. • The North American peer group median credit ratings were unchanged from 2013, and remain slightly lower than the median of the Canadian peer group for two of the ratings. BMO Financial Group Canadian peer group median* North American peer group median* DBRS Fitch Moody’s S&P 2012 AA AA– Aa2 A+ 2013 AA AA– Aa3 A+ 2014 AA AA– Aa3 A+ DBRS Fitch Moody’s S&P 2012 AA AA– Aa2 AA– 2013 AA AA– Aa3 A+ 2014 AA AA– Aa3 A+ DBRS Fitch Moody’s S&P 2012 AAL AA– Aa3 A+ 2013 AAL AA– A1 A+ 2014 AAL AA– A1 A+ * This ratio is calculated excluding insurance policyholder benefits, claims and acquisition expenses (PBCAE). 2012 2013 2014 *Data for all years refl ects the peer group composition in the most recent year. Note 1: Adjusted results in this section are non-GAAP. Please see the Non-GAAP Measures section on page 32. In 2013, we changed the methodology for the Canadian and North American peer group averages to a simple-average calculation from a weighted-average calculation, and restated prior periods. On November 1, 2013, BMO and our Canadian peers adopted several new and amended accounting pronouncements issued by the International Accounting Standards Board. The consolidated fi nancial statements for comparative periods in the fi scal years 2013 and 2012 have been restated. U.S. peer group data continues to be reported in accordance with U.S. GAAP. BMO reported BMO adjusted Canadian peer group average North American peer group average The Canadian peer group averages exclude BMO and are based on the performance of Canada’s fi ve other largest banks: Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, Scotiabank and TD Bank Group. The North American peer group averages are based on the performance of 12 of the largest banks in North America. These include the Canadian peer group, except National Bank of Canada, as well as BB&T Corporation, Bank of New York Mellon, Fifth Third Bancorp, KeyCorp, The PNC Financial Services Group Inc., Regions Financial, SunTrust Banks Inc. and U.S. Bancorp. Results are as at or for the years ended October 31 for Canadian banks and as at or for the years ended September 30 for U.S. banks. BMO reported BMO adjusted Canadian peer group average North American peer group average 24 BMO Financial Group 197th Annual Report 2014 BMO Financial Group 197th Annual Report 2014 25 MANAGEMENT’S DISCUSSION AND ANALYSIS Management’s Discussion and Analysis BMO’s Chief Executive Officer and its Chief Financial Officer have signed a statement outlining management’s responsibility for financial information in the annual consolidated financial statements and Management’s Discussion and Analysis (MD&A). The statement, which can be found on page 120, also explains the roles of the Audit and Conduct Review Committee and Board of Directors in respect of that financial information. The MD&A comments on BMO’s operations and financial condition for the years ended October 31, 2014 and 2013. The MD&A should be read in conjunction with our consolidated financial statements for the year ended October 31, 2014. The MD&A commentary is as of December 2, 2014. Unless otherwise indicated, all amounts are stated in Canadian dollars and have been derived from financial statements prepared in accordance with Interna- tional Financial Reporting Standards (IFRS). References to generally accepted accounting principles (GAAP) mean IFRS. Since November 1, 2011, BMO’s financial results have been reported in accordance with IFRS. Results for years prior to 2011 have not been restated and are presented in accordance with Canadian GAAP as defined at that time (CGAAP). As such, certain growth rates and compound annual growth rates (CAGR) may not be meaningful. On November 1, 2013, BMO adopted several new and amended accounting pronouncements issued by the International Accounting Standards Board. The consolidated financial statements for comparative periods in the fiscal years 2013 and 2012 have been restated. The impact of adoption is discussed in Note 1 on page 128 of the financial statements. Certain other prior year data has also been reclassified to conform with the current year’s presentation, including restatements arising from methodology changes and transfers of certain busi- nesses between operating groups. See pages 42 and 43. A & D M Index 27 Who We Are provides an overview of BMO Financial Group, explains the links between our financial objectives and our overall vision, and outlines “Reasons to Invest in BMO” along with relevant key perform- ance data. 28 Enterprise-Wide Strategy outlines our enterprise-wide strategy and the context in which it is developed, as well as our progress in relation to our priorities. 29 Caution Regarding Forward-Looking Statements advises readers about the limitations and inherent risks and uncertainties of forward- looking statements. 30 Economic Developments and Outlook includes commentary on the Canadian, U.S. and international economies in 2014 and our expect- ations for 2015. 31 Value Measures reviews financial performance on the four key measures that assess or most directly influence shareholder return. It also includes explanations of non-GAAP measures, a reconciliation to their GAAP counterparts for the fiscal year, and a summary of adjusting items that are excluded from results to assist in the review of key measures and adjusted results. Total Shareholder Return Non-GAAP Measures Summary Financial Results and Earnings per Share Growth Return on Equity Basel III Common Equity Tier 1 Ratio 31 32 33 34 34 35 2014 Financial Performance Review provides a detailed review of BMO’s consolidated financial performance by major income statement category. It also includes summaries of the impact of business acquis- itions and changes in foreign exchange rates. 42 2014 Operating Groups Performance Review outlines the strategies and key priorities of our operating groups and the challenges they face, along with their strengths and value drivers. It also includes a summary of their achievements in 2014, their focus for 2015, and a review of their financial performance for the year and the business environment in which they operate. 42 44 45 48 51 54 57 Summary Personal and Commercial Banking Canadian Personal and Commercial Banking U.S. Personal and Commercial Banking BMO Wealth Management BMO Capital Markets Corporate Services, including Technology and Operations 58 Summary Quarterly Earnings Trends, Review of Fourth Quarter 2014 Performance and 2013 Financial Performance Review provide commentary on results for relevant periods other than fiscal 2014. 62 62 64 69 70 71 71 73 73 73 73 74 75 77 78 78 80 84 91 95 101 102 102 103 103 104 105 105 106 Financial Condition Review comments on our assets and liabilities by major balance sheet category. It includes a review of our capital adequacy and our approach to optimizing our capital position to support our business strategies and maximize returns to our share- holders. It also includes a review of off-balance sheet arrangements and certain select financial instruments. Summary Balance Sheet Enterprise-Wide Capital Management Select Financial Instruments Off-Balance Sheet Arrangements Accounting Matters and Disclosure and Internal Control reviews critical accounting estimates and changes in accounting policies in 2014 and for future periods. It also outlines our evaluation of dis- closure controls and procedures and internal control over financial reporting, and provides an index of disclosures recommended by the Enhanced Disclosure Task Force. Critical Accounting Estimates Changes in Accounting Policies in 2014 Future Changes in Accounting Policies Transactions with Related Parties Management’s Annual Report on Disclosure Controls and Procedures and Internal Control over Financial Reporting Shareholders’ Auditors’ Services and Fees Enhanced Disclosure Task Force Enterprise-Wide Risk Management outlines our approach to managing key financial risks and other related risks we face. Overview Risks That May Affect Future Results Framework and Risks Credit and Counterparty Risk Market Risk Liquidity and Funding Risk Operational Risk Insurance Risk Legal and Regulatory Risk Business Risk Model Risk Strategic Risk Reputation Risk Environmental and Social Risk Supplemental Information presents other useful financial tables and more historical detail. Regulatory Filings Our continuous disclosure materials, including our interim financial statements and interim MD&A, annual audited consolidated financial statements and annual MD&A, Annual Information Form and Notice of Annual Meeting of Shareholders and Management Proxy Circular, are available on our website at www.bmo.com/investorrelations, on the Canadian Securities Administrators’ website at www.sedar.com and on the EDGAR section of the SEC’s website at www.sec.gov. BMO’s Chief Executive Officer and its Chief Financial Officer certify the appropriateness and fairness of BMO’s annual and interim consolidated financial statements, MD&A and Annual Information Form, and the effectiveness of BMO’s disclosure controls and procedures and material changes in our internal control over financial reporting. 26 BMO Financial Group 197th Annual Report 2014 Who We Are Established in 1817, BMO Financial Group is a highly diversified financial services provider based in North America. With total assets of $589 billion and more than 46,000 employees, BMO provides a broad range of retail banking, wealth management and investment banking products and services to more than 12 million customers. We serve more than seven million customers across Canada through our Canadian retail arm, BMO Bank of Montreal. We also serve customers through our wealth management businesses: BMO Nesbitt Burns, BMO InvestorLine, BMO Private Banking, BMO Global Asset Management and BMO Insurance. BMO Capital Markets, our investment and corporate banking and trading products division, provides a full suite of financial products and services to North American and international clients. In the United States, BMO serves customers through BMO Harris Bank, based in the U.S. Midwest with more than two million retail, small business and commercial customers. BMO Financial Group conducts business through three operating groups: Personal and Commercial Banking, Wealth Management and BMO Capital Markets. Our Financial Objectives BMO’s medium-term financial objectives for certain important perform- ance measures are set out below. We believe that we will deliver top-tier total shareholder return and meet our medium-term financial objectives by aligning our operations with, and executing on, our strategic priorities, along with our vision and guiding principle, as out- lined on the following page. We consider top-tier returns to be top-quartile shareholder returns relative to our Canadian and North American peer group. BMO’s business planning process is rigorous and considers the prevailing economic conditions, our risk appetite, our customers’ evolving needs and the opportunities available across our lines of busi- ness. It includes clear and direct accountability for annual performance that is measured against both internal and external benchmarks and progress toward our strategic priorities. Over the medium term, our financial objectives on an adjusted basis are to achieve average annual earnings per share (adjusted EPS) growth of 7% to 10%, earn an average annual return on equity (adjusted ROE) of between 15% and 18%, generate average annual operating leverage of 2% or more and maintain strong capital ratios that exceed regulatory requirements. These objectives are key guideposts as we execute against our strategic priorities. Our operating philosophy is to increase revenues at rates higher than general economic growth rates, while limiting expense growth to achieve average annual adjusted operating leverage. In managing our operations, we balance current profitability with the need to both invest in our businesses for future growth and manage risk. M D & A Reasons to Invest in BMO ‰ Clear opportunities for growth across a diversified North American footprint: O Large North American commercial banking business with advantaged market share. O Good momentum in our well-established Canadian Personal and Commercial Banking business. O Award-winning wealth franchise with strong growth oppor- tunities in North America and select global markets. O Operating leverage across our U.S. businesses. ‰ Strong capital position and an attractive dividend yield. ‰ Focus on efficiency through core operations and technology integration, particularly for retail businesses across North America. Industry-leading customer loyalty and a focus on customer experience to increase market share and drive revenue growth. ‰ ‰ Committed to the highest standards of business ethics and corporate governance. As at and for the periods ended October 31, 2014 (%, except as noted) Average annual total shareholder return Compound growth in annual EPS Compound growth in annual adjusted EPS Average annual ROE Average annual adjusted ROE Compound growth in annual dividends declared per share Dividend yield** Price-to-earnings multiple** Market value/book value ratio** Common Equity Tier 1 Ratio (Basel III basis) 1-year 5-year* 10-year* 17.1 3.9 6.1 14.0 14.4 4.8 3.8 12.8 1.70 10.1 15.5 15.8 10.4 15.0 15.2 1.9 4.4 11.8 1.62 na 8.4 3.8 4.4 15.0 16.2 6.8 4.5 12.8 1.78 na * 5-year and 10-year growth rates reflect growth based on CGAAP in 2009 and 2004, respectively, and IFRS in 2014. ** 1-year measure as at October 31, 2014. 5-year and 10-year measures are the average of year-end values. na – not applicable In Our Financial Objectives section above and the Enterprise-Wide Strategy and Economic Developments and Outlook sections that follow contain certain forward-looking statements. By their nature, forward-looking statements require us to make assumptions and are subject to inherent risks and uncertainties. Please refer to the Caution Regarding Forward-Looking Statements on page 29 of this MD&A for a discussion of such risks and uncertainties and the material factors and assumptions related to the statements set forth in such sections. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 27 MANAGEMENT’S DISCUSSION AND ANALYSIS Enterprise-Wide Strategy A & D M Our Vision To be the bank that defines great customer experience. Our Guiding Principle We aim to deliver top-tier total shareholder return and balance our commitments to financial performance, our customers and employees, the environment and the communities where we live and work. Our Strategy in Context Customers are redefining their expectations of the banking industry in real time. Amidst this change, we have evolved our brand position in the belief that money is personal, and a bank should be, too. Grounded in our vision, We’re here to help is a simple statement meant to inspire and guide what we do every day. We aim to help customers feel valued, understood and confident in the decisions they make. Our strategic priorities have proven to be robust in the midst of evolving expectations, strong competitive activity and continued market uncertainty. We believe that the strength of our business model, balance sheet, risk management framework and leadership team, along with the advantages offered by the scale of our consolidated North American platform, will continue to generate sustainable growth and help us deliver on our vision and brand promise. Our commitment to stakeholders is evident in our focus on delivering an industry-leading customer experience, managing revenue and expenses to achieve our financial goals, and maintaining a prudent approach to risk management. We are making good progress on our enterprise strategic priorities, with select accomplishments outlined below, as well as on our group strategies, detailed in the 2014 Operating Groups Performance Review, which starts on page 42. Our Priorities and Progress 1. Achieve industry-leading customer loyalty by delivering on our ‰ Continued to develop new products designed to respond to clients’ brand promise. ‰ Developed capabilities in digital banking and investing to help customers in new and innovative ways: o Refreshed our public websites, bmo.com and bmoharris.com, with a brand-aligned user interface and updated navigation, enabling customers to get the help and information they need. o Enhanced our Canadian mobile banking application with a simple interface and new capabilities, including allowing customers to send Interac® e-Transfers and book branch appointments any- where, anytime. The updated application has been well received by customers, and the number of mobile transactions has nearly doubled over the past year. o Became the first Canadian bank to give customers the ability to transfer money between Canadian and U.S. dollar accounts through our Canadian mobile banking application. o Launched an integrated Personal Banking and InvestorLine tablet application with enhanced functionality, allowing customers to seamlessly access banking and investing services online through a single secure channel. o Added automated banking machine (ABM) cheque image capture capability at more than 500 ABMs in the United States. o In Illinois, launched BMO Harris Healthy CreditTM, an innovative service offering that educates customers about their credit scores when they open an account. ‰ Sponsored a variety of financial education and home ownership workshops throughout our U.S. market as part of the Federal Reserve Bank’s Money Smart Week. ‰ Across North America, sponsored the second annual Talk With Our ‰ ‰ Kids About Money Day, offering tools and resources to raise financial awareness among children. Enhanced our customer loyalty measurement program to provide a deeper understanding of loyalty drivers and more timely measure- ment at both a full relationship and transaction level, allowing us to continue improving our customers’ experience. In Wealth Management, launched a new webpage designed to educate and recruit women for investment advisory careers, making BMO the first Canadian financial institution to offer a website focused exclusively on educating women about opportunities within the financial services industry. 28 BMO Financial Group 197th Annual Report 2014 emerging needs, including the launch of seven new exchange traded funds (ETFs) this year. Assets under management in our ETF line of business have grown to over $17 billion, a 45% increase over last year. ‰ Recognized with awards across our groups, including Best Wealth Management in Canada, 2014 (Global Banking and Finance Review), Best Private Bank in Canada, 2014 (World Finance Magazine and Global Banking and Finance Review), Best Full-Service Investment Advisory in Canada (Global Banking and Finance Review), 2014 Greenwich Quality Leader for Canadian Fixed Income Research, Cana- dian Equity Sales, Canadian Equity Research and Analyst Service, Canadian Mergers & Acquisitions and Canadian Equity Capital Markets (Greenwich Associates) and World’s Best Metals & Mining Investment Bank (Global Finance) for the fifth consecutive year. 2. Enhance productivity to drive performance and shareholder value. Although we did not have positive operating leverage this year, we made significant progress on a range of productivity initiatives as follows: In Personal and Commercial Banking (P&C), we continued to make improvements to our processes, enabling front-line employees to add new customers and strengthen existing relationships: o In Canadian P&C, implemented a new commercial lending platform, ‰ enabling consistent process execution and a better customer experience. Also completed the migration of retail credit card accounts to a better platform providing new functionality, including enhanced risk management capabilities. o In U.S. P&C, enhanced training for our treasury sales force, which resulted in productivity gains of 22% for commercial banking and 53% for business banking, compared to the prior year. o In Canadian P&C, our leads management engine continued to provide our customers with relevant and timely offers and services, increasing share of wallet and contributing to the personal banking revenue growth achieved in 2014. o In Canadian P&C, expanded relationships with our customers and streamlined organizational structures and processes, resulting in continued strong volume growth and greater sales force productivity. ‰ Reviewed our cost structure to find greater efficiency: o Continued to roll out new branch formats offering smaller, more flexible and more cost-effective points of distribution across North America. ‰ o Improved technological and analytical capabilities, which in turn improved oversight and management of BMO’s procurement expenses, including travel, recruitment and print services. ‰ Grew our distribution capacity: o Continued to build sales capacity in our North American branch network, opening or upgrading more than 130 branches and expanding our ABM network. o Improved online sales processes, resulting in greater sales volumes on our online channel. Online retail banking sales levels across Canada and the United States are now equivalent to sales at over 120 branches. 3. Leverage our consolidated North American platform to deliver quality earnings growth. ‰ Continued to develop consolidated North American capabilities and platforms in priority areas: o Developed consistent branding in Canadian and U.S. P&C busi- nesses, building on common customer insights and changing expectations of the banking industry. o Maintained key North-South leadership mandates to achieve greater consistency and eliminate duplication. ‰ Continued to expand our business and capabilities in the United States: o In Premier Services, our mass affluent client service model placed more than 100 banker-advisor teams in markets across the country. This program provides clients with personalized, holistic financial solutions. o Increased total sales generated per mortgage banker by 37% through enhanced coaching focused on the realtor and purchase business and a more effective approach to the credit approval process. o Posted our best ever investment banking performance in the United States, with record revenue performance for Mergers & Acquisitions, Acquisitions & Divestitures and Equity Capital Markets. Introduced compelling offers in Canada that increased sales and established and strengthened client relationships, including the BMO World Elite MasterCard UPGRADE, our Spring Home Financing and Summer Everyday Banking campaigns. 4. Expand strategically in select global markets to create future growth. ‰ Completed the acquisition of F&C Asset Management plc (F&C). This acquisition strengthens the position of BMO Global Asset Manage- ment as a globally significant money manager, adding scale, capa- bilities and resources to its asset management platform and providing attractive cross-selling opportunities. ‰ ‰ Ranked among Top 20 global investment banks, and 13th-largest investment bank in North and South America based on fees by Thomson Reuters. Expanded our Capital Markets footprint in London, the hub of our Europe, Middle East and Africa activity, supporting our focused leader- ship expertise and enhancing our ability to execute global deals. ‰ Added Trade Finance capabilities in Hong Kong, further strengthening our overall Asia platform. 5. Ensure our strength in risk management underpins everything we do for our customers. ‰ Significantly reduced our U.S. impaired loan portfolio. ‰ Received approval to use the Advanced Measurement Approach to ‰ manage operational risk. Further embedded our risk culture across the enterprise with the rotation of more than 100 employees and executives across risk management and the operating groups. Enhanced our risk appetite framework with stronger linkages to strategic planning, performance management and compensation. ‰ Continued to develop our risk infrastructure to support the efficiency ‰ and effectiveness of risk management. M D & A Factors That May Affect Future Results As noted in the following Caution Regarding Forward-Looking State- ments, all forward-looking statements and information, by their nature, are subject to inherent risks and uncertainties, both general and specific, which may cause actual results to differ materially from the expect- ations expressed in any forward-looking statement. The Enterprise-Wide Risk Management section starting on page 77 describes a number of risks, including credit and counterparty, market, liquidity and funding, operational, insurance, legal and regulatory, business, model, strategic, reputation, environmental and social. Should our risk management framework prove ineffective, there could be a material adverse impact on our financial position. Caution Regarding Forward-Looking Statements Bank of Montreal’s public communications often include written or oral forward-looking statements. Statements of this type are included in this document, and may be included in other filings with Canadian securities regulators or the U.S. Securities and Exchange Commission, or in other communications. All such statements are made pursuant to the “safe harbor” provisions of, and are intended to be forward-looking statements under, the United States Private Securities Litigation Reform Act of 1995 and any applicable Canadian securities legislation. Forward-looking statements may involve, but are not limited to, comments with respect to our objectives and priorities for 2015 and beyond, our strategies or future actions, our targets, expectations for our financial condition or share price, and the results of or outlook for our operations or for the Canadian, U.S. and international economies. By their nature, forward-looking statements require us to make assumptions and are subject to inherent risks and uncertainties. There is significant risk that predictions, forecasts, conclusions or projections will not prove to be accurate, that our assumptions may not be correct and that actual results may differ materially from such predictions, forecasts, conclusions or projections. We caution readers of this document not to place undue reliance on our forward-looking statements as a number of factors could cause actual future results, conditions, actions or events to differ materially from the targets, expectations, estimates or intentions expressed in the forward-looking statements. The future outcomes that relate to forward-looking statements may be influenced by many factors, including but not limited to: general economic and market conditions in the countries in which we operate; weak, volatile or illiquid capital and/or credit markets; interest rate and currency value fluctuations; changes in monetary, fiscal or economic policy; the degree of competition in the geographic and business areas in which we operate; changes in laws or in supervisory expectations or requirements, including capital, interest rate and liquidity requirements and guidance; judicial or regulatory proceedings; the accuracy and completeness of the information we obtain with respect to our customers and counterparties; our ability to execute our strategic plans and to complete and integrate acquisitions, including obtaining regulatory approvals; critical accounting estimates and the effect of changes to accounting standards, rules and interpretations on these estimates; operational and infrastructure risks; changes to our credit ratings; general political conditions; global capital markets activities; the possible effects on our business of war or terrorist activities; disease or illness that affects local, national or international economies; natural disasters and disruptions to public infrastructure, such as transportation, communications, power or water supply; technological changes; and our ability to anticipate and effectively manage risks associated with all of the foregoing factors. We caution that the foregoing list is not exhaustive of all possible factors. Other factors and risks could adversely affect our results. For more information, please see the discussion in the Risks That May Affect Future Results section on page 78, and the credit and counterparty, market, liquidity and funding, operational, insurance, legal and regu- latory, business, model, strategic, reputation, and environmental and social risk sections starting on page 84, which outline in detail certain of these key factors and risks that may affect Bank of Montreal’s future results. When relying on forward-looking statements to make decisions with respect to Bank of Montreal, investors and others should care- fully consider these factors and risks, as well as other uncertainties and potential events, and the inherent uncertainty of forward-looking statements. Bank of Montreal does not undertake to update any forward-looking statements, whether written or oral, that may be made from time to time by the organization or on its behalf, except as required by law. The forward-looking information contained in this document is presented for the purpose of assisting our shareholders in understanding our financial position as at and for the periods ended on the dates presented, as well as our strategic priorities and objectives, and may not be appropriate for other purposes. Assumptions about the level of default and losses on default were material factors we considered when establishing our expectations regarding the future performance of the transactions into which our credit protection vehicle has entered. Among the key assumptions were that the level of default and losses on default would be consistent with historical experience. Material factors that were taken into account when establishing our expectations regarding the risk of future credit losses in our credit protection vehicle and risk of loss to Bank of Montreal included industry diversification in the portfolio, initial credit quality by portfolio, the first-loss protection incorporated into the structure and the hedges into which Bank of Montreal has entered. Assumptions about the performance of the Canadian and U.S. economies, as well as overall market conditions and their combined effect on our business, are material fac- tors we consider when determining our strategic priorities, objectives and expectations for our business. In determining our expectations for economic growth, both broadly and in the financial services sector, we primarily consider historical economic data provided by the Canadian and U.S. governments and their agencies. See the Economic Develop- ments and Outlook section of this document. BMO Financial Group 197th Annual Report 2014 29 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Economic Developments and Outlook Economic and Financial Services Developments in 2014 After strengthening in 2013, the rate of economic growth in Canada improved further to approximately 2.4% in 2014. Despite continued weakness in the Eurozone economy and slower growth in China, Cana- dian exports picked up in response to stronger U.S. demand and a weaker Canadian dollar. In addition, rising energy output drove rapid growth in Alberta’s economy. Consumer spending remained robust, led by record numbers of motor vehicle sales, although elevated debt levels continued to curb personal loan growth. While housing markets strengthened in a few major cities, activity slowed or remained modest in most regions, keeping residential mortgage growth steady at approx- imately 5%. Household credit quality remained solid, with delinquency rates on credit card loans and residential mortgages trending below historical averages. Despite weaker business investment, commercial loan demand continues to grow at a healthy rate due to low interest rates and attractive financing conditions. Demand for non-residential mortgages has been supported by low commercial real estate vacancy rates. Personal deposit growth continued to moderate, in part reflecting depositors’ preference for higher-yielding assets and mutual funds. By contrast, a sharp increase in corporate profits supported business deposit growth. The unemployment rate fell to a six-year low of 6.5% in October, as employment growth picked up even as companies strove to improve productivity and competitiveness. Although inflation rose moderately, the Bank of Canada held its overnight interest rate target at 1% for a fourth consecutive year in response to weaker job growth. Longer-term interest rates declined, reflecting more aggressive mone- tary easing in the United States and lower interest rates in the Eurozone and Japan. In addition, geopolitical conflicts threaten to slow the global economy. The rate of economic growth in the United States remained moderate at approximately 2.3% in 2014, largely as a result of severe winter weather in the first quarter, but rebounded strongly in the second quarter due to an upswing in motor vehicle sales and business spending. Demand for commercial credit and automotive financing strengthened and growth in consumer credit gained momentum. However, slower housing market activity, due in part to tighter mort- gage lending rules, restrained residential loan demand growth. Employment growth was relatively strong, with the unemployment rate reaching a six-year low of 5.8% in October from 7.2% a year earlier. The Federal Reserve maintained its near-zero interest rate policy for a sixth consecutive year, but ended its long-standing program to purchase fixed income securities. Longer-term interest rates declined in response to expansionary monetary policies in Europe and Japan. In the U.S. Midwest, which includes the six contiguous states in BMO’s U.S. footprint, the economy grew in line with the national average, supported by less restrictive fiscal policies, an upturn in business spending and continued expansion in the automobile and housing industries. Economic and Financial Services Outlook for 2015 Economic growth in Canada is expected to reach 2.4% in the coming year, led by growth in exports in response to the strengthening U.S. economy and a weaker Canadian dollar. Improved exports are expected to support business spending and commercial loan growth, though lower oil prices will slow investment in the energy sector. High levels of household debt and expected moderate increases in interest rates will likely dampen consumer spending and housing market activity, restraining personal loan and mortgage demand. A firmer economy is expected to reduce the unemployment rate slightly further to 6.4% by the end of 2015 and prompt the Bank of Canada to raise interest rates in the fall. The Canadian dollar is projected to weaken moderately further due to the trade deficit and long-term interest rates that are higher in the United States than in Canada. Economic growth in the United States is projected to reach 3% in 2015, lowering the unemployment rate to 5% by December 2015. Rela- tively low interest rates, lower gasoline prices, improved household finances and pent-up demand for automobiles should encourage a pickup in consumer spending and personal loan growth. Demand for 30 BMO Financial Group 197th Annual Report 2014 residential mortgages will likely grow as housing affordability remains healthy. Lower vacancy rates for commercial and industrial properties should support growth in non-residential construction. An improving economy and easier credit conditions should continue to sustain growth in business investment and loans. The Federal Reserve is expected to raise the federal funds rate by the middle of 2015, resulting in moderate upward pressure on longer-term interest rates. Growth in the U.S. Midwest economy is expected to climb to 2.7% in 2015, supported by ongoing expansion in the automobile industry, continued strength in business spending and improved global demand. Real Growth in Gross Domestic Product (%) Canadian and U.S. Unemployment Rates (%) 3.0 2.4 2.3 2.4 7.9 7.0 7.07.2 2.3 1.9 2.2 2.0 2012 2013 2014* 2015* Canada United States *Forecast Jan 2013 Oct 2013 Canada United States 6.5 6.4 5.8 5.1 Oct 2014 Oct 2015* *Forecast The Canadian and U.S. economies are expected to strengthen in 2015. Unemployment rates in Canada and the United States are projected to decline further. Housing Starts (in thousands) 250 200 150 100 1500 1000 500 0 Consumer Price Index Inflation (%) 2.1 1.5 1.5 2.0 1.9 2.0 1.7 0.9 08 09 10 11 12 13 14* 15* 2012 2013 2014* 2015* Canada United States *Forecast Housing market activity should moderate in Canada but strengthen in the United States. Canada United States *Forecast Inflation is expected to remain low. Canadian and U.S. Interest Rates (%) Canadian/U.S. Dollar Exchange Rates 0.99 1.04 1.18 1.12 1.00 1.00 1.00 1.25 0.63 0.13 0.13 0.13 Jan 2013 Oct 2013 Oct 2014 Oct 2015* Jan 2013 Oct 2013 Oct 2014 Oct 2015* Canadian overnight rate U.S. federal funds rate *Forecast *Forecast Central banks will likely raise interest rates moderately in 2015. The Canadian dollar is expected to weaken further against the U.S. dollar. Note: Data points are averages for the month, quarter or year, as appropriate. References to years are calendar years. Value Measures Total Shareholder Return The average annual total shareholder return (TSR) is a key measure of shareholder value, and is confirmation that our strategic priorities drive value creation for our shareholders. Our one-year TSR of 17.1% and our five-year average annual TSR of 15.5% were strong, and both out- performed the comparable Canadian indices. Our three-year average annual TSR of 16.7% was also strong, outperforming the overall market return in Canada, despite being lower than the S&P/TSX Financial Serv- ices Index. The table below summarizes dividends paid on BMO common shares over the past five years and the movements in BMO’s share price. An investment of $1,000 in BMO common shares made at the beginning of fiscal 2010 would have been worth $2,055 at October 31, 2014, assuming reinvestment of dividends, for a total return of 105.5%. On December 2, 2014, BMO announced that the Board of Directors had declared a quarterly dividend payable to common shareholders of $0.80 per common share, an increase of $0.02 per share or 3% from the prior quarter and up $0.04 per share or 5% from a year ago. The divi- dend is payable February 26, 2015 to shareholders of record on February 2, 2015. We have increased our quarterly dividend declared three times over the past two years from $0.72 per common share for the first quarter of 2013. Dividends paid over a ten-year period have increased at an average annual compound rate of 7.3%. One-Year Total Shareholder Return (%) Three-Year Average Annual Total Shareholder Return (%) Five-Year Average Annual Total Shareholder Return (%) 17.3 16.9 17.1 17.6 16.7 16.7 19.8 12.6 15.5 13.5 9.3 9.1 S&P 500 Index S&P/TSX Composite Index S&P/TSX Financial Services Index BMO common shares S&P 500 Index S&P/TSX Composite Index S&P/TSX Financial Services Index BMO common shares S&P 500 Index S&P/TSX Composite Index S&P/TSX Financial Services Index BMO common shares All returns represent total returns. All returns represent total returns. All returns represent total returns. BMO’s one-year TSR was strong and above the comparable Canadian indices. BMO’s three-year average annual return was strong and outperformed the overall market return in Canada. BMO’s five-year TSR outperformed the comparable Canadian indices. M D & A The average annual total shareholder return (TSR) represents the average annual total return earned on an investment in BMO common shares made at the beginning of a fixed period. The return includes the change in share price and assumes that dividends received were reinvested in additional common shares. Total Shareholder Return For the year ended October 31 Closing market price per common share ($) Dividends paid ($ per share) Dividend yield (%) Increase (decrease) in share price (%) Total annual shareholder return (%) (2) 2014 81.73 3.04 3.8 12.5 17.1 2013 72.62 2.92 4.0 23.0 28.8 2012 59.02 2.80 4.8 0.2 5.2 2011 58.89 2.80 4.8 (2.2) 2.4 2010 60.23 2.80 4.6 20.3 26.4 3-year CAGR (1) 5-year CAGR (1) 11.5 2.8 nm nm 16.7 10.3 1.7 nm nm 15.5 (1) Compound annual growth rate (CAGR) expressed as a percentage. (2) Total annual shareholder return assumes reinvestment of quarterly dividends and therefore does not equal the sum of dividend and share price returns in the table. nm – not meaningful BMO Financial Group 197th Annual Report 2014 31 MANAGEMENT’S DISCUSSION AND ANALYSIS Non-GAAP Measures Results and measures in this MD&A are presented on a GAAP basis. They are also presented on an adjusted basis that excludes the impact of certain items as set out in the following table. Management assesses performance on a reported basis and on an adjusted basis and considers both to be useful in assessing underlying ongoing business performance. Presenting results on both bases provides readers with a better under- standing of how management assesses results. It also permits readers to assess the impact of certain specified items on results for the periods presented and to better assess results excluding those items if they consider the items to not be reflective of ongoing results. As such, the presentation may facilitate readers’ analysis of trends, as well as comparisons with our competitors. Adjusted results and measures are non-GAAP and as such do not have standardized meaning under GAAP. They are unlikely to be comparable to similar measures presented by other companies and should not be viewed in isolation from or as a substitute for GAAP results. (Canadian $ in millions, except as noted) Reported Results Revenue Provision for credit losses Non-interest expense Income before income taxes Provision for income taxes Net income EPS ($) A & D M Adjusting Items (Pre-tax) (1) Credit-related items on the purchased performing loan portfolio (see below*) Acquisition integration costs (2) Amortization of acquisition-related intangible assets (3) Decrease in the collective allowance for credit losses (4) Run-off structured credit activities (5) Restructuring costs (6) Adjusting items included in reported pre-tax income Adjusting Items (After tax) (1) Credit-related items on the purchased performing loan portfolio (see below*) Acquisition integration costs (2) Amortization of acquisition-related intangible assets (3) Decrease (increase) in the collective allowance for credit losses (4) Run-off structured credit activities (5) Restructuring costs (6) Adjusting items included in reported net income after tax Impact on EPS ($) Adjusted Results Revenue Provision for credit losses Non-interest expense Income before income taxes Provision for income taxes Net income EPS ($) *Credit-related items on the purchased performing loan portfolio are comprised of the following amounts: (7) Revenue (8) Provision for credit losses Increase in pre-tax income Provision for income taxes Increase in reported net income after tax 2014 2013 2012 16,718 (561) (10,921) 16,063 (587) (10,226) 15,929 (764) (10,135) 5,236 (903) 4,333 6.41 5,250 (1,055) 4,195 6.17 5,030 (874) 4,156 6.10 – (20) (140) – – – (160) – (16) (104) – – – (120) (0.18) 406 (251) (125) 2 40 (82) (10) 250 (155) (89) (9) 34 (59) (28) (0.04) 407 (402) (134) 82 264 (173) 44 251 (250) (96) 53 261 (122) 97 0.15 16,718 (561) (10,761) 5,396 (943) 4,453 6.59 15,372 (357) (9,755) 5,260 (1,037) 4,223 6.21 14,866 (470) (9,410) 4,986 (927) 4,059 5.95 – – – – 638 (232) 406 (156) 250 783 (376) 407 (156) 251 Adjusted results and measures in this table are non-GAAP amounts or non-GAAP measures. (1) Adjusting items in 2013 and prior years are included in Corporate Services with the (5) Primarily comprised of valuation changes associated with these activities that are mainly exception of the amortization of acquisition-related intangible assets, which is charged to the operating groups. Acquisition integration costs in 2014 related to F&C are charged to Wealth Management. (2) Acquisition integration costs are included in non-interest expense. (3) These expenses were charged to the non-interest expense of the operating groups. Before and after-tax amounts for each operating group are provided on pages 44, 46, 49, 52 and 55. (4) In 2014, changes to the collective allowance include the impact of changes in the purchased performing portfolio. In 2013 and 2012, the impact of the purchased performing portfolio on the collective allowance is reflected in credit-related items. included in trading revenues in non-interest revenue. (6) Restructuring charge to align our cost structure with the current and future business environment as part of a broader effort to improve productivity. (7) Effective the first quarter of 2014, Corporate Services adjusted results include credit-related items in respect of the purchased performing loan portfolio, including $238 million of revenue and $82 million of specific provisions for credit losses in 2014. (8) Recognition in net interest income of a portion of the credit mark on the purchased performing loan portfolio. 32 BMO Financial Group 197th Annual Report 2014 Summary Financial Results and Earnings per Share Growth The year-over-year percentage change in earnings per share (EPS) and in adjusted EPS are our key measures for analyzing earnings growth. All references to EPS are to diluted EPS, unless indicated otherwise. BMO Capital Markets reported net income increased $35 million or 3% to $1,079 million. The increase reflected growth in revenue across both Investment and Corporate Banking and Trading Products, with good contribution from our U.S. businesses. This growth was partially offset by an increase in expenses. BMO Capital Markets results are discussed in the operating group review on page 54. Corporate Services adjusted net loss for the year was $193 million, compared with an adjusted net loss of $133 million a year ago. Adjusted results decreased due to lower adjusted recoveries, primarily on the purchased credit impaired loan portfolio, partially offset by better adjusted revenues which included the purchased performing loan portfolio results. Corporate Services results are discussed in the operating group review on page 57. Changes to reported and adjusted net income for each of our operating groups are discussed in more detail in the 2014 Operating Groups Performance Review, which starts on page 42. M D & A EPS ($) 6.59 6.41 6.17 6.21 6.10 5.95 2012 2013 2014 EPS Adjusted EPS Growth reflects strong momentum in Canadian P&C and an improving environment for our U.S. businesses, partially offset by lower recoveries. Earnings per share (EPS) is calculated by dividing net income attributable to bank shareholders, after deduction of preferred dividends, by the average number of common shares outstanding. Diluted EPS, which is our basis for measur- ing performance, adjusts for possible conversions of financial instruments into common shares if those conversions would reduce EPS, and is more fully explained in Note 26 on page 173 of the financial statements. Adjusted EPS is calculated in the same manner using adjusted net income. EPS was $6.41, up $0.24 or 4% from $6.17 in 2013. Adjusted EPS was $6.59, up $0.38 or 6% from $6.21 in 2013. Our three-year average annual adjusted EPS growth rate was 9%, in line with our current medium-term objective of achieving average annual adjusted EPS growth of 7% to 10%. EPS growth in both 2014 and 2013 reflected increased earnings. Adjusted net income available to common share- holders was 40% higher over the three-year period from the end of 2011, while the average number of diluted common shares outstanding increased 7% over the same period. Net income was $4,333 million in 2014, up $138 million or 3% from the previous year. Adjusted net income was $4,453 million, up $230 million or 5%. On an adjusted basis, there was good revenue growth in 2014. Higher revenues exceeded incremental costs, contributing to growth in net income. There were higher provisions for credit losses and a lower effective income tax rate in 2014. There was strong adjusted net income growth in Canadian P&C and 3% growth in BMO Capital Markets and U.S. P&C on a U.S. dollar basis, with a modest decline in Wealth Management and lower results in Corporate Services. Canadian P&C reported net income increased $202 million or 11% to $2,014 million, due to continued good revenue growth driven by strong loan and deposit growth, partially offset by higher expenses. Expenses rose primarily due to continued investment in the business, net of expense management. Canadian P&C results are discussed in the operating group review on page 45. U.S. P&C adjusted net income increased $17 million or 3% to $636 million on a U.S. dollar basis. Lower provisions for credit losses were partially offset by lower revenue. The benefits of strong commercial loan growth were more than offset by the effects of lower net interest margin and reduced mortgage banking revenue. U.S. P&C results are discussed in the operating group review on page 48. Wealth Management adjusted net income was $848 million, down $9 million or 1% from a year ago, as the prior year included a $121 million after-tax security gain. Adjusted net income in traditional wealth of $562 million decreased $34 million. Strong growth of $87 million, including the contribution from the acquired F&C business, was more than offset by the security gain in the prior year. Adjusted net income in insurance was $286 million, up $25 million or 9%. Wealth Management results are discussed in the operating group review on page 51. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 33 MANAGEMENT’S DISCUSSION AND ANALYSIS Return on Equity In 2014 we held higher levels of average common shareholders’ equity as a result of increased capital expectations for banks internationally. As a result, return on equity (ROE) was 14.0% in 2014 and adjusted ROE was 14.4%, compared with 14.9% and 15.0%, respectively, in 2013. There was an increase of $147 million in earnings ($239 million in adjusted earnings) available to common shareholders in 2014. Average common shareholders’ equity increased by $2.7 billion from 2013. A & D M ROE (%) 15.9 15.5 14.9 15.0 14.0 14.4 2012 2013 2014 ROE Adjusted ROE ROE continues to be strong. BMO has achieved an ROE of 13% or better in 24 of the past 25 years. Return on common shareholders’ equity (ROE) is calculated as net income, less non-controlling interest in subsidiaries and preferred dividends, as a percentage of average common shareholders’ equity. Common shareholders’ equity is comprised of common share capital, contributed surplus, accumulated other comprehensive income (loss) and retained earnings. Adjusted ROE is calculated using adjusted net income rather than net income. Return on Equity and Adjusted Return on Equity (Canadian $ in millions, except as noted) For the year ended October 31 Reported net income Attributable to non-controlling interest in subsidiaries (1) Preferred dividends Net income available to common shareholders Average common shareholders’ equity Return on equity (%) Adjusted net income available to common shareholders Adjusted return on equity (%) *2010 is based on CGAAP. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. (1) Prior to 2011, non-controlling interest in subsidiaries was deducted in the determination of net income. na – not applicable Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. Basel III Common Equity Tier 1 Ratio BMO’s Basel III Common Equity Tier 1 (CET1) Ratio is the last of our four key value measures. BMO’s CET1 Ratio is strong and exceeds the Office of the Superintendent of Financial Institutions Canada’s requirements for large Canadian banks. Our CET1 Ratio was 10.1% at October 31, 2014, compared to 9.9% at October 31, 2013. The CET1 Ratio increased by 20 basis points from the end of fiscal 2013 primarily due to higher capital, partially offset by the impact of the F&C acquisition and a moderate increase in risk-weighted assets. 2014 2013 2012 2011* 2010* 4,333 (56) (120) 4,157 29,680 14.0 4,277 14.4 4,195 (65) (120) 4,010 26,956 14.9 4,038 15.0 4,156 (74) (136) 3,946 24,863 15.9 3,849 15.5 3,114 (73) (146) 2,895 19,145 15.1 3,056 16.0 2,810 na (136) 2,674 17,980 14.9 2,780 15.0 Basel III Common Equity Tier 1 (CET1) Ratio is calculated as CET1 capital, which is comprised of common shareholders’ equity less deductions for goodwill, intangible assets, pension assets, certain deferred tax assets and other items, divided by risk-weighted assets for CET1. Basel III CET1 Ratio (%) 9.9 10.1 8.7 2012* 2013 2014 BMO’s CET1 Ratio remains strong. *2012 CET1 Ratio is on a pro-forma basis. 34 BMO Financial Group 197th Annual Report 2014 2014 Financial Performance Review This section provides a review of our enterprise financial performance for 2014 that focuses on the Consolidated Statement of Income included in our consolidated financial statements, which begin on page 123. A review of our operating groups’ strategies and performance follows the enterprise review. A summary of the enterprise financial performance for 2013 appears on page 61. This section contains adjusted results, which are non-GAAP and are disclosed in more detail in the Non-GAAP Measures section on page 32. Highlights ‰ Revenue increased $655 million or 4% in 2014 to $16,718 million. Adjusted revenue increased $1,346 million or 9% to $16,718 million. The increase was mainly due to revenue growth in Canadian P&C, Wealth Management and BMO Capital Markets, and continues to demonstrate the benefits of our diversified business mix and successful execution against our strategic priorities. The impact of the stronger U.S. dollar increased revenue growth by $310 million. ‰ Revenue growth in Canadian P&C reflected strong loan and deposit growth. Wealth Management revenue increased $385 million or 11% to $3,833 million. Revenue growth was driven by increases across all the businesses and a contribution from the acquired F&C business, partly offset by a security gain in the prior year. BMO Capital Markets revenue growth was driven by higher net securities gains and increases in trading revenues, lending revenues and investment banking fees, particularly in our U.S. platform. U.S. P&C revenue decreased modestly on a U.S. dollar basis, as the benefits of strong commercial loan growth were more than offset by the effects of lower net interest margin and reduced mortgage banking rev- enue. Corporate Services adjusted revenues improved from the prior year. Impact of Business Acquisitions BMO Financial Group has selectively acquired a number of businesses, as outlined in Note 12 on page 153 of the financial statements. These acquisitions increase revenues and expenses, affecting year-over-year comparisons of operating results. The adjacent table outlines the impact of these acquisitions on BMO’s adjusted revenue, non-interest expense and net income for 2014 and 2013 to assist in analyzing changes in results. The effect on adjusted net income includes the impact of provi- sions for credit losses and income taxes, which are not disclosed sepa- rately in the table. For 2014, on an adjusted basis, the business acquisitions con- tributed $221 million of revenues, $178 million of non-interest expense and $34 million of net income. ‰ Provisions for credit losses totalled $561 million in the current year, down from $587 million in 2013. Adjusted provisions for credit losses totalled $561 million, up from $357 million in 2013, primarily due to lower recoveries on the purchased credit impaired loan portfolio. ‰ Adjusted non-interest expense increased $1,006 million or 10% to $10,761 million primarily due to continued investment in the business, higher employee-related costs, including severance, increased regulatory costs, the impact of the stronger U.S. dollar and the acquired F&C business. ‰ The effective income tax rate in 2014 was 17.2%, compared with 20.1% in 2013. The adjusted effective income tax rate(1) was 17.5%, compared with 19.7% in 2013. The lower adjusted effective rate in 2014 was mainly attributable to higher tax-exempt income and a lower proportion of income from higher tax-rate jurisdictions. (1) The adjusted rate is computed using adjusted net income rather than net income in the determination of income subject to tax. M D & A Impact of Business Acquisitions on Adjusted Operating Results (1) (Canadian $ in millions) For the year ended October 31 Total revenue Non-interest expense (2) Net income (loss) 2014 2013 221 178 34 20 32 (9) (1) Results for both 2014 and 2013 include the results of the acquired Asia-based wealth management business, which is part of our Wealth Management reporting segment, and the results of Aver Media LP, which is part of our Canadian P&C reporting segment. Results for 2014 also include the results of F&C Asset Management plc, which is part of our Wealth Management reporting segment. (2) Adjusted non-interest expense in 2013 includes acquisition and integration costs in respect of the acquired Asia-based wealth management business and Aver Media LP. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 35 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Foreign Exchange The U.S. dollar was stronger compared to the Canadian dollar at October 31, 2014 than at October 31, 2013. BMO’s U.S.-dollar- denominated assets and liabilities are translated at year-end rates. The average exchange rate over the course of 2014, which is used in the translation of BMO’s U.S.-dollar-denominated revenues and expenses, was higher in 2014 than in 2013. Consequently, the Canadian dollar equivalents of BMO’s U.S.-dollar-denominated net income, revenues, expenses, provisions for (recoveries of) credit losses and income taxes in 2014 increased relative to the preceding year. The table below indicates average Canadian/U.S. dollar exchange rates in 2014, 2013 and 2012 and the impact of changes in the average rates on our U.S. segment results. At October 31, 2014, the Canadian dollar traded at $1.127 per U.S. dollar. It traded at $1.043 per U.S. dollar at October 31, 2013. Changes in the exchange rate will affect future results measured in Canadian dollars and the impact on those results is a function of the periods in which revenues, expenses and provisions for (recoveries of) credit losses arise. If future results are consistent with results in 2014, each one cent increase (decrease) in the Canadian/U.S. dollar exchange rate, expressed in terms of how many Canadian dollars one U.S. dollar buys, would be expected to increase (decrease) the Canadian dollar equivalent of U.S.-dollar-denominated adjusted net income before income taxes for the year by $10 million in the absence of hedging transactions. BMO may execute hedging transactions to mitigate the impact of foreign exchange rate movements on net income. Effects of Changes in Exchange Rates on BMO’s Reported and Adjusted Results (Canadian $ in millions, except as noted) Canadian/U.S. dollar exchange rate (average) 2014 2013 2012 Effects on reported results Increased net interest income Increased non-interest revenue Increased revenues Increased recovery of (provision for) credit losses Increased expenses Increased income taxes Increased reported net income Effects on adjusted results Increased net interest income Increased non-interest revenue Increased revenues Increased recovery of credit losses Increased expenses Increased income taxes Increased adjusted net income 2014 vs. 2013 vs. 2013 2012 1.094 1.024 1.024 1.003 182 143 325 (1) (252) (15) 57 167 143 310 3 (246) (12) 55 57 39 96 4 (75) (8) 17 48 39 87 4 (69) (6) 16 Caution This Foreign Exchange section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. Revenue Revenue increased $655 million or 4% in 2014 to $16,718 million. Amounts in the rest of this Revenue section are stated on an adjusted basis. Adjusted revenue increased $1,346 million or 9% to $16,718 million mainly due to growth in Canadian P&C, Wealth Management and BMO Capital Markets. The stronger U.S. dollar added $310 million or 2% to adjusted revenue growth. BMO analyzes revenue at the consolidated level based on GAAP revenues as reported in the financial statements, and on an adjusted basis. Consistent with our Canadian peer group, we analyze revenue on a taxable equivalent basis (teb) at the operating group level. The teb adjustments for 2014 totalled $476 million, up from $344 million in 2013. Canadian P&C revenue increased $389 million or 6% due to strong loan and deposit growth. Wealth Management revenue increased $385 million or 11% to $3,833 million. Revenue growth was driven by increases across all the businesses and a contribution from the acquired F&C business, partly offset by a security gain in the prior year. BMO Capital Markets revenue increased $332 million or 10% to $3,724 million, driven by higher net securities gains and increases in trading revenues, lending revenues and investment banking fees, particularly in our U.S. platform. The stronger U.S. dollar increased revenue by $85 million. U.S. P&C revenue decreased $45 million or 2% to $2,796 million on a U.S. dollar basis as the benefits of strong commercial loan growth were more than offset by the effects of lower net interest margin and reduced mortgage banking revenue. Corporate Services adjusted revenues improved by $89 million or 18%, mainly due to the inclusion of purchased performing loan revenue, partially offset by a higher group teb offset. Adjusted revenue excluded the portion of the credit mark recorded in net interest income on the purchased performing loan portfolio and income or losses from run-off structured credit activities for 2013 and 2012, which are recorded in Corporate Services, as discussed in the Non- GAAP Measures section on page 32. Revenue and Adjusted Revenue (Canadian $ in millions, except as noted) For the year ended October 31 2014 2013 2012 2011* 2010 Net interest income Year-over-year growth (%) Non-interest revenue Year-over-year growth (%) Total revenue Year-over-year growth (%) 8,461 (3) 8,257 12 8,677 (3) 7,386 6 8,937 20 6,992 8 7,474 20 6,469 8 6,235 12 6,004 9 16,718 16,063 15,929 13,943 12,239 11 14 14 4 1 Adjusted net interest income Year-over-year growth (%) Adjusted non-interest revenue Year-over-year growth (%) 8,461 5 8,257 12 8,020 (2) 7,352 10 8,158 13 6,708 3 7,248 16 6,494 8 6,235 12 6,004 – Total adjusted revenue Year-over-year growth (%) 16,718 15,372 14,866 13,742 12,239 6 12 9 8 3 * Growth rates for 2011 reflect growth based on CGAAP in 2010 and IFRS in 2011. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. Taxable equivalent basis (teb) Revenues of operating groups are presented in our MD&A on a taxable equivalent basis (teb). The teb adjustment increases GAAP revenues and the provision for income taxes by an amount that would increase revenues on certain tax- exempt items to a level that would incur tax at the statutory rate, to facilitate comparisons. This adjustment is offset in Corporate Services. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 36 BMO Financial Group 197th Annual Report 2014 Net Interest Income Net interest income for the year was $8,461 million, a decrease of $216 million or 3% from 2013. Adjusted net interest income of $8,461 million increased $441 million or 5%, due to volume growth, revenue from the purchased performing loan portfolio and the impact of the stronger U.S. dollar, partially offset by lower net interest margin. The impact of the stronger U.S. dollar increased adjusted net interest income by $167 million. Adjusted net interest income excluded amounts related to the credit mark on the purchased performing loan portfolio in 2013 and 2012. BMO’s average earning assets increased $43.6 billion or 9% in 2014, including a $13.5 billion increase as a result of the stronger U.S. dollar. There was strong growth in all of the operating groups. The main drivers of BMO’s overall net interest margin are the individual group margins, changes in the magnitude of each operating group’s average earning assets and changes in net interest income in Corporate Services. Changes are discussed in the 2014 Operating Groups Performance Review section on page 42. Table 5 on page 110 and Table 6 on page 111 provide further details on net interest income and net interest margin. Net interest income is comprised of earnings on assets, such as loans and securities, including interest and dividend income and BMO’s share of income from investments accounted for using the equity method of accounting, less interest expense paid on liabilities, such as deposits. Net interest margin is the ratio of net interest income to average earning assets, expressed as a percentage or in basis points. Average Earning Assets and Net Interest Margin Net Interest Income and Non-Interest Revenue* ($ billions) 461 1.94 1.77 485 1.79 1.65 529 1.60 1.60 15.9 14.9 16.1 15.4 8.9 8.2 8.7 8.0 16.7 16.7 8.5 8.5 7.0 6.7 7.4 7.4 8.3 8.3 2012 2013 2014 2012 2013 2014 Average earning assets ($ billions) Net interest margin (%) Adjusted net interest margin (%) Net interest income Non-interest revenue Adjusted net interest income Adjusted non-interest revenue Average earning assets increased 9% and adjusted net interest margin decreased in the low-rate environment. There was growth in adjusted non-interest revenue and net interest income, reflecting good underlying business growth. M D & A Revenue ($ billions) *Numbers may not add due to rounding. Revenue by Country (%) 15.9 14.9 16.1 15.4 16.7 16.7 63 64 65 34 33 30 3 3 5 2012 2013 2014 2012 2013 2014 Total revenue Total adjusted revenue Canada United States Other countries Canadian P&C, Wealth Management and BMO Capital Markets drove revenue growth. The change in revenue in other countries is primarily due to the F&C acquisition. Change in Net Interest Income, Average Earning Assets and Net Interest Margin For the year ended October 31 Canadian P&C U.S. P&C Personal and Commercial Banking (P&C) Wealth Management BMO Capital Markets Corporate Services, including Technology and Operations Total BMO adjusted Adjusting items impacting net interest income Total BMO reported na – not applicable nm – not meaningful Net interest income (teb) Average earning assets (Canadian $ in millions) Change (Canadian $ in millions) Change 2014 2013 4,772 2,488 7,260 560 1,179 (538) 4,526 2,327 6,853 558 1,202 (593) 8,461 8,020 – 657 % 5 7 6 1 (2) (9) 5 nm 2014 2013 183,947 66,565 250,512 21,169 223,677 33,428 171,285 58,369 229,654 19,399 202,960 33,178 528,786 485,191 na na 8,461 8,677 (3) 528,786 485,191 % 7 14 9 9 10 1 9 na 9 Net interest margin (in basis points) 2014 2013 Change 259 264 374 399 290 298 265 287 59 nm 53 nm 160 165 nm nm (5) (25) (8) (22) (6) nm (5) nm 160 179 (19) Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 37 MANAGEMENT’S DISCUSSION AND ANALYSIS Non-Interest Revenue (Canadian $ in millions) For the year ended October 31 2014 2013 Change from 2013 (%) 2012 Securities commissions and fees Deposit and payment service charges Trading revenues Lending fees Card fees Investment management and custodial fees Mutual fund revenues Underwriting and advisory fees Securities gains, other than trading Foreign exchange, other than trading Insurance income Other Total BMO reported Total BMO adjusted 934 1,002 949 680 462 1,246 1,073 744 162 179 503 323 846 916 849 603 461 971 832 659 285 172 445 347 825 929 1,025 544 441 967 665 600 152 153 335 356 8,257 7,386 6,992 8,257 7,352 6,708 10 9 12 13 – 28 29 13 (43) 4 13 (7) 12 12 A & D M Non-Interest Revenue Non-interest revenue, which comprises all revenues other than net interest income, was $8,257 million in 2014, an increase of $871 million or 12% from 2013. Adjusted non-interest revenue increased $905 million or 12%, with the majority of the growth driven by strong performance in Wealth Management and BMO Capital Markets, as well as good growth in Canadian P&C. Investment management and custodial fees increased $275 million or 28% and mutual fund revenues increased $241 million or 29%, both due to growth in client assets and a contribution from the acquired F&C business. Trading revenues increased $100 million or 12% and are discussed in the Trading-Related Revenues section that follows. Securities commissions and fees increased $88 million or 10%. These revenues consist largely of brokerage commissions within Wealth Management, which account for about three-quarters of the total, and institutional equity trading commissions within BMO Capital Markets. In Wealth Management, securities commissions were up 9% due to growth in client assets, with BMO Capital Markets increasing 13% due to higher client activity. Deposit and payment service charges increased $86 million or 9%, primarily due to growth in Canadian P&C. Underwriting and advisory fees increased $85 million or 13% reflecting higher activity levels particularly in equity underwriting. Lending fees increased $77 million or 13%, primarily due to strong growth in lending activity in BMO Capital Markets and in the Canadian P&C loan portfolio. Insurance income increased $58 million or 13%, primarily due to the beneficial impact of changes in the approach to calculating the ultimate reinvestment rate less the impact of annual actuarial assump- tion changes. Foreign exchange, other than trading increased by $7 million or 4%. Securities gains decreased by $123 million or 43% due to a security gain in Wealth Management of $191 million in the prior year, partially offset by higher net securities gains in BMO Capital Markets. Card fees were relatively unchanged from the prior year. Other non-interest revenue includes various sundry amounts and decreased by $24 million or 7% from the prior year. Adjusted non-interest revenue excluded the income or losses from run-off structured credit activities in 2013 and 2012, which were mainly included in trading revenues. Table 3 on page 108 provides further details on revenue and rev- enue growth. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 38 BMO Financial Group 197th Annual Report 2014 Trading-Related Revenues Trading-related revenues are dependent on, among other things, the volume of activities undertaken for clients who enter into transactions with BMO to mitigate their risks or to invest. BMO earns a spread or profit on the net sum of its client positions by profitably managing, within prescribed limits, the overall risk of the net positions. On a lim- ited basis, BMO also earns revenue from principal trading positions. Interest and non-interest trading-related revenues decreased $93 million or 9% from 2013. Adjusted trading-related revenues were $933 million in 2014, down $39 million or 4%. Interest rate trading- related revenues decreased $154 million or 32%, primarily due to decreased client activity in our fixed income businesses and the unfavourable impact from a funding valuation adjustment implemented in 2014. Foreign exchange trading-related revenues were up $71 million or 25% from 2013, primarily driven by increased client activity levels. Equities trading-related revenues increased $127 million or 25%, primarily due to increased activity with corporate and investor clients and a conducive market environment. Commodities trading-related revenues increased $3 million. Nominal revenues from run-off structured credit activities in 2014, compared to $34 million in 2013, are included in other trading revenues in the adjacent table. Prior to 2014, these revenues were adjusting items and excluded from adjusted trading-related revenues. The Market Risk section on page 91 provides more information on trading-related revenues. Trading-related revenues include net interest income and non- interest revenue earned from on and off-balance sheet positions undertaken for trading purposes. The management of these posi- tions typically includes marking them to market on a daily basis. Trading-related revenues also include income (expense) and gains (losses) from both on-balance sheet instruments and interest rate, foreign exchange (including spot positions), equity, commodity and credit contracts. Interest and Non-Interest Trading-Related Revenues (1) (Canadian $ in millions) (taxable equivalent basis) For the year ended October 31 Interest rates Foreign exchange Equities Commodities Other (2) Total (teb) Teb offset Total Reported as: Net interest income Non-interest revenue – trading revenues Total (teb) Teb offset Total M D & A 2014 2013 2012 325 356 626 46 13 479 285 499 43 29 449 269 413 66 267 1,366 433 1,335 309 1,464 234 933 1,026 1,230 417 949 486 849 1,366 433 1,335 309 439 1,025 1,464 234 933 1,026 1,230 Change from 2013 (%) (32) 25 25 7 (55) 2 40 (9) (14) 12 2 40 (9) Adjusted net interest income net of teb offset (16) 157 209 (+100) Adjusted non-interest revenue – trading revenues Adjusted total 949 933 815 972 741 950 16 (4) (1) Trading-related revenues are presented on a taxable equivalent basis. (2) Includes nominal revenues from run-off structured credit activities in 2014 ($34 million in 2013; $284 million in 2012) and hedging exposures in BMO’s structural balance sheet. Prior to 2014, the structured credit revenues were adjusting items and excluded from adjusted trading-related revenues. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 39 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Provision for Credit Losses The provision for credit losses (PCL) was $561 million in the current year, down from $587 million in 2013 and up from $357 million in 2013 on an adjusted basis. There were no adjusting items in the current year. The prior year included a $240 million specific provision on the pur- chased performing loan portfolio and a $10 million decrease in the collective allowance. The increase in adjusted PCL was due to a sig- nificant reduction in recoveries on the purchased credit impaired portfolio and provisions on the purchased performing loan portfolio, offset in part by reduced provisions in Canadian P&C and U.S. P&C. PCL as a percentage of average net loans and acceptances declined to 0.19% in 2014 from 0.22% in 2013. This positive ratio trend reflects lower new provisions across both our consumer and commercial loan portfolios, compared to 2013. On an operating group basis, most of our provisions relate to Personal and Commercial Banking. In Canadian P&C, PCL decreased by $31 million to $541 million in 2014, reflecting lower provisions in both the commercial and consumer portfolios. U.S. P&C PCL was $164 million, down $59 million from 2013, primarily reflecting better credit quality in the consumer loan portfolio. Wealth Management had a $3 million recovery in 2014, compared to a provision of $3 million in the previous year. BMO Capital Markets recorded a net recovery of $18 million, down from a net recovery of $36 million in the prior year. Corporate Services adjusted recoveries of credit losses of $123 million in 2014 were down from $405 million in 2013, primarily reflecting $158 million lower recoveries on the purchased credit impaired loan portfolio, provisions of $82 million on the purchased performing loan portfolio and $64 million higher provisions on the impaired real estate secured loan portfolio. On a geographic basis, the majority of our provisions relate to our Canadian loan portfolio. Specific PCL in Canada and other countries (excluding the United States) was $527 million, compared to $566 million in 2013. Specific adjusted PCL in the United States was $34 million, down from a $209 million recovery in 2013, reflecting lower recoveries of credit losses on the purchased credit impaired loans and provisions on the purchased performing loan portfolio in 2014. Note 4 on page 136 of the financial statements provides PCL information on a geographic basis. Table 15 on page 118 provides further PCL segmenta- tion information. Provision for Credit Losses For the year ended October 31 (Canadian $ in millions, except as noted) 2014 2013 2012 New specific provisions Reversals of previously established allowances Recoveries of loans previously written off 1,413 (228) (624) 1,636 (267) (772) 1,859 (252) (846) Specific provision for credit losses Increase (decrease) in collective allowance Provision for credit losses (PCL) PCL as a % of average net loans and acceptances (annualized) (1) 561 – 561 597 (10) 587 761 3 764 0.19 0.22 0.31 (1) Certain ratios for 2012 were restated in the first quarter of 2013 to reflect the reclassified balance sheet presentation. Provision for Credit Losses by Operating Group (1) For the year ended October 31 (Canadian $ in millions) Canadian P&C U.S. P&C Personal and Commercial Banking Wealth Management BMO Capital Markets Corporate Services, including T&O (2) Impaired real estate loans Interest on impaired loans Purchased credit impaired loans Purchased performing loans (2) Adjusted provision for credit losses Purchased performing loans (2) Increase (decrease) in collective allowance Provision for credit losses 2014 2013 2012 541 164 705 (3) (18) 21 26 (252) 82 561 – – 561 572 223 795 3 (36) (43) 48 (410) – 357 240 (10) 587 613 274 887 22 6 20 44 (509) – 470 291 3 764 (1) Effective the first quarter of 2013, provisions in the operating groups are reported on an actual loss basis and interest on impaired loans is allocated to the operating groups. Results for prior periods have been restated accordingly. (2) Effective the first quarter of 2014, Corporate Services adjusted results include credit- related items in respect of the purchased performing loan portfolio. Further details are provided in the Non-GAAP Measures section on page 32. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 40 BMO Financial Group 197th Annual Report 2014 Non-Interest Expense Non-interest expense increased $695 million or 7% to $10,921 million in 2014. Amounts in the rest of this Non-Interest Expense section are stated on an adjusted basis, unless otherwise noted. Adjusted non-interest expense excludes acquisition integration costs for certain significant acquisitions and amortization of acquisition- related intangible assets in 2014, 2013 and 2012, and restructuring costs in 2013 and 2012 to align our cost structure with the environment. Adjusted non-interest expense increased $1,006 million or 10% to $10,761 million. Excluding the impact of the stronger U.S. dollar, adjusted non-interest expense increased by 8%. The dollar and percentage changes in expense by category are outlined in the adjacent Adjusted Non-Interest Expense and Non-Interest Expense table. Table 4 on page 109 provides more detail on expenses and expense growth. Performance-based compensation increased 13%, excluding the impact of the stronger U.S. dollar, in part due to acquisitions, with the remainder mainly driven by improved revenue in Wealth Management and BMO Capital Markets. Other employee compensation, which includes salaries, benefits and severance, increased 4%, excluding the impact of the stronger U.S. dollar, due to continued investment in the business and higher severance. Premises and equipment costs increased $165 million or 9%, due to higher costs related to technology investments. Other adjusted expenses increased $316 million or 14%, reflecting increases in legal and regulatory costs, professional fees and marketing costs. BMO’s reported efficiency ratio increased by 160 basis points to 65.3% in 2014. The adjusted efficiency ratio increased by 90 basis points to 64.4%. The adjusted efficiency ratio excluding PBCAE(1) was 59.1% in 2014 compared to 60.4% in 2013. Canadian P&C is BMO’s largest operating segment, and its reported efficiency ratio of 50.2% improved by 100 basis points mainly due to good revenue growth and disciplined cost management. The adjusted efficiency ratio in Wealth Management increased by 480 basis points to 71.8%, mainly due to a security gain in the prior year and the settlement of a legal matter in 2014. The efficiency ratio (or expense-to-revenue ratio) is a key measure of productivity. It is calculated as non-interest expense divided by total revenues (on a taxable equivalent basis in the operating groups), expressed as a percentage. The adjusted efficiency ratio is another key measure of productivity and is calculated in the same manner, utilizing adjusted revenue and expense. Contribution to Growth in Adjusted Non-Interest Expense and Non-Interest Expense (%) For the year ended October 31 2014 2013 Significant businesses acquired Canadian/U.S. dollar translation effect, excluding acquisitions Other Total adjusted non-interest expense growth Impact of adjusting items Total non-interest expense growth 1.5 2.5 6.3 10.3 (3.5) 6.8 0.4 0.8 2.5 3.7 (2.8) 0.9 2012 10.2 0.7 0.4 11.3 4.6 15.9 M D & A Adjusted Non-Interest Expense and Non-Interest Expense (Canadian $ in millions, except as noted) For the year ended October 31 2014 2013 Change from 2013 (%) 2012 Performance-based compensation Other employee compensation Total employee compensation Premises and equipment Other Amortization of intangible assets 1,939 4,294 6,233 1,908 2,378 242 Total adjusted non-interest expense Adjusting items 10,761 160 1,682 4,026 5,708 1,743 2,083 221 9,755 471 1,641 3,710 5,351 1,719 2,143 197 9,410 725 Total non-interest expense 10,921 10,226 10,135 Adjusted non-interest expense growth (%) Non-interest expense growth (%) na – not applicable 10.3 6.8 3.7 0.9 11.3 15.9 15 7 9 9 14 10 10 (66) 7 na na BMO Capital Markets reported efficiency ratio increased by Efficiency Ratio by Group (teb) (%) 180 basis points to 63.2% as the rate of growth in revenue across both Investment and Corporate Banking and Trading Products was more than offset by the pace of growth on employee-related costs and increased support costs, both driven by a changing business and regulatory envi- ronment, as well as by stronger performance. The adjusted efficiency ratio in U.S. P&C increased by 170 basis points to 63.4% primarily due to lower revenue. Reported operating leverage was negative 2.7% in 2014 and adjusted operating leverage was negative 1.6%. We aim to improve efficiency and generate operating leverage by driving revenue growth through a strong customer focus and by maintaining disciplined cost management while making selective investments. Examples of initiatives to enhance productivity are outlined in the 2014 Operating Groups Performance Review, which starts on page 42. (1) This ratio is calculated excluding insurance policyholder benefits, claims and acquisition expenses (PBCAE). For the year ended October 31 2014 2013 2012 Efficiency Ratio Canadian P&C U.S. P&C Wealth Management BMO Capital Markets Total BMO Adjusted Efficiency Ratio Canadian P&C U.S. P&C Wealth Management BMO Capital Markets Total BMO 50.2 65.6 73.9 63.2 65.3 50.1 63.4 71.8 63.1 64.4 51.2 64.3 68.1 61.4 63.7 51.0 61.7 67.0 61.4 63.5 50.8 64.0 76.4 61.1 63.6 50.7 60.8 75.4 61.1 63.3 Caution This Non-Interest Expense section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 41 MANAGEMENT’S DISCUSSION AND ANALYSIS Provision for Income Taxes The provision for income taxes reflected in the Consolidated Statement of Income is based upon transactions recorded in income, regardless of when such transactions are subject to taxation by tax authorities, with the exception of the repatriation of retained earnings from foreign sub- sidiaries, as outlined in Note 25 on page 171 of the financial statements. Management assesses BMO’s consolidated results and associated provisions for income taxes on a GAAP basis. We assess the perform- ance of the operating groups and associated income taxes on a taxable equivalent basis and report accordingly. The provision for income taxes was $903 million in 2014, compared with $1,055 million in 2013. The reported effective tax rate in 2014 was 17.2%, compared with 20.1% in 2013. The adjusted provision for income taxes(1) was $943 million in 2014, compared with $1,037 million in 2013. The adjusted effective tax rate in 2014 was 17.5%, compared with 19.7% in 2013. The lower adjusted effective tax rate was mainly attributable to higher tax-exempt income and a lower proportion of income from higher tax-rate jurisdictions. BMO partially hedges the foreign exchange risk arising from its for- A & D M currency. Under this program, the gain or loss on hedging and the unreal- ized gain or loss on translation of foreign operations are charged or credited to shareholders’ equity. For income tax purposes, the gain or loss on the hedging activities results in an income tax charge or credit in the current period, which is charged or credited to shareholders’ equity, while the associated unrealized gain or loss on the foreign operations does not incur income taxes until the investments are liquidated. The income tax charge/benefit arising from a hedging gain/loss is a function of the fluctuations in exchange rates from period to period. Hedging of the foreign operations has given rise to an income tax recovery in shareholders’ equity of $144 million for the year, compared with $146 million in 2013. Refer to the Consolidated Statement of Changes in Equity on page 126 of the financial statements for further details. Table 4 on page 109 details the $1,505 million of total net govern- ment levies and income tax expense incurred by BMO in 2014. The decrease from $1,641 million in 2013 was primarily due to lower income tax expense. (1) The adjusted rate is computed using adjusted net income rather than net income in the eign operations by funding the investments in a corresponding foreign determination of income subject to tax. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 2014 Operating Groups Performance Review Adjusted Net Income by Operating Segment* Adjusted Net Income by Country 2014 Canadian P&C 44% U.S. P&C 15% Wealth Management 18% BMO CM 23% 2013 Canadian P&C 42% U.S. P&C 14% Wealth Management 20% BMO CM 24% 2014 Canada 74% U.S. 21% Other countries 5% 2013 Canada 71% U.S. 25% Other countries 4% Results provide attractive diversification across businesses and geographies. *Percentages determined excluding results in Corporate Services. This section includes an analysis of the financial results of our operating groups and descriptions of their businesses, strategies, strengths, chal- lenges, key value drivers, achievements and outlooks. Personal and Commercial Banking (P&C) (pages 44 to 50) Net income was $2,662 million in 2014, an increase of $269 million or 11% from 2013. Adjusted net income was $2,718 million, an increase of $265 million or 11%. Personal and Commercial Banking is comprised of two operating segments: Canadian Personal and Commercial Banking (Canadian P&C) and U.S. Personal and Commercial Banking (U.S. P&C). Wealth Management (pages 51 to 53) Net income was $785 million in 2014, a decrease of $45 million or 5% from 2013. Adjusted net income was $848 million, a decrease of $9 million or 1% as the prior year included a significant security gain. BMO Capital Markets (BMO CM) (pages 54 to 56) Net income was $1,079 million in 2014, an increase of $35 million or 3% from 2013. Adjusted net income was $1,080 million, an increase of $34 million or 3%. Corporate Services, including Technology and Operations (page 57) Net loss was $193 million in 2014, compared with a net loss of $72 million in 2013. Adjusted net loss was $193 million, compared with an adjusted net loss of $133 million in 2013. Allocation of Results The basis for the allocation of results geographically and among operating groups is outlined in Note 27 on page 173 of the financial statements. Certain prior year data has been restated, as explained on the following page, which also provides further information on the allocation of results. 42 BMO Financial Group 197th Annual Report 2014 Contributions to Revenue, Expenses, Net Income and Average Assets by Operating Group and by Location (Canadian $ in millions, except as noted) Personal and Commercial Banking Wealth Management BMO Capital Markets Corporate Services, including Technology and Operations Total Consolidated For the year ended October 31 2014 2013 2012 2014 2013 2012 2014 2013 2012 2014 2013 2012 2014 2013 2012 Operating Groups Relative Contribution to BMO’s Performance (%) 56.1 Revenue 48.8 Expenses 57.0 Net income Adjusted net income 57.1 48.2 61.4 22.9 26.0 18.1 56.4 48.9 55.8 21.5 23.0 19.8 61.0 44.3 58.1 43.6 59.0 41.1 19.0 4.2 20.3 4.0 18.2 21.9 12.7 13.5 3.7 22.3 21.5 24.9 24.3 43.9 21.1 20.4 24.9 24.8 44.6 20.4 19.6 23.7 24.3 46.2 (2.3) 4.3 (4.4) (4.3) 7.6 1.3 7.8 (1.7) (3.2) 7.8 Average assets Total Revenue Canada United States Other countries Total Expenses Canada United States Other countries Net Income Canada United States Other countries 6,404 3,146 2 6,020 2,991 1 5,900 3,078 – 2,509 788 536 2,234 910 304 1,977 702 221 2,215 1,299 210 2,146 1,093 153 2,028 1,022 199 (209) (203) 21 (116) 322 5 9,552 9,012 8,978 3,833 3,448 2,900 3,724 3,392 3,249 (391) 211 3,194 2,071 – 3,055 1,940 – 2,957 2,001 – 1,818 721 295 1,647 599 101 1,602 557 56 1,174 984 195 1,074 854 156 1,005 831 150 5,265 4,995 4,958 2,834 2,347 2,215 2,353 2,084 1,986 2,006 655 1 1,810 582 1 1,768 552 – 2,662 2,393 2,320 Adjusted Net Income Canada United States Other countries 2,009 708 1 1,815 637 1 1,771 623 – 2,718 2,453 2,394 503 58 224 785 521 80 247 848 428 206 196 830 429 228 200 857 272 88 167 527 274 104 170 548 799 253 27 823 220 1 1,079 1,044 799 254 27 823 222 1 1,080 1,046 803 140 42 985 803 141 42 986 5.0 9.6 7.8 3.2 9.0 66 655 81 802 407 538 31 976 1 257 66 324 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 10,919 5,030 769 10,284 5,316 463 9,971 5,457 501 16,718 16,063 15,929 6,447 3,936 538 6,115 3,821 290 5,971 3,927 237 10,921 10,226 10,135 3,261 847 225 2,889 1,126 180 2,844 1,037 275 4,333 4,195 4,156 M D & A 261 160 48 469 339 428 33 800 (47) (119) (27) (172) 118 (18) (193) (72) (47) (119) (27) (87) (25) (21) (40) 217 (46) 3,282 923 248 2,980 1,062 181 2,808 1,085 166 (193) (133) 131 4,453 4,223 4,059 Average Assets Canada United States Other countries 190,053 177,016 161,301 62,218 64,866 – 18 73,165 39 18,368 17,438 15,974 3,678 3,527 702 1,178 4,055 2,557 142,231 133,151 139,333 94,691 96,101 17,538 18,357 99,062 19,669 19,408 17,735 15,994 25,260 25,345 30,161 2,341 699 61 370,060 345,340 332,602 201,542 189,839 190,748 20,581 20,252 22,326 263,257 241,900 223,519 24,980 22,143 20,354 260,962 247,609 251,562 44,729 43,779 48,496 593,928 555,431 543,931 How BMO Reports Operating Group Results Periodically, certain business lines and units within the business lines are transferred between client and corporate support groups to more closely align BMO’s organizational structure with its strategic priorities. In addition, revenue and expense allocations are updated to more accurately align with current experience. Results for prior periods are restated to conform to the current presentation. Corporate Services results reflect certain items in respect of the purchased loan portfolio, including the recognition of a portion of the credit mark that is reflected in net interest income over the term of the purchased loans and provisions and recoveries of credit losses on the purchased portfolio. Amounts excluded from adjusted results in prior years included credit-related items in respect of the purchased performing loan portfolio, acquisition integration costs, restructuring costs and run-off structured credit activities. periodic provisions for credit losses charged to the operating group segments under our expected loss provisioning methodology and the periodic provisions required under GAAP. As part of this change, the interest income resulting from the accretion of the net present value of impaired loans is also included in operating group net interest income. Prior period results have been restated accordingly. Provisions for the purchased performing and purchased credit impaired loan portfolios continue to be evaluated and reported in Corporate Services. During 2013, we refined our methodology for the allocation of certain revenues in Corporate Services by geographic region. As a consequence, we have reallocated certain revenues reported in prior periods from Canada to the United States in Corporate Services. During 2012, Wealth Management and Canadian P&C entered into an agreement that changes the way they report the financial results related to retail mutual fund sales. Effective November 1, 2013, we adopted several new and amended BMO analyzes revenue at the consolidated level based on GAAP accounting pronouncements issued by the International Accounting Standards Board (IASB), which are outlined in Note 1 on page 128 of the financial statements. In the first quarter of 2013, we changed the way in which we evaluate our operating segments to reflect the provisions for credit losses on an actual credit loss basis. The change in allocation method- ology enhances the assessment of performance against our peer group. Previously, we had charged the operating groups with credit losses based on an expected loss provisioning methodology whereby Corpo- rate Services was charged (or credited) with differences between the revenue reflected in the consolidated financial statements rather than on a taxable equivalent basis (teb), which is consistent with our Cana- dian peer group. Like many banks, we analyze revenue on a teb basis at the operating group level. This basis includes an adjustment that increases GAAP revenue and the GAAP provision for income taxes by an amount that would raise revenues on certain tax-exempt items to a level equivalent to amounts that would incur tax at the statutory rate. The offset to the group teb adjustments is reflected in Corporate Serv- ices revenue and income tax provisions. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 43 MANAGEMENT’S DISCUSSION AND ANALYSIS Personal and Commercial Banking The Personal and Commercial Banking (P&C) operating group represents the sum of our two retail and business banking operating segments, Canadian Personal and Commercial Banking (Canadian P&C) and U.S. Personal and Commercial Banking (U.S. P&C). These operating segments are reviewed separately in the sections that follow. Canadian P&C U.S. P&C Total P&C 2014 2013 2012 2014 2013 2012 2014 2013 2012 (Canadian $ in millions, except as noted) As at or for the year ended October 31 Net interest income (teb) Non-interest revenue Total revenue (teb) Provision for credit losses Non-interest expense Income before income taxes Provision for income taxes (teb) Reported net income Amortization of acquisition-related intangible assets (1) A & D M 4,772 1,723 6,495 541 3,260 2,694 680 2,014 8 4,526 1,580 6,106 572 3,126 2,408 596 1,812 10 4,467 1,517 5,984 613 3,043 2,328 579 1,749 10 Adjusted net income 2,022 1,822 1,759 Key Performance Metrics and Drivers Net income growth (%) Adjusted net income growth (%) Revenue growth (%) Non-interest expense growth (%) Adjusted non-interest expense growth (%) Return on equity (%) Adjusted return on equity (%) Operating leverage (teb) (%) Adjusted operating leverage (teb) (%) Efficiency ratio (teb) (%) Adjusted efficiency ratio (teb) (%) Net interest margin on average earning assets (teb) (%) Average common equity Average earning assets Average current loans and acceptances Average deposits Assets under administration Full-time equivalent employees 11.1 11.0 6.4 4.3 4.3 2.1 2.1 50.2 50.1 2.59 3.6 3.6 2.1 2.7 2.8 (0.6) (0.7) 51.2 51.0 2.64 2.1 2.2 (3.3) (2.9) (3.0) (0.4) (0.3) 50.8 50.7 2.85 183,947 171,285 156,723 188,330 175,079 159,484 124,930 113,912 106,555 15,521 16,148 16,197 15,945 17,486 15,921 2,488 569 3,057 164 2,005 888 240 648 48 696 11.5 10.2 5.2 7.2 8.0 (2.0) (2.8) 65.6 63.4 3.74 2,327 579 2,906 223 1,869 814 233 581 50 631 1.8 (0.5) (3.0) (2.4) (1.6) (0.6) (1.4) 64.3 61.7 3.99 2,405 589 2,994 274 1,915 805 234 571 64 635 +100 +100 49.7 55.5 54.0 (5.8) (4.3) 64.0 60.8 4.31 66,565 59,848 64,973 58,369 55,857 52,421 50,711 60,645 59,147 123,082 112,732 96,803 7,906 7,753 7,932 7,260 2,292 9,552 705 5,265 3,582 920 2,662 56 6,853 2,159 9,012 795 4,995 3,222 829 2,393 60 6,872 2,106 8,978 887 4,958 3,133 813 2,320 74 2,718 2,453 2,394 11.2 10.8 6.0 5.4 5.7 16.7 17.0 0.6 0.3 55.1 54.3 2.90 15,410 17.6 3.2 18.7 2.5 9.6 0.4 13.6 0.8 12.7 1.1 17.8 16.9 18.4 17.3 (4.0) (0.4) (3.1) (0.7) 55.2 55.4 54.1 54.5 3.23 2.98 12,611 13,723 250,512 229,654 212,580 248,178 227,500 210,195 189,903 174,557 165,702 140,568 128,880 112,324 24,103 23,877 23,674 (1) Before tax amounts of: $76 million in 2014; $87 million in 2013; and $105 million in 2012 are included in non-interest expense. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 44 BMO Financial Group 197th Annual Report 2014 Canadian Personal and Commercial Banking Canadian Personal and Commercial Banking provides a full range of financial products and services to more than seven million customers. We’re here to help our customers make the right financial decisions as they do business with us through their channel of choice: in our branches, on their mobile devices, online, over the telephone, and through our automated banking machines. Cameron Fowler Group Head Canadian Personal and Commercial Banking BMO Financial Group Lines of Business Personal Banking provides customers with a wide range of products and services, including chequing and savings accounts, credit cards, mortgages, creditor insurance and everyday financial and investment advice. M D & A Commercial Banking provides small business and commercial banking customers with a broad suite of commercial products and services, including business deposit accounts, commercial credit cards, business loans and commercial mortgages, cash management solutions, foreign exchange and specialized banking programs. Strengths and Value Drivers ‰ Highly engaged team of 16,000 employees focused on anticipating customers’ needs, finding ways to help and providing a personalized banking experience. ‰ Award-winning mobile and online banking services. ‰ Largest MasterCard® issuer in Canada as measured by transaction volumes, and one of the top commercial card issuers in North America. ‰ Highly experienced team of commercial bankers with deep knowl- edge; specialized banking programs, including Automotive Finance for Dealerships, Agriculture, Healthcare and Franchising. ‰ Strong competitive position in commercial banking, reflected in our number two ranking in market share for business loans of $25 million and less. ‰ Effective and consistently applied credit risk management practices that provide customers with reliable access to appropriate financing solutions in all economic conditions. Strategy and Key Priorities 2015 Focus ‰ Continue to focus on achieving industry-leading employee engage- ment and customer loyalty. Expand relationships with our personal banking customers 2014 Achievements ‰ Achieved strong personal lending and deposit growth of 7% and 10%, respectively. ‰ Our successful UPGRADE card campaign generated more than double the number of new accounts opened in the prior year. ‰ Our Summer Everyday Banking campaign generated growth of 10% in new chequing account acquisitions. ‰ Our leads management engine continued to provide our customers with relevant and timely offers and services, increasing share of wallet and contributing to the personal banking revenue growth achieved in 2014. ‰ 2015 Focus Increase share of wallet and attract new customers in under- represented customer segments and products. Our strategy is focused on improving sales productivity and delivering a differentiated customer experience to drive peer leading organic growth. Drive growth in commercial lending and deposits through targeted opportunities Achieve industry-leading employee engagement and customer loyalty 2014 Achievements ‰ Achieved exemplary employee engagement and commitment to providing a differentiated customer experience. Scores in our annual employee survey indicated a high level of confidence in BMO and our customer-focused strategy. ‰ Achieved top-tier customer loyalty as measured by Net Promoter Score. Enhanced our methodology to provide our employees with a deeper understanding of loyalty drivers at both a full relationship and transaction level. 2014 Achievements ‰ ‰ Achieved commercial lending and deposit growth of 10% and 9%, respectively, while adhering to prudent risk management practices. Implemented new commercial organizational structure and improved our performance management process to enhance sales force pro- ductivity. ‰ Successfully completed a pilot program for BMO DepositEdge™ that will provide businesses with the capability to deposit cheques remotely. 2015 Focus ‰ Continue to grow our commercial business by targeting opportunities by geography, segment and industry. BMO Financial Group 197th Annual Report 2014 45 MANAGEMENT’S DISCUSSION AND ANALYSIS Reported Net Income ($ millions) 2,014 1,749 1,812 Average Current Loans and Acceptances ($ billions) 138.3 129.3 117.9 41.6 45.8 50.0 Personal Commercial Average Deposits ($ billions) 69.6 72.5 79.6 37.0 41.4 45.3 Personal Commercial 2012 2013 2014 2012 2013 2014 2012 2013 2014 Build an integrated and seamless channel experience, and accelerate our digital and physical channel capabilities Canadian P&C (Canadian $ in millions, except as noted) As at or for the year ended October 31 2014 2013 2012 A & D M 2014 Achievements ‰ Enhanced our BMO mobile banking application, which provides customers with enhanced capabilities, including the ability to send Interac® e-Transfers and book branch appointments anywhere, any- time. The updated application has been well received by our customers, and the number of mobile transactions has nearly doubled over the past year. ‰ ‰ First Canadian bank to give customers the ability to transfer money between Canadian and U.S. dollar accounts through mobile banking. Implemented a new commercial lending platform with end-to-end adjudication capabilities, enabling consistent process execution and a better customer experience. ‰ Completed conversion of our retail credit card portfolio to a better platform, providing enhanced functionality as well as stronger risk management capabilities. ‰ Opened or upgraded 93 branches across Canada and expanded our ABM network by 116. 2015 Focus ‰ Enhance our digital capabilities and provide a seamless channel experience. Financial Review Canadian P&C reported net income of $2,014 million, up $202 million or 11% from a year ago. Revenue increased $389 million or 6% to $6,495 million. Revenue growth was at or above 6% each quarter driven by strong loan and deposit growth. Operating leverage was 2.1% and there was a 100 basis point improvement in our efficiency ratio. Revenue increased $239 million or 6% in our personal banking business and revenue increased $150 million or 7% in our commercial banking business, mainly driven by growth in balances and fees across most products. Provisions for credit losses declined $31 million or 5% to $541 million, due to lower provisions in both the commercial and consumer portfolios. Non-interest expense was $3,260 million, up $134 million or 4% from a year ago, primarily due to continued investment in the business, net of expense management. 46 BMO Financial Group 197th Annual Report 2014 Net interest income Non-interest revenue Total revenue Provision for credit losses Non-interest expense Income before income taxes Provision for income taxes 4,772 1,723 6,495 541 3,260 2,694 680 4,526 1,580 6,106 572 3,126 2,408 596 4,467 1,517 5,984 613 3,043 2,328 579 Reported net income 2,014 1,812 1,749 Amortization of acquisition-related intangible assets (1) Adjusted net income Key Performance Metrics and Drivers Personal revenue Commercial revenue Net income growth (%) Revenue growth (%) Non-interest expense growth (%) Operating leverage (%) Efficiency ratio (%) Net interest margin on average earning assets (%) Average earning assets Average current loans and acceptances Average deposits Full-time equivalent employees 8 10 10 2,022 1,822 1,759 4,271 2,224 11.1 6.4 4.3 2.1 50.2 4,032 2,074 3.6 2.1 2.7 (0.6) 51.2 3,934 2,050 2.1 (3.3) (2.9) (0.4) 50.8 2.64 2.59 2.85 183,947 171,285 156,723 188,330 175,079 159,484 124,930 113,912 106,555 16,197 15,945 15,921 (1) Before tax amounts of $10 million in 2014, $12 million in 2013, and $11 million in 2012 are included in non-interest expense. Average current loans and acceptances increased $13.3 billion or 8% from a year ago to $188.3 billion. Total personal lending balances (excluding retail cards) increased 7% year over year, driven by strong residential mortgage growth. Credit card balances increased 2%, reflecting modestly higher growth in both retail and corporate cards. Broad-based growth across industry sectors contributed to commercial loan balances (excluding corporate cards) increasing 10% year over year. Average deposits increased $11.0 billion or 10% to $124.9 billion. Personal deposit balances increased 10%, mainly due to growth in term deposits, as well as growth in primary chequing accounts. Commercial deposit balances grew 9% with growth coming across a wide number of sectors. We expect to generate revenue growth by targeting opportunities to attract new customers and increasing our share of wallet while con- tinuing to improve productivity. Business Environment, Outlook and Challenges Canada’s economy is expected to grow moderately in 2015, reflecting rising levels of business investment and exports in response to the strengthening U.S. economy and a weaker Canadian dollar. In the Canadian personal banking sector, retail operating deposits are projected to grow in 2015 by approximately 5%, slightly below 2014 levels and in line with the expected increase in personal income. Credit card loan balances grew by approximately 3% in 2014 and this growth is projected to strengthen gradually next year. The slowdown in resi- dential mortgage growth over the past several years appears to be ending, with 2015 growth rates expected to be in line with 2014 levels of approximately 5%. Moderate increases anticipated in employment in 2015 should keep the demand for housing and house prices fairly steady. In the commercial banking sector, growth in commercial operating deposits is expected to moderate in 2015 from double-digit levels in 2014. With a higher rate of economic growth, companies are expected to reduce their precautionary savings and increase business investment. We will target growth in under-represented customer segments and products, as well as by continuing to improve our sales force pro- ductivity. While the industry faces increasingly complex regulatory, information security and fraud prevention requirements, our robust and effective governance framework continues to position us well to mon- itor any such changes and respond accordingly. With competition for skilled resources becoming more intense, we continue to monitor employee engagement to ensure that BMO remains at or above the financial industry average. The Canadian economic environment in 2014 and outlook for 2015 are discussed in more detail in the Economic Developments and Outlook section on page 30. Caution This Canadian P&C Banking section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. M D & A Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 47 MANAGEMENT’S DISCUSSION AND ANALYSIS U.S. Personal and Commercial Banking We help more than two million customers feel confident in the decisions they make. Our retail and small and mid-sized business banking customers are served through our more than 600 branches, contact centres, online and mobile banking platforms and more than 1,300 ABMs across eight states. We offer financial expertise to our commercial banking customers with in-depth, specific industry knowledge and strategic capital markets solutions. A & D M Mark Furlong Group Head U.S. Personal and Commercial Banking and CEO, BMO Harris Bank N.A. Chicago Lines of Business Personal Banking offers a broad range of products and services to individuals, as well as small and mid-sized business customers, including deposits, mortgages, consumer credit, business lending, credit cards and other banking services. Strengths and Value Drivers ‰ Rich heritage of more than 160 years in the U.S. Midwest, with a deep commitment to the community and helping our customers succeed. ‰ Strong, experienced leadership team that knows how to compete and excel in our markets. ‰ Enviable platform for profitable growth provided by our attractive branch footprint and top-tier deposit market share in key U.S. Midwest markets. ‰ Large-scale, relationship-based national commercial banking business based in the U.S. Midwest, with in-depth industry knowledge in select sectors. ‰ We actively manage risks and regulatory compliance through a comprehensive and integrated control structure. Strategy and Key Priorities We aim to grow our business and be a leader in our markets by creating a differentiated customer experience and helping our customers with a wide range of financial topics, leveraging our brand reputation, local presence and high-performance teams. Deliver a great customer experience to a loyal, profitable and growing customer base 2014 Achievements ‰ Loan and deposit sales to our mass affluent customers grew by 60% and 26%, respectively. ‰ Positive customer response on our mid-market business banker per- formance survey, with high marks for trust, confidence and responsiveness. The number of new business banking customers was 20% higher than in the prior year. In Illinois, launched BMO Harris Healthy CreditTM, an innovative service that educates customers about their credit scores when they open a deposit account. ‰ ‰ Enhanced customer satisfaction monitoring with the introduction of Customer Pulse U.S., which provides frequent updates on customers’ needs and enables a faster response from management. 2015 Focus ‰ Maintain strong customer loyalty and increase brand awareness, while growing our customer base in high-opportunity segments, including the Latino community and mass affluent and earlier life stage consumers. 48 BMO Financial Group 197th Annual Report 2014 Commercial Banking provides larger businesses with a broad range of banking products and services, including lending, deposits, treasury management and risk management. Continue to improve our product and channel capabilities to better meet our customers’ needs 2014 Achievements ‰ ‰ Enhanced our mobile banking platform to enable our customers to book appointments with branch staff. The number of customers accessing our mobile banking platform grew by 18% and mobile banking deposits increased by 60%. Increased the total sales generated per mortgage banker by 37% through enhanced coaching, which focused on both the realtor and purchase business and a more effective approach to customer inter- action during the credit approval process. Increased core business banking loan balances through continual coaching that focused on improving interactions with customers. ‰ Enhanced training for our treasury sales force, resulting in a better ‰ client experience and gains in productivity of 22% over the prior year for commercial banking and 53% for business banking. 2015 Focus ‰ Continue to build foundational capabilities in products, digital chan- nels, our customer acquisition engine and branch format. Improve financial performance by growing revenue and effectively managing costs 2014 Achievements ‰ Total loans grew by $2.9 billion or 5%, while the core commercial and industrial (C&I) loan portfolio grew by $4.0 billion or 18%. ‰ Deposits remained stable, while chequing account balances grew by $2.7 billion or 9%. We maintained the number four market share position within our primary footprint of Illinois, Wisconsin, Missouri, Kansas, Indiana and Minnesota. ‰ Good momentum in the second half of the year, with 2% year-over- year revenue growth and full-year adjusted net income growth of 3%. ‰ Continued to manage expenses effectively despite higher regulatory costs and ongoing investments in the business. ‰ 2015 Focus Increase loan and deposit balances while focusing on cost management. Adjusted Net Income (US$ millions) 632 619 636 Average Current Loans and Acceptances (US$ billions) Average Deposits (US$ billions) 26.0 24.5 26.8 24.6 30.8 23.9 Personal Commercial Personal Commercial 41.3 39.6 37.7 17.7 19.7 21.7 2012 2013 2014 2012 2013 2014 2012 2013 2014 Continue to deploy our unique commercial operating model by delivering local access and industry expertise to our clients across a broad geographic footprint 2014 Achievements ‰ Continued focus on new client acquisitions resulted in an increase of 9% in new client relationships over 2013 base. ‰ Strong core C&I and commercial real estate loan growth, with year- over-year increases of 18% in both segments. ‰ Strong focus on our corporate payments business, which had an increase of 6% in transactional revenues from the prior year. 2015 Focus ‰ Keep building on the strength of our commercial banking business, focusing on new client acquisitions, increasing our market share and extending our corporate payments penetration. Financial Review Amounts in this section are expressed in U.S. dollars. Net income of $592 million increased $22 million or 4% from a year ago. Adjusted net income of $636 million increased $17 million or 3%. Revenue decreased $45 million or 2% to $2,796 million as the benefits of strong commercial loan growth were more than offset by the effects of lower net interest margin and reduced mortgage banking revenue. In our commercial banking business, revenue increased $52 million or 4% to $1,386 million, reflecting strong loan balance growth, primarily in the core C&I loan portfolio, partly offset by the impact of competitive spread compression. In our personal banking business, revenue decreased by $110 million or 7% to $1,363 million, primarily due to declines in loan spreads and balances and reduced mortgage banking revenue. Net interest margin decreased by 25 basis points to 3.74%, driven by competitive loan pricing, changes in mix including loans growing faster than deposits and the low rate environment. Provisions for credit losses of $150 million declined by $67 million or 31% from a year ago, primarily reflecting better credit quality in the consumer loan portfolio. Non-interest expense of $1,833 million increased $7 million. Adjusted non-interest expense of $1,772 million increased $20 million or 1%, as we continue to focus on productivity while making selective investments in the business and responding to regulatory changes. M D & A U.S. P&C (US$ in millions, except as noted) As at or for the year ended October 31 2014 2013 2012 Net interest income (teb) Non-interest revenue Total revenue (teb) Provision for credit losses Non-interest expense Income before income taxes Provision for income taxes (teb) Reported net income Amortization of acquisition-related intangible assets (1) Adjusted net income Key Performance Metrics and Drivers Net income growth (%) Adjusted net income growth (%) Revenue growth (%) Non-interest expense growth (%) Adjusted non-interest expense growth (%) Operating leverage (teb) (%) Adjusted operating leverage (teb) (%) Efficiency ratio (teb) (%) Adjusted efficiency ratio (teb) (%) Net interest margin on average earning assets (teb) (%) Average earning assets Average current loans and acceptances Average deposits Full-time equivalent employees 2,275 521 2,796 150 1,833 813 221 592 44 636 3.9 2.7 (1.6) 0.4 1.1 (2.0) (2.7) 65.6 63.4 2,274 567 2,841 217 1,826 798 228 570 49 619 – (2.2) (4.9) (4.4) (3.5) (0.5) (1.3) 64.3 61.7 2,398 588 2,986 273 1,910 803 234 569 63 632 +100 +100 47.4 53.2 51.6 (5.7) (4.2) 64.0 60.8 3.74 60,845 54,706 59,403 7,753 3.99 57,023 51,356 59,257 7,932 4.31 55,682 50,549 58,964 7,906 (1) Before tax amounts of: $61 million in 2014; $74 million in 2013; and $94 million in 2012 are included in non-interest expense. Average current loans and acceptances increased $3.4 billion to $54.7 billion. The core C&I loan portfolio continues to experience strong growth, increasing by $4.0 billion or 18% from a year ago to $26.5 billion. We have grown our commercial real estate portfolio by $0.5 billion or 18% in addition to growing our indirect automobile loan portfolio by $0.8 billion or 13% from a year ago. These increases parti- ally offset decreases in home equity and mortgage loans, due in part to the effects of our continued practice of selling most mortgage origi- nations in the secondary market and our active loan portfolio management. Average deposits of $59.4 billion were relatively unchanged, as growth in our commercial business and in our personal chequing accounts was offset by a planned reduction in higher-cost personal money market and time deposit accounts. BMO Financial Group 197th Annual Report 2014 49 MANAGEMENT’S DISCUSSION AND ANALYSIS Business Environment, Outlook and Challenges U.S. P&C has a significant footprint in eight states, primarily concentrated in six contiguous states (Illinois, Wisconsin, Indiana, Minnesota, Missouri and Kansas). After modest growth in 2013, the U.S. Midwest economy is on pace to grow by 2.1% in 2014, with that rate expected to reach 2.7% in 2015. An increase in business investments, expansion in the automobile sector and a continued recovery in housing markets supported growth in 2014, while fiscal policies became less restrictive. Growth in consumer and commercial loans accelerated in 2014, although residential mortgage growth was strained by tighter mortgage lending rules. Consumer loan volumes are expected to trend higher in 2015 due to relatively low interest rates, improved household finances and pent-up demand for automobiles. Residential mortgage growth will likely pick up as housing affordability remains healthy. Commercial loan growth should remain strong in response to higher levels of expected activity across our footprint. A & D M The banking environment in the U.S. Midwest remains highly competitive and the low interest rate environment continues to be challenging for the banking industry. We are continuing to concentrate on our customer-focused growth strategy and commercial sector expertise to generate growth in our loan and deposit balances and improve our financial performance, while actively managing costs to achieve greater efficiency. We expect to deliver growth while still operating within the parameters of our risk appetite, and we will con- tinue to actively manage risks and regulatory compliance through a reinforced oversight and control structure. The U.S. economic environment in 2014 and outlook for 2015 are discussed in more detail in the Economic Developments and Outlook section on page 30. Caution This U.S. P&C Banking section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 50 BMO Financial Group 197th Annual Report 2014 BMO Wealth Management BMO’s wealth business serves a full range of client segments from mainstream to ultra high net worth and institutional, with a broad offering of wealth management products and services including insurance products. Wealth Management is a global business with an active presence in markets across Canada, the United States, Europe and Asia. Gilles Ouellette Group Head Wealth Management Lines of Business BMO Nesbitt Burns, our full-service investing business in Canada, offers comprehensive and client-focused investment and wealth advisory services leveraging strong financial planning capabilities. BMO InvestorLine is an online investing service that offers clients two ways to invest: clients can choose our top-ranked self-directed service, which provides tools to help investors make independent investment decisions; or adviceDirect™, which provides investors with online advice and investment recommendations for their portfolios. BMO’s Private Banking businesses operate in Canada, the United States, Hong Kong and Singapore, offering a comprehensive range of financial services and solutions to high net worth and ultra high net worth clients and, under BMO Harris Financial Advisors, to mass affluent clients in the United States. Strengths and Value Drivers ‰ Planning and advice-based approach that integrates investments, insurance, specialized wealth management and core banking solutions. ‰ Team of highly skilled wealth professionals committed to providing an exceptional client experience. ‰ Brand prestige, recognition and trust. ‰ Strong national presence in Canada, as well as strategic positioning in the United States and select global markets including Europe and Asia. ‰ Access to BMO’s broad client base and distribution networks. ‰ A transparent, strong and effective risk management framework that enables us to operate within our risk appetite, effectively monitoring risk positions and limits and responding to heightened regulatory expectations. Strategy and Key Priorities Our vision is to be the wealth management solutions provider that defines great client experience. Our strategy is to deliver on our cli- ents’ wealth management needs now and in the future by enhancing the client experience, while focusing on productivity and investing for future growth. Enhance our clients’ experience by delivering on their evolving wealth management needs 2014 Achievements ‰ Enhanced digital client experience with a focus on convenience and value. ‰ Achieved assets under management and administration growth of $242 billion or 44% from a year ago to $794 billion, with the acquired F&C business contributing $150 billion to the increase. ‰ Continued to develop new products designed to respond to clients’ emerging needs. Launched seven new ETF funds this year and grew ETF assets under management to over $17 billion, representing a year-over-year increase of 45% in assets under management. M D & A BMO Global Asset Management is a global investment organization that provides investment management, retirement, and trust and custody services to institutional, retail and high net worth investors around the world. BMO Insurance operates in Canada and internationally. In Canada, we manufacture life insurance, accident and sickness insurance, and annuity products that are marketed both to brokers and directly to individuals. Our creditor insurance division markets group creditor insurance, and internationally, we provide reinsurance solutions. ‰ BMO Nesbitt Burns launched a new webpage designed to educate and recruit women for investment advisory careers. BMO is the first finan- cial institution in Canada to do so. ‰ Received numerous awards, including Best Wealth Management in Canada, 2014 (Global Banking and Finance Review), BMO Harris Pri- vate Banking named Best Private Bank – Canada, 2014 (World Finance Magazine and Global Banking and Finance Review), and BMO Nesbitt Burns named Best Full-Service Investment Advisory in Canada (Global Banking and Finance Review). 2015 Focus ‰ Attract new clients and focus on delivering a tailored client experience. Streamline our products and simplify our processes 2014 Achievements ‰ Enhanced team-based client service model to provide a holistic approach that supports clients as they move through different life stages. ‰ Leveraged process transformation to increase capacity for our sales force and streamline our lending processes. ‰ Completed enhancements to our financial planning tool to deliver intuitive and customized graphics, additional retirement and scenario planning features, improved user interface, and client reporting. ‰ Launched pilot training program to develop best-in-class sales and relationship management capabilities. 2015 Focus ‰ Continue to improve productivity with emphasis on increasing revenue per employee. BMO Financial Group 197th Annual Report 2014 51 MANAGEMENT’S DISCUSSION AND ANALYSIS Adjusted Net Income ($ millions) Assets under Management and Administration ($ billions) 2014 Revenue by Line of Business (%) 857 848 Wealth Insurance 548 Assets under administration Assets under management 414.5 379.6 357.6 313.3 172.1 194.2 2012 2013 2014 2012 2013 2014 BMO Nesbitt Burns 31% BMO Insurance 12% BMO Global Asset Management 28% BMO’s Private Banking Businesses 24% BMO InvestorLine 5% A & D M Invest in our people, products, technology and footprint to drive future growth 2014 Achievements ‰ Completed the acquisition of F&C Asset Management plc (F&C). This acquisition strengthens the position of BMO Global Asset Management as a globally significant money manager, adding scale, capabilities and resources to its asset management platform and providing attrac- tive cross-selling opportunities. ‰ Continued to expand our sales forces in strategically important segments. ‰ Leveraged investments in technology to drive sales and improve efficiency. ‰ 2015 Focus Invest in our sales force and enhance technology to drive revenue growth. Financial Review Wealth Management net income was $785 million, compared to $830 million a year ago. Adjusted net income, which excludes the amortization of acquisition-related intangible assets and acquisition integration costs, was $848 million, compared to $857 million a year ago. Current year results reflect the contribution from the acquired F&C business and the prior year results included a $121 million after-tax security gain. Excluding the prior year security gain, Wealth Manage- ment revenue, adjusted non-interest expense and adjusted net income are up 18%, 19% and 15%, respectively. F&C contributed approximately 5% of the growth in each of these measures. Adjusted net income in traditional wealth was $562 million com- pared to $596 million a year ago, as strong growth from the businesses of $87 million or 18%, including the contribution from the acquired F&C business, was more than offset by the security gain in the prior year. Adjusted net income in insurance was $286 million, up $25 million or 9%. Revenue of $3,833 million increased $385 million or 11%. Revenue in traditional wealth increased $526 million or 19%, excluding the $191 million security gain in the prior year, reflecting growth in client assets and a contribution from the F&C acquisition. Insurance revenue increased $50 million or 12%, due to continued growth in both the underlying creditor and life insurance businesses of 10% and the impact of benefi- cial changes in actuarial reserves. The stronger U.S. dollar increased revenue by $50 million or 1%. The recovery of credit losses was $3 million as compared to a $3 million provision a year ago. Non-interest expense was $2,834 million, up $487 million or 21%. Adjusted non-interest expense was $2,752 million, up $441 million or 19%. The increase was due primarily to the impact of the F&C acquis- ition and higher revenue-based costs from organic operations. Current year results also include costs related to the settlement of a legal matter, as well as higher sales force investments for future revenue growth. The stronger U.S. dollar increased expenses by $44 million or 2%. 52 BMO Financial Group 197th Annual Report 2014 Wealth Management (Canadian $ in millions, except as noted) As at or for the year ended October 31 Net interest income Non-interest revenue Total revenue Provision for (recovery of) credit losses Non-interest expense Income before income taxes Provision for income taxes Reported net income Acquisition integration costs (1) Amortization of acquisition-related intangible assets (2) Adjusted net income Key Performance Metrics and Drivers Net income growth (%) Adjusted net income growth (%) Revenue growth (%) Non-interest expense growth (%) Adjusted non-interest expense growth (%) Return on equity (%) Adjusted return on equity (%) Operating leverage (%) Adjusted operating leverage (%) Efficiency ratio (%) Adjusted efficiency ratio (%) Net interest margin on average earning assets (%) Average common equity Average earning assets Average current loans and acceptances Average deposits Assets under administration Assets under management Full-time equivalent employees 2014 560 3,273 3,833 (3) 2,834 1,002 217 785 16 47 848 (5.4) (1.0) 11.2 20.8 19.1 18.6 20.1 (9.6) (7.9) 73.9 71.8 2013 558 2,890 3,448 3 2,347 1,098 268 830 – 27 857 57.4 56.4 18.9 6.0 5.7 28.5 29.4 12.9 13.2 68.1 67.0 2012 556 2,344 2,900 22 2,215 663 136 527 – 21 548 9.7 11.6 11.9 13.2 12.5 24.2 25.2 (1.3) (0.6) 76.4 75.4 2.65 4,181 21,169 12,897 24,912 414,547 379,606 6,792 2.87 2,884 19,399 11,909 23,337 357,594 194,158 6,005 3.11 2,143 17,875 10,833 21,753 313,337 172,076 6,108 U.S. Business Select Financial Data (US$ in millions) Total revenue Non-interest expense Reported net income Adjusted net income Average earning assets Average current loans and acceptances Average deposits 720 658 53 73 3,028 2,629 5,834 886 585 199 220 2,687 2,510 4,947 701 555 87 102 2,914 2,650 4,960 (1) F&C acquisition integration costs of $20 million before tax in 2014 are included in non- interest expense. (2) Before tax amounts of: $62 million in 2014; $36 million in 2013; and $28 million in 2012 are included in non-interest expense. Assets under management and administration grew by $242 billion to $794 billion, with the acquired F&C business contributing $150 billion. Excluding F&C, assets under management and administration grew by $92 billion, driven by market appreciation, the stronger U.S. dollar and growth in new client assets. Net income in Wealth Management U.S. businesses was US$53 million. Adjusted net income in Wealth Management U.S. businesses was US$73 million, compared to US$220 million a year ago, due to the prior year security gain, costs related to the settlement of a legal matter in the current year and sales force investments for future revenue growth. Business Environment, Outlook and Challenges Economic growth in Canada improved further to approximately 2.4% while the United States remained at approximately 2.3% in fiscal 2014. Canadian and U.S. stock markets recorded year-over-year gains in fiscal 2014 despite recent weakness. Our strong client asset growth and increase in transaction volumes have benefited from the favourable investment climate in addition to growth driven by our strategies focused on enhancing client experience, product innovation and sales force investments. In 2015 we anticipate that a sustained level of healthy activity in equity markets will continue to positively influence both transaction volumes and asset levels. Interest rates may start to rise in the fall of 2015 in Canada and the middle of year in the United States which will have a positive impact on our insurance business. Changing demographics, particularly in the retirement, mass affluent and high net worth sectors will continue to drive the North American wealth management industry over the longer term. Tailoring our offering for key client segments, enhancing our team-based client service model to provide a holistic approach that supports clients as they move through different life stages and keeping pace with technology advancements are ways in which we can continue to meet our clients’ evolving needs. We have experienced significant growth, both organically and through strategic acquisitions. Our recent F&C acquisition further strengthens our position as a globally significant money manager and supports our plans to offer truly global services to our clients across our international footprint. The Canadian and U.S. economic environment in fiscal 2014 and the outlook for fiscal 2015 are discussed in more detail in the Economic Developments and Outlook section on page 30. Caution This Wealth Management section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. M D & A Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 53 MANAGEMENT’S DISCUSSION AND ANALYSIS BMO Capital Markets BMO Capital Markets is a North American-based financial services provider offering a complete range of products and services to corporate, institutional, and government clients. BMO Capital Markets has approximately 2,400 professionals in 29 locations around the world, including 16 offices in North America. Darryl White Group Head BMO Capital Markets A & D M Lines of Business Investment and Corporate Banking offers clients debt and equity capital-raising services, as well as loan origination and syndication, balance sheet management solutions and treasury management services. We provide strategic advice on mergers and acquisitions, restructurings and recapitalizations, as well as valuation and fairness opinions. We also offer trade finance and risk mitigation services to support the international business activities of our clients and provide a wide range of banking and other operating services tailored to North American and international financial institutions. Strengths and Value Drivers ‰ A unified coverage approach and integrated distribution that creates an exceptional client experience across our North American platform, together with a complementary international presence in select industry sectors. Innovative ideas and expertise delivered through our top-tier coverage team, dedicated to understanding and meeting our core clients’ needs. ‰ ‰ Top-ranked equity and fixed income research, sales and trading capa- bilities with deep expertise in core sectors. ‰ Focus on first line of defence risk management capabilities enabling effective decision-making in support of our strategy and client experience. Strategy and Key Priorities BMO Capital Markets’ vision is to be the lead investment bank that enables our clients to achieve their ambitions. We offer an integrated platform that is differentiated by leading ideas and unified coverage. Continue to earn leading market share in Canada by delivering leading ideas through our top-tier coverage team 2014 Achievements ‰ Named 2014 Greenwich Quality Leader for Canadian Fixed Income Research, Canadian Equity Sales, Canadian Equity Research and Ana- lyst Service, Canadian Mergers and Acquisitions and Canadian Equity Capital Markets by Greenwich Associates. ‰ Ranked #1 (tied) as a Greenwich 2014 Share Leader in Canadian Investment Banking Market Penetration and #3 (tied) in Canadian Large Corporate Cash Management Market Penetration by Greenwich Associates. ‰ Ranked #2 (tied) as a 2014 Greenwich Share Leader for Canadian Equity Trading Share and #3 (tied) in Canadian Equity Research/ Advisory Portfolio manager Vote Share by Greenwich Associates. ‰ Ranked #2 as a 2014 Greenwich Share Leader in Canadian Foreign Exchange Market Share by Greenwich Associates. ‰ Named Best Bank in Canadian Dollar Foreign Exchange by FX week magazine for the fourth consecutive year. 54 BMO Financial Group 197th Annual Report 2014 Trading Products offers research and access to global markets for institutional, corporate and retail clients through an integrated suite of sales and trading solutions that include debt, foreign exchange, interest rate, credit, equity, securitization and commodities. We also offer new product development and origination services as well as risk management (derivatives) advice and services to hedge against price fluctuations on a variety of key inputs, including interest rates and commodities. In addition, we provide funding and liquidity management to our clients. 2015 Focus ‰ Continue to earn leading market share in Canada without taking out- sized risk. Leverage our North American capabilities in select strategic sectors in international markets to expand our client offering 2014 Achievements ‰ Named World’s Best Metals & Mining Investment Bank for the fifth consecutive year by Global Finance magazine. ‰ Named Best Trade Bank in Canada for the fifth consecutive year and named Best Supply Chain Finance Bank in North America by Trade Finance magazine. ‰ Co-financial advisor on one of the largest mining deals in recent years, representing the U.K.-based seller. 2015 Focus ‰ Continue to serve global clients with North American interests and extend our global leadership in select strategic sectors. Drive performance in our U.S. platform by leveraging our expanded distribution capabilities and focused research and coverage in strategic sectors 2014 Achievements ‰ ‰ Ranked among Top 20 global investment banks, and 13th-largest investment bank in North and South America based on fees by Thomson Reuters. Increased investment banking market share by 10% in our target U.S. mid-cap market year over year using Dealogic data. ‰ Increased equity-raising lead mandates by 85% year over year. ‰ Grew market share by 38% year over year in U.S. Equity Sales and Trading. 2015 Focus ‰ Continue to drive performance in our U.S. client franchise with a greater weighting in corporate banking to further support our clients and the stability of future earnings. Reported Net Income ($ millions) 1,044 1,079 985 Revenue ($ millions) 3,249 3,392 3,724 Revenue by Geography (%) 69% 68% 65% Canada and other countries United States 31% 32% 35% 2012 2013 2014 2012 2013 2014 2012 2013 2014 Continue to enhance our risk management and regulatory compliance practices to be responsive to an evolving regulatory environment 2014 Achievements ‰ Significantly invested in our next-generation market risk infrastructure which will generate future benefits for our risk governance structure. ‰ Continued to invest and proactively position the business to meet regulatory requirements using a cross-border approach for both compliance and risk management. 2015 Focus ‰ Continue to enhance our risk management, regulatory and compliance practices. Financial Review BMO Capital Markets net income increased $35 million or 3% to $1,079 million. The increase reflected growth in revenue across both Investment and Corporate Banking and Trading Products, with good contribution from our U.S. businesses, partially offset by an increase in expenses. Return on equity of 19.2% improved by 1.2% from the prior year. Revenue increased $332 million or 10% to $3,724 million, driven by higher net securities gains and increases in trading revenues, lending revenues and investment banking fees, particularly in our U.S. platform. The stronger U.S. dollar increased revenue by $85 million. Investment and Corporate Banking revenue increased $203 million or 16%, reflecting higher net securities gains and higher activity levels, particularly in equity underwriting, as well as growth in lending revenue. Trading Products revenue increased $129 million or 6%, reflecting growth in trading revenues, particularly from equity trading and foreign exchange trading related to more favourable market conditions, as well as higher securities commissions and fees. Our businesses continue to experience very low levels of credit losses. The recovery of credit losses was $18 million in 2014, compared to $36 million in 2013. Non-interest expense increased $269 million or 13% to $2,353 million, resulting from higher employee-related expenses and increased support costs, both driven by a changing business and regu- latory environment, as well as by stronger performance. The stronger U.S. dollar increased expenses by $63 million. Net income from U.S. operations increased US$17 million or 8% to US$233 million. Revenue increased from the prior year, driven by growth in investment banking fees, higher gains on securities and an increase in commission fees, partially offset by a decline in trading rev- enues. Recoveries of credit losses were lower compared with 2013. Non-interest expense increased from the prior year, resulting from higher employee-related expenses and increased support costs, both driven by a changing business and regulatory environment. M D & A BMO Capital Markets (Canadian $ in millions, except as noted) As at or for the year ended October 31 2014 2013 2012 Net interest income (teb) Non-interest revenue Total revenue (teb) Provision for (recovery of) credit losses Non-interest expense Income before income taxes Provision for income taxes (teb) Reported net income Amortization of acquisition-related intangible assets (1) Adjusted net income Key Performance Metrics and Drivers Trading Products revenue Investment and Corporate Banking revenue Net income growth (%) Revenue growth (%) Non-interest expense growth (%) Return on equity (%) Operating leverage (teb) (%) Efficiency ratio (teb) (%) Net interest margin on average earning assets (teb) (%) Average common equity Average earning assets Average assets Average current loans and acceptances Average deposits Full-time equivalent employees 1,179 2,545 3,724 (18) 2,353 1,389 310 1,202 2,190 3,392 (36) 2,084 1,344 300 1,164 2,085 3,249 6 1,986 1,257 272 1,079 1,044 985 1 2 1,080 1,046 1 986 2,254 1,470 3.3 9.8 12.9 19.2 (3.1) 63.2 2,125 1,267 6.0 4.4 5.0 18.0 (0.6) 61.4 2,063 1,186 1.0 (2.0) 4.7 20.9 (6.7) 61.1 0.59 5,582 0.53 5,422 0.60 4,527 223,677 202,960 194,198 260,962 247,609 251,562 30,125 24,874 23,441 133,839 121,881 103,836 2,176 2,376 2,247 U.S. Business Select Financial Data (US$ in millions) Total revenue (teb) Non-interest expense Reported net income Average earning assets Average assets Average current loans and acceptances Average deposits 1,069 834 216 1,190 900 233 1,019 829 139 81,060 77,860 72,233 90,574 93,919 94,391 8,089 8,567 58,151 60,788 48,776 9,559 (1) Before tax amounts of $2 million in 2014; $2 million in 2013; and $1 million in 2012 are included in non-interest expense. Average assets of $261.0 billion increased $13.4 billion from the prior year. Higher levels of securities balances, increases in net loans and acceptances related to growth in corporate banking, and higher cash balances were partly offset by decreases in derivative financial assets, primarily due to declines in the fair value of interest rate contracts. BMO Capital Markets participated in 1,496 new global issues in 2014, comprised of 666 corporate debt deals, 520 government debt deals and 310 equity transactions, raising $3,198 billion. BMO Financial Group 197th Annual Report 2014 55 MANAGEMENT’S DISCUSSION AND ANALYSIS Business Environment, Outlook and Challenges BMO Capital Markets’ performance in fiscal 2014 reflected our balanced, diversified and client-focused business model, as well as our disciplined approach to risk management in an environment influenced by market factors that contribute to variability in results. There was growth in our Investment and Corporate Banking businesses, with particular improve- ment in equity underwriting activity, driven by active markets. Our diversified business mix has enabled us to generate earnings growth of 3% and improve our ROE from 18.0% to 19.2% in 2014. Looking forward to fiscal 2015, we expect sustained, moderately stronger economic growth in both Canada and the United States. Falling unemployment rates and low levels of inflation are expected to con- tinue in the United States, with moderate increases in interest rates expected in both Canada and the United States. Our capital markets A & D M outlook is influenced by the performance of financial markets, business confidence and evolving regulatory requirements. Despite some areas of weakness and concern in financial markets, we anticipate continued growth in revenue and earnings with a focus on driving further performance in our U.S. platform. The Canadian and U.S. economic environment in fiscal 2014 and the outlook for fiscal 2015 are discussed in more detail in the Economic Developments and Outlook section on page 30. Caution This BMO Capital Markets section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 56 BMO Financial Group 197th Annual Report 2014 Corporate Services, including Technology and Operations Corporate Services consists of Corporate Units and Technology and Operations (T&O). Corporate Units provide enterprise-wide expertise and governance support in a variety of areas, including strategic planning, risk management, finance, legal and regulatory compliance, marketing, communications and human resources. T&O manages, maintains and provides governance over information technology, operations services, real estate and sourcing for BMO Financial Group. The costs of providing these Corporate Units and T&O services are largely transferred to the three client operating groups (P&C, Wealth Management and BMO Capital Markets), and only relatively minor amounts are retained in Corporate Services results. As such, Corporate Services adjusted operating results largely reflect the impact of certain asset-liability management activities, the elimination of taxable equiv- alent adjustments, the results from certain impaired real estate secured assets and purchased loan accounting impacts. Corporate Services reported results in 2013 and prior years reflected a number of items and activities that were excluded from BMO’s adjusted results to help assess BMO’s performance. These adjusting items were not reflective of core operating results. They are itemized in the Non-GAAP Measures section on page 32. Corporate Services focuses on enterprise-wide priorities that improve service quality and efficiency to deliver an excellent customer experience. Notable achievements during the year included: ‰ Upgrades to our digital channels: launched new mobile application providing ten new functionalities such as eTransfers, bill manage- ment, booking an appointment, and travel notification; and new InvestorLine tablet application. Improvements to our branch and ABM network: modernization of the retail branch network, which increases our footprint by equipping smaller branches with upgraded technology, and implementation of cheque image based capture at ABMs and deposit system technology in the United States with roll out in Canada to follow. ‰ ‰ Realizing real estate synergies and improving our U.S. operations technology capabilities in channels, products, functions and infrastructure. ‰ Continuing to advance the bank’s regulatory capabilities by implementing key functionalities to deal with a changing business and regulatory environment. Financial Review Corporate Services reported and adjusted net loss for the year was $193 million, compared with a reported net loss of $72 million and an adjusted net loss of $133 million a year ago. Beginning in 2014, the impact from the purchased performing loan portfolio is included in adjusted results. Adjusted recoveries of credit losses were $282 million lower, primarily due to $158 million lower recoveries on the purchased credit impaired loan portfolio and the impact of provisions on the pur- chased performing loan portfolio and the impaired real estate secured loan portfolio. Adjusted revenue improved $89 million mainly due to the inclusion of purchased performing loan revenue of $238 million, partially offset by a higher group teb offset of $132 million. Adjusted non- interest expense was up $15 million mainly due to higher technology investments and regulatory-related costs. Corporate Services, including Technology and Operations (Canadian $ in millions, except as noted) As at or for the year ended October 31 2014 2013 2012 Net interest income before group teb offset Group teb offset Net interest income (teb) Non-interest revenue Total revenue (teb) Recovery of credit losses Non-interest expense Loss before income taxes Recovery of income taxes (teb) (62) (476) (538) 147 (391) (123) 469 (737) (544) 408 (344) 611 (266) 64 147 211 (175) 800 (414) (342) 345 457 802 (151) 976 (23) (347) Reported net income (loss) (193) (72) 324 M D & A Adjusted total revenue (teb) Adjusted recovery of credit losses Adjusted non-interest expense Adjusted net income (loss) Full-time equivalent employees (391) (123) 469 (193) (261) (445) 385 131 13,936 13,502 13,885 (480) (405) 454 (133) U.S. Business Select Financial Data (US$ in millions) Total revenue (teb) Recovery of credit losses Non-interest expense Provision for (recovery of) income taxes (teb) Reported net income (loss) Adjusted total revenue (teb) Adjusted recovery of credit losses Adjusted non-interest expense Adjusted net income (loss) (183) (120) 146 (103) 315 (256) 420 38 652 (168) 537 29 (106) 113 254 (183) (117) 146 (105) (313) (398) 163 (28) (127) (441) 93 215 Corporate Services Provision for Credit Losses (Canadian $ in millions) As at or for the year ended October 31 2014 2013 2012 Impaired real estate loans Interest on impaired loans Purchased credit impaired loans Purchased performing loans (1) Recovery of credit losses, adjusted basis Purchased performing loans (1) Increase (decrease) in collective allowance 21 26 (252) 82 (123) – – (43) 48 (410) – (405) 240 (10) Recovery of credit losses, reported basis (123) (175) 20 44 (509) – (445) 291 3 (151) Average loans and acceptances Year-end loans and acceptances 452 306 972 526 1,847 1,314 (1) Effective the first quarter of 2014, Corporate Services adjusted results include credit-related items in respect of the purchased performing loan portfolio. Further details are provided in the Non-GAAP Measures section on page 32. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 57 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Summary Quarterly Earnings Trends BMO’s results and performance measures for the past eight quarters are outlined on page 59. Periodically, certain business lines and units within the business lines are transferred between client operating groups to more closely align BMO’s organizational structure and its strategic priorities. Comparative figures have been restated to conform to the current presentation. Over the past two years, we have remained focused on executing our strategic priorities. Economic conditions have generally been stable to improving. Seasonality BMO’s quarterly earnings, revenue and expense are modestly affected by seasonal factors. Since our second fiscal quarter has 89 days (90 in a leap year) and other quarters have 92 days, second-quarter results are lower relative to other quarters because there are fewer calendar days, and thus fewer business days. The months of July (third quarter) and August (fourth quarter) are typically characterized by lower levels of capital markets activity, which has an effect on results in Wealth Management and BMO Capital Markets. The December holiday season also contributes to a slowdown in some activities. Canadian P&C Canadian P&C’s strong momentum has continued since the second half of 2013. Improved net income in the last six quarters was driven by good revenue growth that has been at least 6% for each of the last four quarters. Revenue growth was due to continued loan and deposit bal- ance growth with net interest margin remaining stable over the past five quarters. Loan growth has been strong, although abating in recent quarters, and deposit growth has been strong over the past six quarters. Expenses have grown moderately as a result of continued investment in the business. Provisions for credit losses have decreased in 2014 com- pared to the prior year, and have remained relatively consistent over the past four quarters. U.S. P&C U.S. P&C had strong results in the first quarter of 2013 and results were relatively stable in the second and third quarters due to core commercial and industrial loan growth and lower expenses compared to the prior year, offsetting lower margins and balances in certain portfolios. Results in the fourth quarter of 2013 were negatively impacted by above trend provisions for credit losses. A significant increase in provisions for credit losses in the fourth quarter of 2013 led to lower earnings. Results in the third quarter of 2014 reflect improved revenue growth, primarily driven by strong commercial loan growth, which continued in the fourth quarter as revenue remained stable and provisions for credit losses declined. Net interest margin has declined relative to 2013, primarily due to lower loan spreads due to competitive loan pricing, changes in mix including loans growing faster than deposits and a decline in deposit spreads given the low-rate environment. Wealth Management Wealth Management operating results have grown significantly since 2013. Traditional wealth operating results benefited from the acquired F&C business in the second half of 2014, as well as good organic growth in client assets. The fourth quarter of the prior year included a large security gain. Excluding this gain, the traditional wealth businesses recorded double-digit revenue growth for the past six quarters. Expenses have grown as we continue to make investments in our sales force for future revenue growth. The fourth quarter of the current year includes costs related to the settlement of a legal matter. Quarterly results in the insurance businesses have been subject to variability, resulting primarily from changes in long-term interest rates and methodology and actuarial assumptions changes. There was continued growth in both the underlying creditor and life insurance businesses. BMO Capital Markets Building on the momentum of 2012 and improved results in 2013, BMO Capital Markets continued to show strength in the first three quarters of 2014, benefiting from favourable market conditions as well as a con- sistent and diversified strategy, with good revenue performance across both Investment and Corporate Banking and Trading Products. Results in the fourth quarter of 2014 were impacted by lower client activity levels. Provisions for Credit Losses BMO’s PCL measured as a percentage of loans and acceptances has been declining since 2012 with some quarter-to-quarter variability – this is particularly notable when the recoveries from the purchased credit impaired loan portfolio are excluded. Corporate Services Corporate Services quarterly net income can vary, in large part due to the inclusion of the adjusting items in 2013, which are largely recorded in Corporate Services, and recoveries of credit losses on the purchased credit impaired portfolio in all periods. Reduced recoveries in the first quarter of 2013, together with lower revenue and increased expenses, lowered Corporate Services results that quarter. These recoveries increased in the last three quarters of 2013, reducing the net loss. Adjusted quarterly net income decreased in 2014, reflecting variability in the recoveries and in Corporate Services revenue. Foreign Exchange Fluctuations in exchange rates in 2012 and 2013 were subdued. The U.S. dollar strengthened significantly in 2014, with the exception of a slight weakening in the third quarter of 2014. A stronger U.S. dollar increases the translated value of U.S.-dollar-denominated revenues, expenses, provisions for (recoveries of) credit losses, income taxes and net income. Provision for Income Taxes The effective income tax rate can vary, as it depends on the timing of resolution of certain tax matters, recoveries of prior periods’ income taxes and the relative proportion of earnings attributable to the different jurisdictions in which we operate. Caution This Summary Quarterly Earnings Trends section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 58 BMO Financial Group 197th Annual Report 2014 M D & A Summarized Statement of Income and Quarterly Financial Measures (Canadian $ in millions, except as noted) Q4-2014 Q3-2014 Q2-2014 Q1-2014 Q4-2013 Q3-2013 Q2-2013 Q1-2013 Net interest income Non-interest revenue Total revenue Provision for credit losses – specific (see below) Provision for (recovery of) credit losses – collective Non-interest expense Income before provision for income taxes Provision for income taxes Reported net income (see below) Adjusted net income (see below) Provision for credit losses – specific Canadian P&C U.S. P&C Personal and Commercial Banking Wealth Management BMO Capital Markets Corporate Services, including T&O BMO Financial Group provision for credit losses – specific Operating group reported net income Canadian P&C U.S. P&C Personal and Commercial Banking Wealth Management BMO Capital Markets Corporate Services, including T&O BMO Financial Group net income Operating group adjusted net income Canadian P&C U.S. P&C Personal and Commercial Banking Wealth Management BMO Capital Markets Corporate Services, including T&O 2,178 2,162 4,340 170 – 2,887 1,283 213 1,070 1,111 133 43 176 (1) (7) 2 170 524 168 692 226 191 (39) 2,107 2,108 4,215 130 – 2,756 1,329 203 1,126 1,162 134 52 186 (3) (6) (47) 130 526 159 685 190 306 (55) 2,063 1,978 4,041 162 – 2,594 1,285 209 1,076 1,097 133 50 183 2 (4) (19) 162 480 155 635 194 305 (58) 2,113 2,009 4,122 99 – 2,684 1,339 278 1,061 1,083 141 19 160 (1) (1) (59) 99 484 166 650 175 277 (41) 2,117 2,021 4,138 189 – 2,580 1,369 295 1,074 1,088 166 96 262 1 (17) (57) 189 458 102 560 311 217 (14) 2,183 1,817 4,000 56 20 2,526 1,398 275 1,123 1,122 125 40 165 (1) 2 (110) 56 486 149 635 217 268 3 1,070 1,126 1,076 1,061 1,074 1,123 526 180 706 253 191 (39) 528 171 699 212 306 (55) 482 167 649 200 306 (58) 486 178 664 183 277 (41) 461 114 575 318 217 (22) 489 161 650 224 269 (21) BMO Financial Group adjusted net income 1,111 1,162 1,097 1,083 1,088 1,122 Information per Common Share ($) Dividends declared Earnings Basic Diluted Adjusted earnings Basic Diluted Book value Market price High Low Close Financial Measures (%) Dividend yield Return on equity Adjusted return on equity Net interest margin on average earning assets Adjusted net interest margin on average earning assets Efficiency ratio Efficiency ratio, excluding PBCAE (1) Adjusted efficiency ratio Adjusted efficiency ratio, excluding PBCAE (1) Operating leverage Adjusted operating leverage PCL as a % of average net loans and acceptances Effective tax rate Adjusted effective tax rate Canadian/U.S. dollar average exchange rate ($) Cash and securities-to-total assets Capital Ratios (%) Common Equity Tier 1 Ratio Tier 1 Capital Ratio Total Capital Ratio 0.78 1.57 1.56 1.63 1.63 48.18 85.71 76.41 81.73 3.8 13.1 13.7 1.60 1.60 66.5 62.2 65.3 61.1 (7.0) (5.9) 0.23 16.6 16.8 1.111 30.2 10.1 12.0 14.3 0.78 1.68 1.67 1.73 1.73 46.69 82.79 74.28 81.27 3.8 14.4 14.9 1.58 1.58 65.4 58.2 64.2 57.2 (3.7) (1.1) 0.18 15.3 15.6 1.081 33.0 9.6 11.4 13.3 0.76 1.61 1.60 1.64 1.63 45.94 76.68 67.04 75.55 4.0 14.3 14.6 1.59 1.59 64.2 59.4 63.5 58.8 1.9 1.2 0.22 16.2 16.5 1.103 32.1 9.7 11.1 13.0 0.76 1.58 1.58 1.62 1.61 45.60 74.69 68.01 68.06 4.5 14.2 14.5 1.62 1.62 65.1 59.9 64.3 59.2 (2.1) (0.3) 0.14 20.8 20.9 1.080 32.3 9.3 10.6 12.4 0.74 1.60 1.60 1.62 1.62 43.22 73.90 63.21 72.62 4.1 14.8 15.0 1.69 1.60 62.3 59.7 61.9 59.3 3.9 0.6 0.27 21.6 21.5 1.042 31.4 9.9 11.4 13.7 0.74 1.67 1.66 1.66 1.66 41.96 65.99 58.68 63.87 4.6 15.5 15.5 1.78 1.65 63.2 61.8 63.6 62.2 1.8 0.4 0.11 19.7 19.2 1.038 31.1 9.6 11.2 13.5 2,129 1,764 3,893 174 (30) 2,550 1,199 237 962 984 153 55 208 1 (6) (29) 174 421 151 572 140 261 (11) 962 422 164 586 147 262 (11) 984 0.74 1.41 1.40 1.44 1.44 40.87 64.50 61.51 63.19 4.7 14.2 14.6 1.82 1.67 65.5 60.2 64.3 58.8 (3.5) (1.4) 0.22 19.8 19.0 1.018 30.3 9.7 11.3 13.7 2,248 1,784 4,032 178 – 2,570 1,284 248 1,036 1,029 128 32 160 2 (15) 31 178 447 179 626 162 298 (50) 1,036 450 192 642 168 298 (79) 1,029 0.72 1.51 1.51 1.50 1.50 40.13 64.70 56.74 62.99 4.6 14.9 14.8 1.87 1.70 63.8 61.4 64.1 61.6 (2.5) (0.7) 0.28 19.3 19.0 0.995 30.8 9.4 11.1 13.4 (1) This ratio is calculated excluding insurance policyholder benefits, claims and acquisition expenses (PBCAE). In the opinion of Bank of Montreal management, information that is derived from unaudited financial information, including information as at and for the interim periods, includes all adjustments necessary for a fair presentation of such information. All such adjustments are of a normal and recurring nature. Financial ratios for interim periods are stated on an annualized basis, where appropriate, and the ratios, as well as interim operating results, are not necessarily indicative of actual results for the full fiscal year. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. BMO Financial Group 197th Annual Report 2014 59 MANAGEMENT’S DISCUSSION AND ANALYSIS Review of Fourth Quarter 2014 Performance Reported net income for the fourth quarter of 2014 was $1,070 million, down $4 million from a year ago. Adjusted net income for the fourth quarter was $1,111 million, up $23 million or 2% from a year ago. Adjusted results for the quarter exclude the amortization of acquisition- related intangible assets of $42 million ($32 million after tax) and acquisition integration costs of $11 million ($9 million after tax); or a total impact of $0.07 per share. Summary income statements and data for the quarter and comparative quarters are outlined on page 59. Adjusting items are included in Corporate Services except the amor- tization of acquisition-related intangible assets, which is charged to the operating groups. Acquisition integration costs in 2014 related to F&C are charged to Wealth Management. A & D M Amounts in the rest of this Review of Fourth Quarter 2014 Perform- ance section are stated on an adjusted basis. Net income growth was driven by good results in Canadian P&C, U.S. P&C and Wealth Management. Canadian P&C results were up 14% from a year ago, driven by higher revenue from higher balance and fee volumes across most products and lower provisions for credit losses, partially offset by higher expenses. Wealth Management continued to deliver good results, with growth of $56 million or 28%, excluding the $121 million after-tax security gain in the prior year. BMO Capital Mar- kets results decreased as higher revenue was more than offset by higher expenses and lower loan recoveries. U.S. P&C net income was up on a U.S. dollar basis due to lower provisions for credit losses and higher revenue partly offset by increased expenses. Corporate Services results were lower due to lower recoveries primarily on the purchased credit impaired loan portfolio and higher expenses, partially offset by above trend revenue. Revenue increased $330 million or 8% to $4,340 million. Excluding the impact of the stronger U.S. dollar, revenue increased by $258 million or 6%. Canadian P&C had good revenue growth due to strong balance and fee volume growth across most products. Wealth Management revenue increased, excluding the $191 million security gain in the prior year, due to the impact from the acquired F&C business, higher fee- based revenue from strong growth in client assets and higher insurance revenue. BMO Capital Markets revenue increased 2% year over year with solid growth from Investment and Corporate Banking, partly offset by lower revenues in Trading Products, in part due to the introduction of a funding valuation adjustment which reduced revenue by $39 million. U.S. P&C revenue increased on a U.S. dollar basis, due to strong commercial loan and deposit growth, partially offset by lower net interest margin. Corporate Services revenue improved primarily due to higher net interest income and credit-related revenue on the purchased performing loan portfolio. Net interest income increased $178 million or 9% to $2,178 million, principally due to volume growth, the impact of the stronger U.S. dollar and revenue from the purchased performing loan portfolio. BMO’s overall net interest margin was unchanged at 1.60%. Average earning assets increased $43.8 billion or 9% to $540.0 billion, including a $13.6 billion increase as a result of the stronger U.S. dollar. Non-interest revenue increased $152 million or 8% to $2,162 mil- lion, with significant increases in mutual fund revenues and investment management and custodial fees as a result of the acquisition of F&C, and increases in all other types of non-interest revenue, with the exception of securities gains and other. Non-interest expense increased $349 million or 14% to $2,834 million. Excluding the impact of the stronger U.S. dollar, non-interest expense increased by $286 million or 12%, primarily due to increased technology and support costs related to a changing business and regu- latory environment, the impact of the F&C acquisition, higher employee- related expenses and costs related to the settlement of a legal matter. The provision for credit losses of $170 million increased by $30 million from the prior year, due to lower recoveries primarily on the purchased credit impaired loan portfolio. There was no net change to the collective allowance in the quarter. The provision for income taxes of $225 million decreased $72 mil- lion from a year ago. The effective tax rate was 16.8% in the current quarter, compared with 21.5% a year ago primarily due to a lower proportion of income from higher tax-rate jurisdictions. Adjusted results in this table are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. 60 BMO Financial Group 197th Annual Report 2014 M D & A Canadian P&C Net income in Canadian P&C in 2013 rose $63 million or 4% to $1,812 million. Revenue increased $122 million to $6,106 million, due to growth in balances and fees across most products, partially offset by lower net interest margin. Non-interest expense increased $83 million or 3% to $3,126 million, primarily due to continued investment in the business, including our distribution network, net of strong expense management. U.S. P&C Net income in U.S. P&C increased $10 million or 2% in 2013 to $581 million, while adjusted net income of $631 million was relatively unchanged. On a U.S. dollar basis, net income of $570 million was rela- tively unchanged, while adjusted net income decreased $13 million or 2% to $619 million. Revenue decreased $88 million or 3% to $2,906 million, and decreased $145 million or 5% on a U.S. dollar basis, as the benefits of strong growth in core commercial and industrial loans and deposits and higher commercial lending fees were more than offset by the effects of lower net interest margin, reductions in certain portfo- lios and lower deposit and debit card fees. Adjusted non-interest expense decreased $28 million or 2% to $1,793 million, and decreased $64 million or 4% to $1,752 million on a U.S. dollar basis, primarily as a result of synergy-related savings and cost reductions resulting from productivity initiatives, partially offset by the effects of selective investments in the business and higher regulatory-related costs. Wealth Management Net income in Wealth Management was $830 million, up $303 million or 57% from 2012. Adjusted net income was $857 million, up $309 million or 56%. Adjusted net income in our traditional wealth businesses was $596 million, up $206 million or 53%. The significant increase was driven by a security gain of $121 million after tax and strong growth of 22% in our other wealth businesses. Adjusted net income in insurance was $261 million, up $103 million or 65%. Revenue increased $548 million or 19% to $3,448 million in 2013. Revenue in our traditional wealth businesses increased 16%, reflecting strong perform- ance driven by growth in client assets, a $191 million security gain and the benefit of recent acquisitions. Insurance revenue increased 49% as the prior year results were impacted by unfavourable movements in long-term interest rates, and there was continued growth in both the underlying creditor and life insurance businesses. Non-interest expense increased $132 million or 6% to $2,347 million. Adjusted non-interest expense increased $124 million or 6% to $2,311 million, due to growth in revenue-based costs and the costs of recent acquisitions, partly offset by the benefits of a continued focus on productivity. 2013 Financial Performance Review The preceding discussions in the MD&A focused on our performance in 2014. This section summarizes our performance in fiscal 2013 relative to fiscal 2012. As noted on page 26, certain prior year data has been reclassified to conform to the presentation in 2014, including restate- ments arising from transfers between operating groups and restate- ments arising from the adoption of several new and amended IFRS reporting and accounting standards. Further information on restatements is provided on page 43. Net Income Net income increased $39 million or 1% to $4,195 million in fiscal 2013 and earnings per share (EPS) increased $0.07 or 1% to $6.17. Adjusted net income increased $164 million or 4% to $4,223 million and adjusted EPS increased $0.26 or 4% to $6.21, reflecting significant adjusted net income growth in Wealth Management and good growth in Canadian P&C and BMO Capital Markets, with U.S. P&C relatively unchanged and a decline in Corporate Services. Adjusting items are detailed in the Non-GAAP Measures section on page 32. Return on Equity Return on equity and adjusted return on equity were 14.9% and 15.0%, respectively, compared with 15.9% and 15.5%, respectively, in 2012. There was an increase of $64 million in earnings ($189 million in adjusted earnings) available to common shareholders. Average common shareholders’ equity increased by almost $2.1 billion from 2012, primarily due to internally generated capital. Revenue Revenue increased $134 million or 1% in 2013 to $16,063 million. Adjusted revenue increased $506 million or 3% to $15,372 million. Excluding the impact of the stronger U.S. dollar, adjusted revenue increased $419 million or 3%, due to growth in Wealth Management, BMO Capital Markets and Canadian P&C. Provisions for Credit Losses BMO recorded a provision for credit losses of $587 million in 2013, compared with $764 million in 2012. The adjusted provision for credit losses was $357 million in 2013, compared with $470 million in 2012. The improvement reflects decreases in provisions in all of our operating groups, offset in part by lower recoveries on the purchased credit impaired loan portfolio. Non-Interest Expense Non-interest expense increased $91 million or 1% to $10,226 million in 2013. Adjusted non-interest expense increased $345 million or 4% to $9,755 million. Excluding the impact of the stronger U.S. dollar, adjusted non-interest expense increased by only 3%. Provision for Income Taxes The provision for income taxes was $1,055 million in 2013, compared with $874 million in 2012. The adjusted provision for income taxes in 2013 was $1,037 million, compared with $927 million in 2012. The effective tax rate in 2013 was 20.1%, compared with 17.4% in 2012. The adjusted effective tax rate in 2013 was 19.7%, compared with 18.6% in 2012. The higher adjusted effective tax rate in 2013 was mainly attributable to lower recoveries of prior years’ income taxes. BMO Financial Group 197th Annual Report 2014 61 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS BMO Capital Markets Net income in BMO Capital Markets increased $59 million or 6% to $1,044 million in 2013. The increase reflected growth in revenues and higher recoveries of credit losses, partially offset by an increase in expenses. Revenue increased $143 million or 4% to $3,392 million, driven by increases in trading revenues and investment banking fees, particularly in our U.S. platform. Investment and Corporate Banking revenue increased $81 million, reflecting higher activity levels as well as growth in corporate banking levels. Trading Products revenue increased $62 million, reflecting growth in trading revenues related to improved market conditions, partly offset by a decrease in revenues from interest- rate-sensitive businesses and lower securities commissions. Non-interest expense increased $98 million or 5% to $2,084 million, resulting from stronger revenue performance and increased technology and support costs related to a changing business and regulatory environment. Corporate Services Corporate Services net loss for the year was $72 million, compared with net income of $324 million in 2012. The adjusted net loss was $133 million, compared with adjusted net income of $131 million in 2012. Adjusted revenue decreased $219 million, primarily due to a group teb offset that was $78 million higher than the prior year and a decline in treasury-related items. Adjusted non-interest expense increased $69 million, primarily due to increases in regulatory-related and technology costs. Adjusted recoveries of credit losses were $40 million lower, primarily due to lower recoveries on the purchased credit impaired loan portfolio, offset in part by recoveries on the impaired real estate loan portfolio in 2013, compared to provisions in 2012. Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. Financial Condition Review Summary Balance Sheet (Canadian $ in millions) As at October 31 Assets Cash and interest bearing deposits with banks Securities Securities borrowed or purchased under resale agreements Net loans and acceptances Other assets Total assets Liabilities and Shareholders’ Equity Deposits Other liabilities Subordinated debt Capital trust securities Shareholders’ equity Non-controlling interest in subsidiaries (1) Total liabilities and shareholders’ equity (1) Included in other liabilities under CGAAP in 2010. 2014 2013 2012 2011 2010 34,496 143,319 53,555 303,038 54,251 32,607 135,800 39,799 279,294 49,544 26,256 129,441 47,011 253,846 68,130 25,656 122,115 37,970 238,885 75,949 20,554 123,399 28,102 176,643 62,942 588,659 537,044 524,684 500,575 411,640 393,088 155,254 4,913 – 34,313 1,091 368,369 133,500 3,996 – 30,107 1,072 325,235 165,813 4,093 – 28,108 1,435 302,373 164,197 5,348 821 26,353 1,483 249,251 135,933 3,776 800 21,880 – 588,659 537,044 524,684 500,575 411,640 Overview Total assets increased $51.6 billion from the prior year to $588.7 billion, including a $17.1 billion increase due to the stronger U.S. dollar. The increase was comprised of net loans and acceptances of $23.7 billion, securities borrowed or purchased under resale agreements of $13.8 billion, securities of $7.5 billion, cash and interest bearing deposits with banks of $1.9 billion, and other assets of $4.7 billion. Liabilities and shareholders’ equity increased $51.6 billion, including a $17.1 billion increase as a result of the stronger U.S. dollar. The increase was comprised of deposits of $24.7 billion, other liabilities of $21.8 billion, shareholders’ equity of $4.2 billion and subordinated debt of $0.9 billion. Cash and Interest Bearing Deposits with Banks Cash and interest bearing deposits with banks increased $1.9 billion to $34.5 billion in 2014, primarily reflecting an increase in balances held with the Federal Reserve. Securities (Canadian $ in millions) As at October 31 Trading Available-for-sale Held-to-maturity Other 2014 2013 2012 2011 2010 85,022 46,966 10,344 987 75,159 53,710 6,032 899 70,109 57,340 875 1,117 69,925 51,426 – 764 71,710 50,543 – 1,146 143,319 135,800 129,441 122,115 123,399 Securities increased $7.5 billion to $143.3 billion, primarily reflecting increases in trading securities and held-to-maturity securities, partially offset by a decrease in available-for-sale securities. The increase in trading securities is primarily related to client-driven activities in BMO Capital Markets. The increase in held-to-maturity securities reflects higher levels of supplemental liquid assets held to support contingent liability requirements. Supplemental liquid assets held in available-for- sale securities have declined from the prior year. 62 BMO Financial Group 197th Annual Report 2014 Securities Borrowed or Purchased Under Resale Agreements Securities borrowed or purchased under resale agreements increased $13.8 billion to $53.6 billion, in line with the increase in securities lent or sold under repurchase agreements. Both increases were driven by client activities. Loans and Acceptances (Canadian $ in millions) As at October 31 Residential mortgages Consumer instalment and other personal Credit cards Businesses and governments Customers’ liability under 2014 2013 2012 2011 2010 101,013 96,392 84,211 81,075 48,715 64,143 7,972 63,640 7,870 61,436 7,814 59,445 8,038 51,159 3,308 120,766 104,585 94,072 84,883 68,338 acceptances 10,878 8,472 8,019 7,227 7,001 Gross loans and acceptances Allowance for credit losses 304,772 280,959 255,552 240,668 178,521 (1,734) (1,665) (1,706) (1,783) (1,878) Net loans and acceptances 303,038 279,294 253,846 238,885 176,643 Net loans and acceptances increased $23.7 billion to $303.0 billion, including a $7.1 billion increase due to the stronger U.S. dollar. The increase was primarily due to an increase in loans to businesses and governments across most operating groups and an increase in resi- dential mortgages primarily in Canadian P&C. Table 7 on page 112 provides a comparative summary of loans by geographic location and product. Table 9 on page 113 provides a com- parative summary of net loans in Canada by province and industry. Loan quality is discussed on pages 86 and 87 and further details on loans are provided in Notes 4, 5 and 8 to the financial statements, starting on page 136. Other Assets Other assets increased $4.7 billion to $54.3 billion, primarily reflecting a $2.4 billion increase in derivative financial instrument assets, largely due to an increase in the fair value of foreign exchange contracts, partially offset by a decrease in the fair value of interest rate contracts. The balance of other assets, which includes premises and equipment, goodwill and intangible assets, current and deferred tax assets, accounts receivable and prepaid expenses, increased $2.3 billion, primarily due to increases in goodwill and intangible assets associated with the acquis- ition of F&C. Derivative instruments are detailed in Note 10 on page 146 of the financial statements. M D & A Deposits (Canadian $ in millions) As at October 31 Banks Businesses and governments Individuals 2014 2013 2012 2011 2010 18,243 20,591 18,102 20,877 19,435 239,139 222,346 188,103 159,209 130,773 135,706 125,432 119,030 122,287 99,043 393,088 368,369 325,235 302,373 249,251 Deposits increased $24.7 billion to $393.1 billion, including an increase of $14.3 billion due to the stronger U.S. dollar. The increase was largely driven by a $10.3 billion increase in deposits by individuals, primarily in Canada, and a $16.8 billion increase in deposits by businesses and governments, reflecting higher levels of wholesale and customer deposits; while deposits by banks decreased $2.3 billion. Further details on the composition of deposits are provided in Note 15 on page 156 of the financial statements and in the Liquidity and Funding Risk section on page 95. Other Liabilities Other liabilities increased $21.8 billion to $155.3 billion, primarily driven by an increase of $10.8 billion in securities lent or sold under repurchase agreements related to client-driven activities, an increase of $4.9 billion in securities sold but not yet purchased, an increase of $2.4 billion in acceptances and an increase of $1.7 billion in derivatives. Further details on the composition of other liabilities are provided in Note 16 on page 157 of the financial statements. Subordinated Debt Subordinated debt increased $0.9 billion. Further details on the composi- tion of subordinated debt are provided in Note 17 on page 158 of the financial statements. Shareholders’ Equity (Canadian $ in millions) As at October 31 Share capital Preferred shares Common shares Contributed surplus Retained earnings Accumulated other comprehensive income (loss) 2014 2013 2012 2011 2010 3,040 12,357 304 17,237 2,265 12,003 315 15,087 2,465 11,957 213 13,456 2,861 11,332 113 11,381 2,571 6,927 92 12,848 1,375 437 17 666 (558) 34,313 30,107 28,108 26,353 21,880 Shareholders’ equity increased $4.2 billion to $34.3 billion, reflecting growth in retained earnings, accumulated other comprehensive income and share capital. The share capital increase is driven by the issuance of preferred shares, as well as the issuance of common shares under the Shareholder Dividend Reinvestment and Share Purchase Plan (DRIP) and Stock Option Plan. BMO’s DRIP is described in the Enterprise-Wide Capital Management section that follows. Our Consolidated Statement of Changes in Equity on page 126 provides a summary of items that increase or reduce shareholders’ equity, while Note 20 on page 161 of the financial statements provides details on the components of and changes in share capital. Details of our enterprise-wide capital management practices and strategies can be found on the following page. All 2010 data is based on CGAAP in this section. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. BMO Financial Group 197th Annual Report 2014 63 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Enterprise-Wide Capital Management BMO’s Common Equity Tier 1 Ratio of 10.1% is strong and exceeds regulatory requirements. Objective BMO is committed to a disciplined approach to capital management that balances the interests and requirements of shareholders, regulators, depositors and rating agencies. Our objective is to maintain a strong capital position in a cost-effective structure that: ‰ is appropriate given our target regulatory capital ratios and internal assessment of required economic capital; is consistent with our target credit ratings; ‰ ‰ underpins our operating groups’ business strategies; and ‰ supports depositor, investor and regulator confidence, while building long-term shareholder value. Capital Management Framework The principles and key elements of BMO’s capital management frame- work are outlined in our capital management corporate policy and in our annual capital plan, which includes the results of our Internal Capital Adequacy Assessment Process (ICAAP). ICAAP is an integrated process that evaluates capital adequacy on both a regulatory and an economic capital basis, and is used to establish capital targets and capital strategies that take into consideration the strategic direction and risk appetite of the enterprise. The capital plan is developed considering our ICAAP and in conjunction with our annual business plan, promoting alignment between our business and risk strategies, regulatory and economic capital requirements and the avail- ability of capital. Regulatory and economic capital adequacy is assessed by comparing capital supply (the amount of capital available to support risks) to capital demand (the capital required to support the risks arising from our business activities). Enterprise-wide stress testing and scenario analysis are also used to assess the impact of various stress conditions on BMO’s risk profile and capital requirements. The framework seeks to ensure that we are adequately capitalized given the risks we take, and supports the determination of limits, goals and performance measures that are used to manage balance sheet positions, risk levels and capital requirements at both the consolidated entity and line of business levels. Assessments of actual and forecast capital adequacy are compared to the capital plan throughout the year, and the capital plan is updated as required, based on changes in our business activities, risk profile or operating environment. BMO uses a combination of regulatory and economic capital to evaluate business performance and considers capital implications in its strategic, tactical and transactional decision-making. By allocating our capital to operating groups and measuring their performance in relation to the capital necessary to support the risks in their business, we seek to optimize our risk-adjusted return to shareholders, while maintaining a well-capitalized position. This approach aims to protect our stakeholders from the risks inherent in our various businesses, while still allowing the flexibility to deploy resources to support the strategic growth activities of our operating groups. Capital in excess of what is required to support our line of business activities is held in Corporate Services. 64 BMO Financial Group 197th Annual Report 2014 Capital Demand Capital required to support the risks underlying our business activities Capital adequacy assessment of capital demand and supply Capital Supply Capital available to support risks Management Actions For further discussion of the risks that arise from our business activities, refer to the Enterprise-Wide Risk Management section on page 77. Governance The Board of Directors, either directly or in conjunction with its Risk Review Committee, provides ultimate oversight and approval of capital management, including our capital management corporate policy framework, capital plan and capital adequacy assessments. The board regularly reviews BMO’s capital position, key capital management activ- ities and, with the Risk Review Committee, the ICAAP-determined capital adequacy assessment results. The Balance Sheet and Capital Management Committee provides senior management oversight, including the review and discussion of significant capital management policies, issues and activities and, along with the Risk Management Committee, the capital required to support the execution of our enterprise-wide strategy. Finance and Risk Management are responsible for the design and implementation of the corporate policies and frame- work related to capital, risk management and the ICAAP. Regulatory Capital Common equity is the most permanent form of capital. Common Equity Tier 1 (CET1) capital is comprised of common shareholders’ equity less deductions for goodwill, intangible assets, defined benefit pension assets, certain deferred tax assets and certain other items. Additional Tier 1 capital primarily consists of preferred shares and innovative hybrid instruments, less certain regulatory deductions. Tier 1 capital is com- prised of CET1 and Additional Tier 1 capital. Tier 2 capital is primarily comprised of subordinated debentures and a portion of the collective and individual allowance for credit losses, less certain regulatory deductions. Total capital includes Tier 1 and Tier 2 capital. Since the first quarter of 2013, regulatory capital requirements for BMO have been determined on a Basel III basis. In 2014, the minimum Basel III capital ratios proposed by the Basel Committee on Banking Supervision (BCBS) were a 4% CET1 Ratio, 5.5% Tier 1 Capital Ratio and 8% Total Capital Ratio. These ratios are calculated using a five-year transitional phase-in of regulatory adjustments and a nine-year transi- tional phase-out of instruments that no longer qualify as regulatory capital under the Basel III rules. However, guidance issued by the Office of the Superintendent of Financial Institutions Canada (OSFI) required Canadian deposit-taking institutions to meet the 2019 Basel III capital requirements in 2013, other than the phase-out of non-qualifying capital instruments, and OSFI has expected them to attain a target Basel III CET1 Ratio of at least 7% (4.5% minimum plus 2.5% Capital Conservation Buffer) since January 31, 2013 (also referred to as the “all-in” requirements). M D & A In March 2013, OSFI issued guidance designating the six largest Canadian banks, including BMO, as domestic systemically important banks (D-SIBs). The D-SIBs are subject to continued enhanced super- vision and disclosure. Commencing on January 1, 2016, the D-SIBs will be required to hold an additional 1% Common Equity Surcharge in addi- tion to the 2.5% Capital Conservation Buffer. No Canadian banks are currently considered to be globally systemically important. The fully implemented Basel III requirements and the OSFI “all-in” Basel III requirements are summarized in the following table. Regulatory Capital Requirements (% of Risk-Weighted Assets) Basel III – Stated 2019 minimum requirements Plus: Capital Conservation Buffer (2) (effective January 1, 2013) Plus: D-SIB Common Equity Surcharge (effective January 1, 2016) OSFI Basel III effective requirements (4) Common Equity Tier 1 Ratio (1) Tier 1 Capital Ratio Total Capital Ratio Leverage Ratio (3) 4.5 2.5 1.0 8.0 6.0 2.5 1.0 9.5 8.0 2.5 1.0 11.5 3.0 na na 3.0 (1) The minimum 4.5% CET1 Ratio requirement is augmented by the 2.5% Capital Conservation Buffer that can absorb losses during periods of stress. The Capital Conservation Buffer for BMO will be augmented in 2016 with the addition of the 1% Common Equity Surcharge for D-SIBs. If a bank’s capital ratios fall within the range of this combined buffer, restrictions on discretionary distributions of earnings (such as dividends, equity repurchases and discretionary compensation) would ensue, with the degree of such restrictions varying according to the position of the bank’s ratios within the buffer range. (2) The Capital Conservation Buffer does not include the counter-cyclical capital buffer of up to 2.5% of CET1, which may be required on a national basis by supervisors if they perceive credit growth resulting in systemic risk. If imposed, this additional buffer would be effectively combined with the Capital Conservation Buffer. (3) A 3% minimum Leverage Ratio has been established by the BCBS. It will be subject to monitoring and analysis during a four-year parallel run test period, which began on January 1, 2013. Depending upon the results of the parallel run testing, there could be subsequent adjustments, which are targeted to be finalized in 2017, with the final Leverage Ratio requirement effective January 1, 2018. In October 2014, OFSI announced that, in the first quarter of fiscal 2015, its current leverage measure, the Assets-to-Capital Multiple (ACM), will be discontinued and replaced by the Leverage Ratio, and has established a 3% minimum Basel III Leverage Ratio requirement. (4) OSFI’s Basel III “effective requirements” are the capital requirements systemically important Canadian banks must meet in 2016 to avoid being subject to restrictions on discretionary distributions of earnings. na – not applicable OSFI’s Basel III capital rules also require the implementation of BCBS guidance on non-viability contingent capital (NVCC). The guidance stipulates that in order to qualify as regulatory capital, non-common share capital instruments must be automatically convertible into common equity in the event that OSFI announces that a bank is non-viable, that conversion is necessary to protect the interests of the bank’s depositors and creditors and that conversion is reasonably likely to restore the bank to viability. All non-common instruments issued after December 31, 2012, are required to meet these NVCC requirements to qualify as regulatory capital. Under OSFI’s Basel III rules, non-common share capital instruments that do not meet Basel III requirements, including NVCC requirements, are subject to grandfathering provisions requiring that they be phased out over a nine-year period that began on January 1, 2013, at which point their recognition as regulatory capital was capped at 90% of their total value as at that date. This cap reduces by a further 10% each subsequent year until 2022. BMO’s preferred shares, innovative Tier 1 capital (BMO Capital Trust Securities and BMO Tier 1 Notes) and Tier 2 subordinated debt instruments outstanding on January 1, 2013, will not ultimately qualify as regulatory capital under Basel III and are accordingly being phased out. OSFI’s guidance also outlines the requirements for redemption of these regulatory capital instruments due to a regulatory capital event. BMO currently does not expect to redeem any outstanding regulatory capital instruments due to a regulatory capital event. Under Basel III, banks may select from alternative approaches to determine their minimum regulatory capital requirements to support the credit, market and operational risks they undertake. We primarily use the Advanced Internal Ratings Based (AIRB) Approach to determine credit risk-weighted assets (RWA) in our portfolio. Credit RWA arising from certain U.S. portfolios are determined using the Standardized Approach. The AIRB Approach is the most advanced of the approaches for determining credit risk capital requirements. It utilizes sophisticated techniques to measure RWA at the exposure level based on sound risk management principles, including consideration of estimates of the probability of default, the likely loss given default and exposure at default, term to maturity and the type of Basel Asset Class exposure. These risk parameters are determined using historical portfolio data supplemented by benchmarking, and are updated periodically. Vali- dation procedures related to these parameters are in place and are enhanced periodically in order to appropriately quantify and differ- entiate risks so they reflect changes in economic and credit conditions. BMO’s market risk RWA are primarily determined using the Internal Models Approach, but the Standardized Approach is used for some exposures. Commencing in the third quarter of 2014, operational risk capital requirements have been determined using the Advanced Measurement Approach and are based on our internal operational risk measurement system, using quantitative and qualitative criteria. Prior to the third quarter of 2014, BMO’s operational risk RWA were determined using the Standardized Approach and were based on the size and type of our lines of business. In August 2013, OSFI advised banks that it would begin phasing in the Credit Valuation Adjustment (CVA) risk capital charge for Canadian banks in the first quarter of 2014. The CVA risk capital charge applicable to CET1 was 57% of the fully implemented charge during 2014, and will increase to 64% in 2015. This will increase each year until it reaches 100% by 2019. In January 2014, BCBS released its Basel III Leverage Ratio frame- work and reporting requirements. In October 2014, OSFI issued its final Leverage Requirements Guideline and announced that, in the first quarter of fiscal 2015, its current leverage measure, the Assets-to- Capital Multiple (ACM), will be discontinued and replaced by the Leverage Ratio, and has established a 3% minimum Basel III Leverage Ratio requirement. A number of other potential regulatory changes are still under discussion with regulators. OSFI may implement a stand-alone or “solo” capital framework that would assess a bank’s stand-alone capital adequacy by reducing such bank’s capital by the portion of its invest- ments in subsidiaries that are not considered available to protect the parent bank depositors and senior creditors under exceptional circum- stances. These changes could affect the amount of capital that we hold or are required to hold, or the attractiveness of certain investments in subsidiaries. In an effort to increase the comparability of capital requirements, the BCBS is considering various alternatives, in particular including measures to improve the risk sensitivity of standardized approaches and to reduce excessive variability in advanced approaches. The BCBS is also expected to propose revised capital floors based on standardized approaches. If such changes were implemented, they could have the effect of increasing the capital that we are required to hold. In August 2014, Canada’s Department of Finance issued a Con- sultation Paper outlining a Canadian bail-in regime, which includes a proposal for a Higher Loss Absorbency (HLA) requirement applicable to D-SIBs, to be met through a combination of regulatory capital and long- term senior debt. In November 2014, the Financial Stability Board (FSB) issued a Consultation Paper to enhance the loss-absorbing capacity of global systemically important banks (G-SIBs) in resolution. Under the FSB proposal, G-SIBs would be required to maintain minimum amounts of BMO Financial Group 197th Annual Report 2014 65 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Total Loss Absorbency Capacity (TLAC) comprised of regulatory capital and eligible liabilities that can absorb losses in resolution. For further discussion of the Department of Finance and FSB proposals, please refer to the Liquidity and Funding Risk section starting on page 95. BMO conducts business through a variety of corporate structures, including subsidiaries and joint ventures. A framework is in place for subsidiaries to appropriately manage their funding and capital. As a bank holding company with total consolidated assets of US$50 billion or more, our subsidiary BMO Financial Corp. (BFC) in fiscal 2014 became subject to the Federal Reserve Board’s (FRB) annual Compre- hensive Capital Analysis and Review (CCAR) and mid-year Dodd-Frank Act stress testing (DFAST) requirements. CCAR requires BFC to test its ability to meet applicable regulatory capital requirements and continue to operate under severe stress. The quantitative and qualitative aspects of BFC’s 2014 CCAR capital plan were subject to supervisory review and the FRB applied its own quantitative tools to evaluate BFC. The FRB announced its decision not to object to BFC’s capital plan in March 2014 and disclosed the results of its quantitative analysis. BFC and its bank subsidiary BMO Harris Bank N.A. (BHB) also disclosed their results under the CCAR supervisory severely adverse scenario. Under DFAST, BFC and BHB execute mid-year company-run stress tests. BFC and BHB submitted their DFAST stress tests to the FRB and the Office of the Comptroller of the Currency in July 2014, and disclosed the results in September 2014. The Common Equity Tier 1 Ratio reflects Basel III CET1 capital divided by CET1 capital RWA. The Tier 1 Capital Ratio reflects Basel III Tier 1 capital divided by Tier 1 capital RWA. The Total Capital Ratio reflects Basel III Total capital divided by Total capital RWA. The Assets-to-Capital Multiple, a leverage ratio monitored by OSFI, reflects total assets, including specified off-balance sheet items net of other specified deductions, divided by Total capital, calculated on a transitional basis. The Leverage Ratio is defined as Basel III Tier 1 capital divided by the sum of on-balance sheet items and specified off-balance sheet items, net of specified deductions. Banks will be required to publicly disclose their Basel III Leverage Ratio on a consolidated basis commencing in the first quarter of 2015. 2014 Regulatory Capital Review BMO’s capital ratios are strong and exceed OSFI’s requirements for large Canadian banks, including the 1% D-SIB Common Equity Surcharge to be implemented in 2016. Our CET1 Ratio was 10.1% at October 31, 2014, compared to 9.9% at October 31, 2013. The CET1 Ratio increased by 20 basis points from the end of fiscal 2013 primarily due to higher capital, partially offset by the impact of the F&C acquisition, and a moderate increase in RWA. The RWA increase was attributable to higher business volumes, foreign exchange rate movements, which we largely hedge as discussed below, partly offset by methodology changes, improved risk assessments and risk mitigation. Our Tier 1 Capital and Total Capital Ratios were 12.0% and 14.3%, respectively, at October 31, 2014, compared to 11.4% and 13.7%, respectively, at October 31, 2013. The Tier 1 and Total Capital Ratios each increased by 60 basis points from the end of fiscal 2013 due to the factors impacting the CET1 Ratio, discussed above, as well as the issu- ances of NVCC-qualifying preferred shares, partially offset by preferred share redemptions. The increase in the Total Capital Ratio was also partly due to the issuance of NVCC-qualifying subordinated notes during the fourth quarter. BMO’s ACM was 16.1 at October 31, 2014, up from 15.6 at October 31, 2013, primarily due to balance sheet growth, partly offset by higher Total capital. Our ACM remains well below the maximum permitted by OSFI. If the Basel III Leverage Ratio was in force at the end of the 2014 fiscal year, BMO would have a Leverage Ratio comfortably in excess of the 3% minimum requirement. BMO’s investments in foreign operations are primarily denominated in U.S. dollars. The foreign exchange impact of U.S. dollar-denominated RWA and U.S. dollar-denominated capital deductions may result in variability in the bank’s capital ratios. BMO may enter into hedging arrangements to reduce the impact of foreign exchange movements on its capital ratios. 66 BMO Financial Group 197th Annual Report 2014 Regulatory Capital (All-in basis) (1) (Canadian $ in millions) Risk-Weighted Assets (Canadian $ in millions) As at October 31 2014 2013 As at October 31 2014 2013 4,027 4,444 for Total Capital Common Equity Tier 1 capital: instruments and reserves Directly issued qualifying common share capital plus related stock surplus Retained earnings Accumulated other comprehensive income (and other reserves) Goodwill and other intangibles (net of related tax liability) Other common equity Tier 1 capital deductions Common Equity Tier 1 capital (CET1) Additional Tier 1 capital: instruments Directly issued qualifying Additional Tier 1 instruments plus related stock surplus Directly issued capital instruments subject to 12,661 17,237 12,318 15,224 1,375 602 (6,875) (1,977) (4,910) (2,007) 22,421 21,227 1,200 – phase-out from Additional Tier 1 3,332 3,770 Additional Tier 1 instruments (and CET1 instruments not otherwise included) issued by subsidiaries and held by third parties (amount allowed in group AT1) of which: instruments issued by subsidiaries subject to phase-out Total regulatory adjustments applied to Additional Tier 1 capital Additional Tier 1 capital (AT1) Tier 1 capital (T1 = CET1 + AT1) 7 7 11 11 (358) (409) 4,181 3,372 26,602 24,599 Tier 2 capital: instruments and provisions Directly issued qualifying Tier 2 instruments plus related stock surplus 1,002 – Directly issued capital instruments subject to phase-out from Tier 2 Tier 2 instruments (and CET1 and AT1 instruments not included) issued by subsidiaries and held by third parties (amount allowed in group Tier 2) of which: instruments issued by subsidiaries subject to phase-out Collective allowances 80 80 266 176 176 331 Total regulatory adjustments to Tier 2 capital (50) (50) Tier 2 capital (T2) Total capital (TC = T1 + T2) 5,325 4,901 31,927 29,500 (1) “All-in” regulatory capital assumes that all Basel III regulatory adjustments are applied effective January 1, 2013, and that the capital value of instruments that no longer qualify as regulatory capital under Basel III rules will be phased out at a rate of 10% per year from January 1, 2013 to January 1, 2022. Our CET1 and Tier 1 capital were $22.4 billion and $26.6 billion, respectively, at October 31, 2014, up from $21.2 billion and $24.6 billion, respectively, at October 31, 2013. CET1 capital increased due to retained earnings growth, increases to accumulated other comprehensive income, the issuance of common shares through the Shareholder Dividend Reinvestment and Share Purchase Plan (DRIP) and the exercise of stock options, partially offset by the payment of divi- dends. The increase in Tier 1 capital since October 31, 2013 was attributable to the growth in CET1 capital and issuance of NVCC- qualifying preferred shares, partially offset by the redemption of pre- ferred shares, as outlined below in the Capital Management Activities section. Total capital was $31.9 billion at October 31, 2014, up from $29.5 billion at October 31, 2013, attributable to the growth in Tier 1 capital mentioned above and issuance of NVCC-qualifying subordinated debt, partially offset by the phase-out of Tier 2 instruments that no longer qualify as capital under Basel III, as mentioned above. Credit Risk Wholesale Corporate, including specialized lending Corporate small and medium-sized enterprises Sovereign Bank 81,340 33,644 1,612 4,186 Retail Residential mortgages, excluding home equity line of credit Home equity line of credit Qualifying revolving retail Other retail, excluding small and medium-sized enterprises Retail small and medium-sized enterprises Equity Trading book Securitization Other credit risk assets – non-counterparty managed assets Scaling factor for credit risk assets under AIRB Approach (1) Total Credit Risk Market Risk Operational Risk CET1 Capital Risk-Weighted Assets Additional CVA adjustment, prescribed by OSFI, for Tier 1 Capital Tier 1 Capital Risk-Weighted Assets Additional CVA adjustment, prescribed by OSFI, 78,671 26,594 904 4,448 8,711 6,579 4,580 12,410 1,535 1,366 6,137 4,598 M D & A 7,618 6,541 4,000 9,826 1,604 1,362 7,359 3,098 14,946 14,822 8,251 7,934 185,387 9,002 27,703 179,289 9,154 26,651 222,092 215,094 336 – 222,428 215,094 503 – Total Capital Risk-Weighted Assets 222,931 215,094 (1) The scaling factor is applied to the risk-weighted assets amounts for credit risk under the AIRB Approach. Economic Capital Review Economic capital is a measure of our internal assessment of the risks underlying BMO’s business activities. It represents management’s estimation of the likely magnitude of economic losses that could occur should adverse situations arise, and allows returns to be measured on a basis that considers the risks taken. Economic capital is calculated for various types of risk – credit, market (trading and non-trading), opera- tional and business – based on a one-year time horizon. Economic capital is a key element of our risk-based capital management and ICAAP framework. BMO Financial Group 197th Annual Report 2014 67 MANAGEMENT’S DISCUSSION AND ANALYSIS Economic Capital and RWA by Operating Group and Risk Type As at October 31, 2014 BMO Financial Group Operating Groups Personal and Commercial Banking Wealth Management BMO Capital Markets Corporate Services Economic Capital by Risk Type (%) A & D M Credit Market Operational/Other RWA by Risk Type (Canadian $ in millions) Credit Market Operational 76% 7% 17% 120,642 15,285 25% 33% 42% 9,072 81 4,790 56% 21% 23% 38,883 8,921 7,628 89% 3% 8% 16,790 Capital Management Activities On December 3, 2013, we announced our intention, and subsequently obtained the approval of OSFI and the Toronto Stock Exchange (TSX), to initiate a normal course issuer bid (NCIB) to purchase up to 15 million of BMO’s common shares on the TSX for the purpose of cancellation. During fiscal 2014, we did not purchase any shares under our NCIB share repurchase program. The current NCIB is set to expire on January 31, 2015. On December 2, 2014, we announced our intention, subject to the approval of OSFI and the TSX, to initiate a new NCIB for up to 15 million of BMO’s common shares, commencing on or about February 1, 2015, after the expiry of the current NCIB. Once approvals are obtained, the share repurchase program will permit BMO to purchase its common shares on the TSX for the purpose of cancellation. Maintaining a NCIB is part of BMO’s capital management strategy. The timing and amount of any purchases under the program are subject to regulatory approvals and to management discretion based on factors such as market con- ditions and capital adequacy. On November 28, 2014, BMO announced its intention to redeem the $600 million of outstanding BMO Capital Trust Securities – Series D (BMO BOaTS – Series D) on December 31, 2014. During 2014, BMO issued 4.9 million common shares through the DRIP and the exercise of stock options. On February 25, 2014, we redeemed all of our $150 million Non- cumulative Class B Preferred shares, Series 18. On May 26, 2014, we redeemed all of our $275 million Non-cumulative Class B Preferred shares, Series 21. On April 23, 2014, we completed our offering of Non-cumulative 5-Year Rate Reset Class B Preferred Shares Series 27, our inaugural issuance of NVCC preferred shares. We issued 20 million shares for aggregate proceeds of $500 million. On June 6, 2014, we completed our offering of Non-cumulative 5-Year Rate Reset Class B Preferred Shares Series 29. We issued 16 million shares for aggregate proceeds of $400 million. On July 30, 2014, we completed our offering of Non-cumulative 5-Year Rate Reset Class B Preferred Shares Series 31. We issued 12 million shares for aggregate proceeds of $300 million. On September 19, 2014, we completed our offering of Series H Medium-Term Notes, Tranche 1, our inaugural issuance of NVCC sub- ordinated notes. We issued the notes for aggregate proceeds of $1.0 billion. Non-viability contingent capital (NVCC) provisions require the conversion of the capital instrument into a variable number of common shares in the event that OSFI publicly announces that the bank is or is about to become non-viable or a federal or provincial government in Canada publicly announces that the bank has accepted or agreed to accept a capital injection. If a NVCC trigger event were to occur, our NVCC capital instruments, Non-cumulative 5-Year Rate Reset Class B Preferred Shares Series 27, Series 29 and Series 31, and Series H Medium-Term Notes, Tranche 1, would be converted into BMO common shares pursuant to automatic conversion formulas with a conversion price based on the greater of: (i) a floor price of $5.00, and (ii) the current market price of our common shares at the time of the trigger event (10-day weighted average). Based on a floor price of $5.00, these NVCC capital instruments would convert into 540 million BMO common shares, assuming no accrued interest and no declared and unpaid dividends. Further details are provided in Notes 17, 18 and 20 on pages 158, 159 and 161 of the financial statements. 68 BMO Financial Group 197th Annual Report 2014 Outstanding Shares and Securities Convertible into Common Shares As at November 26, 2014 Number of shares or dollar amount (in millions) Dividends declared per share 2014 2013 Common shares Class B Preferred shares 649 $3.08 $2.94 2012 $2.82 $1.33 $1.13 $1.31 $1.45 $1.30 – $1.63 $1.63 $1.35 $0.98 – – – $0.33 $1.13 $1.31 $1.45 $1.19 $0.17 $1.63 $1.63 $1.35 $0.98 – – – – na US$0.37 na Series 5 (1) Series 13 Series 14 Series 15 Series 16 (2) Series 17 (2) Series 18 (3) Series 21 (4) Series 23 Series 25 Series 27 Series 29 Series 31 – $ 350 $ 250 $ 250 $ 157 $ 143 – – $ 400 $ 290 $ 500 $ 400 $ 300 Convertible into common shares: Class B Preferred shares (in US$) Series 10 (US$) (5) Medium-Term Notes Series H (6) Stock options – vested – non-vested – $1,000 6.6 6.7 – $1.13 $1.31 $1.45 $0.85 $0.64 $0.41 $0.81 $1.35 $0.98 $0.59 $0.46 $0.31 – na (1) Redeemed in February 2013. (2) In August 2013, approximately 5.7 million Series 16 Preferred shares were converted into Series 17 Preferred shares on a one-for-one basis. (3) Redeemed in February 2014. (4) Redeemed in May 2014. (5) Redeemed in February 2012. (6) Note 17 on page 158 of the financial statements includes details on the Series H Medium- Term Notes, Tranche 1. na – not applicable Note 20 on page 161 of the financial statements includes details on share capital. Dividends Dividends declared per common share in fiscal 2014 totalled $3.08. Annual dividends declared represented 47.6% of reported net income and 46.6% of adjusted net income available to common shareholders on a last twelve months basis. Over the long term, BMO’s dividends are generally increased in line with trends in earnings per share growth. Our target dividend payout range (common share dividends as a percentage of net income available to shareholders, less preferred share dividends, based on adjusted earnings over the last twelve months) is 40% to 50%, which is consistent with our objective of maintaining flexi- bility to execute on our growth strategies, and takes into consideration the higher capital expectations resulting from the Basel III rules. BMO’s target dividend payout range seeks to provide shareholders with stable income, while ensuring sufficient earnings are retained to support anticipated business growth, fund strategic investments and provide continued support for depositors. At year end, BMO’s common shares provided a 3.8% annual divi- dend yield based on the year-end closing share price and dividends declared in the last four quarters. On December 2, 2014, BMO announced that the Board of Directors had declared a quarterly dividend on common shares of $0.80 per share, up $0.02 per share or 3% from the prior quarter and up $0.04 per share or 5% from a year ago. The dividend is payable on February 26, 2015 to shareholders of record on February 2, 2015. Common shareholders may elect to have their cash dividends reinvested in common shares of BMO in accordance with the DRIP. In the first two quarters of 2014, common shares to supply the DRIP were purchased on the open market. In the third quarter of 2014, common shares for the DRIP were issued from treasury without discount and in the fourth quarter of 2014, common shares to supply the DRIP were issued from treasury at a 2% discount from their then-current market price. In the first quarter of 2015, common shares for the DRIP were issued from treasury without discount. Eligible Dividends Designation For the purposes of the Income Tax Act (Canada) and any similar provin- cial and territorial legislation, BMO designates all dividends paid or deemed to be paid on both its common and preferred shares as “eligible dividends”, unless indicated otherwise. Caution This Enterprise-Wide Capital Management section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. M D & A Adjusted results in this section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. Select Financial Instruments The Financial Stability Board (FSB) issued a report in 2012 encouraging enhanced disclosure related to financial instruments that market partic- ipants had come to regard as carrying higher risk. An index of where the disclosures recommended by the Enhanced Disclosure Task Force of the FSB are located is provided on page 75. Caution Given continued uncertainty in the capital markets environment, our capital markets instruments could experience valuation gains and losses due to changes in market value. This section, Select Financial Instru- ments, contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements on page 29. Consumer Loans In Canada, our Consumer Lending portfolio is comprised of three main asset classes: residential mortgages, instalment/other personal loans, including indirect auto loans, and credit card loans. We do not have any subprime or Alt-A mortgage or home equity loan programs, nor do we purchase subprime or Alt-A loans from third party lenders. In the United States, the Consumer Lending portfolio is primarily comprised of three asset classes: residential first mortgages, home equity products and indirect automobile loans. We have a small portfolio of first mortgage and home equity loans outstanding that had subprime or Alt-A characteristics at the date of authorization (e.g., low credit score or limited documentation). These programs have been discontinued. Balances outstanding and amounts in arrears 90 days or more at year end were not significant. In both Canada and the United States, consumer lending products are underwritten to prudent standards relative to credit scores, loan-to- value ratios, and capacity assessment, and are generally based upon documented and verifiable income. Leveraged Finance Leveraged finance loans are defined by BMO as loans to private equity businesses and mezzanine financings where our assessment indicates a higher level of credit risk. BMO has exposure to leveraged finance loans, which represent 1.4% of our total assets, with $8.5 billion outstanding at October 31, 2014, up approximately $2.0 billion from a year ago. Of this amount, $179 million or 2.1% of leveraged finance loans were classified as impaired ($82 million or 1.3% in 2013). BMO-Sponsored Securitization Vehicles BMO sponsors various vehicles that fund assets originated by either BMO (through a bank securitization vehicle) or its customers (several Canadian customer securitization vehicles and one U.S. customer securitization vehicle). We earn fees for providing services related to the customer securitization vehicles, including liquidity, distribution and financial arrangement fees for supporting the ongoing operations of the vehicles. These fees totalled approximately $66 million in 2014 and $53 million in 2013. BMO Financial Group 197th Annual Report 2014 69 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Canadian Customer Securitization Vehicles The customer securitization vehicles we sponsor in Canada provide our customers with access to financing either directly from BMO or in the asset-backed commercial paper (ABCP) markets. Customers sell their assets into these vehicles, which then issue ABCP to either investors or BMO to fund the purchases. In all cases, the sellers remain responsible for the servicing of the transferred assets and are first to absorb any losses realized on the assets. Our exposure to potential losses relates to our investment in ABCP issued by the vehicles, derivative contracts we have entered into with the vehicles and the liquidity support we provide to ABCP purchased by investors. We use our credit adjudication process in deciding whether to enter into these agreements just as we do when extending credit in the form of a loan. Two of these customer securitization vehicles are funded in the market, while a third is funded directly by BMO. BMO consolidates the assets of any customer securitization vehicles that BMO is deemed to control. Further information on the consolidation of customer securitiza- tion vehicles is provided in Note 9 on page 144 of the financial state- ments. There were no mortgage loans with subprime or Alt-A characteristics held in any of the customer securitization vehicles at year end. No losses have been recorded on any of BMO’s exposures to these vehicles. BMO’s investment in the ABCP of the market-funded vehicles totalled $10 million at October 31, 2014 ($13 million in 2013). BMO provided liquidity support facilities to the market-funded vehicles totalling $4.6 billion at October 31, 2014 ($3.9 billion in 2013). This amount comprised part of other credit instruments outlined in Note 5 on page 139 of the financial statements. All of these facilities remain undrawn. The assets of each of these market-funded customer securitization vehicles consist primarily of diversified pools of Canadian automobile-related receivables and Canadian insured residential mort- gages. These two asset classes represent 85% (77% in 2013) of the aggregate assets of these vehicles. U.S. Customer Securitization Vehicle We sponsor a U.S. ABCP multi-seller vehicle that we consolidate under IFRS. This customer securitization vehicle assists our customers with the securitization of their assets to provide them with alternative sources of funding. The vehicle provides funding to diversified pools of portfolios Off-Balance Sheet Arrangements BMO enters into a number of off-balance sheet arrangements in the normal course of operations. 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 payments 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 commitment 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 customers to fail to perform in accordance with the terms of the con- tracts. 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. 70 BMO Financial Group 197th Annual Report 2014 through 30 (47 in 2013) individual securitization transactions with an average facility size of US$136 million (US$94 million in 2013). The size of the pools ranged from US$7 million to US$650 million at October 31, 2014. There were no residential mortgages classified as subprime or Alt-A held in this ABCP multi-seller vehicle. The vehicle holds exposures secured by a variety of asset classes, including mid-market corporate loans, student loans and auto loans. The vehicle had US$2.6 billion of commercial paper outstanding at October 31, 2014 (US$3.4 billion in 2013). The ABCP of the vehicle is rated A1 by S&P and P1 by Moody’s. BMO has not invested in the vehi- cle’s ABCP. BMO provides committed liquidity support facilities to the vehicle, with the undrawn amount totalling US$4.6 billion at October 31, 2014 (US$4.5 billion in 2013). Credit Protection Vehicle We also sponsor a credit protection vehicle that has exposure to diversi- fied corporate credits, which have the benefit of first-loss protection. We consolidate this vehicle under IFRS. No tranches matured in 2014. The remaining notional amount is $6.4 billion with significant first-loss protection starting from 28% of the notional exposure. Approximately 66% of the corporate credits are rated investment grade. The vehicle has $359.9 million of notes outstanding, that have an expected maturity date in 2016. BMO has hedged its exposure to its note holdings of the vehicle. BMO has entered into credit default swap contracts on the net notional positions in the structure with the swap counterparties and into offsetting swaps with the vehicle. Given the level of first-loss protection, the hedges in place on BMO’s note holdings and the protection provided by third-party note- holders, BMO is extremely well protected from losses in relation to the vehicle. Exposure to Other Select Financial Instruments: Collateralized Loan Obligations (CLOs) BMO’s trading and available-for-sale portfolios contain CLOs, all of which are in run-off mode. The underlying securities consist of a wide range of corporate assets. Unhedged exposures to CLOs totalled $237 million and had credit ratings of AA- to AAA at year end. Hedged CLO exposures of $277 million had a carrying value of $274 million at year end, with $3 million recoverable on associated hedges with a monoline insurer that is rated A2 by Moody’s. The maximum amount payable by BMO in relation to these credit instruments was approximately $105 billion at October 31, 2014 ($90 billion in 2013). 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 that only a portion will utilize the facilities related to these instruments. It also does not take into account any amounts that could be recovered under recourse and collateralization provisions. Further information on these instruments can be found in Note 5 on page 139 of the finan- cial 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. Structured Entities (SEs) Our interests in SEs are discussed primarily on pages 69 and 70 in the BMO-Sponsored Securitization Vehicles section and in Note 9 on page 144 of the financial statements. Under IFRS, we consolidate our bank securitization vehicles, U.S. customer securitization vehicles, credit protection vehicle, and certain capital and funding vehicles. We do not consolidate our Canadian customer securitization vehicles, structured finance vehicles, certain capital and funding vehicles, and various BMO managed and non-BMO managed investment funds. 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, as well as indemnification agreements). The maximum amount payable by BMO in relation to these guaran- tees was $31 billion at October 31, 2014 ($31 billion in 2013). However, this amount is not representative of our likely exposure, as it does not take into account customer behaviour, which suggests that only a por- tion 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 142 of the financial statements. Caution This Off-Balance Sheet Arrangements section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. 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; acquired deposits; insurance- related liabilities; and contingent liabilities. We make judgments in assessing whether substantially all risks and rewards have been trans- ferred in respect of transfers of financial assets and whether we control SEs. These judgments are discussed in Notes 8 and 9, respectively, on pages 143 and 144 of the financial statements. Note 31 on page 178 of the financial statements discusses the judgments made in determining the fair value of financial instruments. If actual results differ from the estimates, 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 128 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 2014, our average annual ratio has ranged from a high of 0.88% in 2009 to a low of negative 0.08% in 2004. 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 2014, our provision for credit losses would range from a recovery of $230 million to a provision of $2,571 million. Our provision for credit losses in 2014 was $561 million. Additional information on the process and methodology for determining the allowance for credit losses can be found in the dis- cussion of Credit and Counterparty Risk on page 84 as well as in Note 4 on page 136 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 have 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 valu- ation 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, 2014, as well as a sensitivity M D & A analysis of our Level 3 financial instruments, is disclosed in Note 31 on page 178 of the financial statements. Valuation models use general assumptions and market data, and therefore do not reflect the specific risks and other factors that would affect a particular instrument’s fair value. Valuation Product Control (VPC), a group independent of the trading lines of business, verifies the fair values at 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 Credit risk Funding risk Liquidity risk Administrative costs Other Total 2014 2013 53 39 59 – 2 49 – 48 11 3 153 111 Valuation adjustments increased in 2014 primarily due to the inclusion of the funding valuation adjustment in response to evolving market practice in derivative pricing. Consolidation of Structured Entities In the normal course of business, BMO enters into arrangements with SEs. We are required to consolidate SEs if we determine that we control the SEs. We control a SE when we have power over the entity, exposure or rights to variable returns from our investment and the ability to exercise power to affect the amount of our returns. Additional information con- cerning BMO’s involvement with SEs is included on page 70 as well as in Note 9 on page 144 of the financial statements. BMO Financial Group 197th Annual Report 2014 71 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS 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, pension and other employee future benefits expense could increase or decrease in future years. Pension and other employee future benefits expense and obliga- tions are sensitive to changes in discount rates. We determine discount rates at each year end for our Canadian and U.S. 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 24 on page 166 of the financial statements. Impairment of Securities We have investments in securities issued or guaranteed by Canadian, U.S. and other governments, corporate debt and equity securities, mortgage-backed securities and collateralized mortgage obligations, which are classified as either available-for-sale securities, held-to- maturity or other securities. We review held-to-maturity, available-for- sale and other securities at each quarter-end reporting period to identify and evaluate investments that show indications of possible impairment. An investment is considered impaired if there is objective evidence that the estimated future cash flows will be reduced and the impact can be reliably measured. We consider evidence such as delinquency or default, bankruptcy, restructuring or other evidence of deterioration in the creditworthiness of the issuer or the absence of an active market. The decision to record a write-down, its amount and the period in which it is recorded could change if management’s assessment of those factors were different. We do not record impairment write-downs on debt securities when impairment is due to changes in market rates, if future contractual cash flows associated with the debt security are still expected to be recovered. At the end of 2014, there were total unrealized losses of $35 million on securities for which cost exceeded fair value and an impairment write-down had not been recorded. Of this amount, $20 million related to securities for which cost had exceeded fair value for 12 months or more. These unrealized losses resulted from increases in market interest rates and not from deterioration in the creditworthi- ness of the issuer. Additional information regarding our accounting for available-for- sale securities, held-to-maturity securities and other securities and the determination of fair value is included in Note 3 on page 132 of the financial statements. Income Taxes and Deferred Tax Assets The provision for income taxes is calculated based on the expected tax treatment of transactions recorded in our Consolidated Statements of Income or Changes in Equity. In determining the provision for income taxes, we interpret tax legislation in a variety of jurisdictions and make assumptions about the expected timing of the reversal of deferred tax assets and liabilities. If our interpretations differ from those of tax authorities or if the timing of reversals is not as expected, our provision for income taxes could increase or decrease in future periods. The amount of any such increase or decrease cannot be reasonably estimated. Deferred tax assets are recognized only when it is probable that sufficient taxable profit will be available in future periods against which deductible temporary differences may be utilized. We are required to assess whether it is probable that our deferred income tax asset will be realized prior to its expiration and, based on all the available evidence, determine if any portion of our deferred income tax asset should not be recognized. The factors used to assess the probability of realization are 72 BMO Financial Group 197th Annual Report 2014 our past experience of income and capital gains, forecast of future net income before taxes, available tax planning strategies that could be implemented to realize the deferred income tax asset, and the remaining expiration period of tax loss carryforwards. Changes in our assessment of these factors could increase or decrease our provision for income taxes in future periods. If income tax rates increase or decrease in future periods in a juris- diction, our provision for income tax for future periods will increase or decrease accordingly. Furthermore, our deferred tax assets and liabilities will increase or decrease as income tax rates decrease or increase, respectively, and will result in either an income tax charge or recovery. A 1% decrease in the U.S. federal tax rate from 35% to 34% would reduce our deferred asset by about $55 million and would result in a corresponding income tax charge. Additional information regarding our accounting for income taxes is included in Note 25 on page 171 of the financial statements. Goodwill and Intangible Assets Goodwill is assessed for impairment at least annually. This assessment includes a comparison of the carrying value and the recoverable amount of each business unit to verify that the recoverable amount of the busi- ness unit is greater than its carrying value. If the carrying value were to exceed the recoverable amount of the business unit, an impairment calculation would be performed. The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use. Fair value less costs to sell was used to perform the impairment test in all periods. In determining fair value less costs to sell, we employ a discounted cash flow model, consistent with that used when we acquire businesses. This model is dependent on assumptions related to revenue growth, discount rates, synergies achieved on acquisition and the availability of comparable acquisition data. Changes in each of these assumptions would affect the determination of fair value for each of the business units in a different manner. Management must exercise judgment and make assumptions in determining fair value, and differ- ences in judgments and assumptions could affect the determination of fair value and any resulting impairment write-down. At October 31, 2014, the estimated fair value of each of our business units was greater than its carrying value. Intangible assets are amortized to income on either a straight-line or an accelerated basis over a period not exceeding 15 years, depending on the nature of the asset. We test intangible assets for impairment when circumstances indicate the carrying value may not be recoverable. No such impairment was identified for the years ended October 31, 2014 and 2013. Additional information regarding the composition of goodwill and intangible assets is included in Note 13 on page 154 of the financial statements. Purchased Loans Significant judgment and assumptions were applied to determine the fair value of the Marshall & Ilsley Corporation (M&I) loan portfolio. Loans were identified as either purchased performing loans or purchased credit impaired loans (PCI loans), both of which were recorded at fair value at the time of acquisition. The determination of fair value involved estimating the expected cash flows to be received and determining the discount rate to be applied to the cash flows from the loan portfolio. In determining the possible discount rates, we considered various factors, including our cost to raise funds in the current market, the risk premium associated with the loans and the cost to service the portfolios. PCI loans are those where the timely collection of principal and interest was no longer reasonably assured as at the date of acquisition. We regularly evaluate what we expect to collect on PCI loans. Changes in expected cash flows could result in the recognition of impairment or a recovery through the provision for credit losses. Assessing the timing and amount of cash flows requires significant management judgment regarding key assumptions, including the probability of default, severity of loss, timing of payment receipts and valuation of collateral. All of these factors are inherently subjective and can result in significant changes in cash flow estimates over the term of a loan. The purchased performing loans are subject to the credit review processes applied to loans we originate. Acquired Deposits M&I deposit liabilities were recorded at fair value at the date of acquis- ition. The determination of fair value involved estimating the expected cash flows to be paid and determining the discount rate to be applied to the cash flows. Estimating the timing and amount of cash flows requires significant management judgment regarding the likelihood of early redemption by us and the timing of withdrawal by the client. Discount rates were based on the prevailing rates we were paying on similar deposits at the date of acquisition. Insurance-Related Liabilities Insurance claims and policy benefit liabilities represent current claims and estimates for future insurance policy benefits. Liabilities for life insurance contracts are determined using the Canadian Asset Liability Method, which incorporates best-estimate assumptions for mortality, morbidity, policy lapses, surrenders, future investment yields, policy dividends, administration costs and margins for adverse deviation. These assumptions are reviewed at least annually and updated to reflect actual experience and market conditions. The most significant impact on the valuation of a liability results from a change in the assumption for future investment yields. If the assumed yield were to increase by one percentage point, net income would increase by approximately $71 million. A reduction of one percentage point would lower net income by approximately $63 million. See the Insurance Risk section on page 102 for further discussion of the impact of changing rates on insurance earnings. Contingent Liabilities BMO and its subsidiaries are involved in various legal actions in the ordinary course of business. Provisions are recorded at the best estimate of the amount required to settle the obligation related to these legal actions as at the balance sheet date, taking into account the risks and uncertainties surrounding the obligation. Management and internal and external experts are involved in estimating any amounts required. The actual costs of resolving these claims may be substantially higher or lower than the amount of the provisions. Additional information regarding provisions is provided in Note 30 on page 178 of the financial statements. Caution This Critical Accounting Estimates section contains forward-looking statements. Please see the Caution Regarding Forward-Looking Statements. M D & A Changes in Accounting Policies in 2014 BMO adopted the following new or amended standards in 2014: IAS 19 Employee Benefits; IAS 1 Presentation of Financial Statements; IFRS 10 Consolidated Financial Statements; IFRS 11 Joint Arrangements; IFRS 12 Disclosure of Interests in Other Entities; IFRS 13 Fair Value Measurement; Future Changes in Accounting Policies BMO monitors the potential changes to IFRS proposed by the Interna- tional Accounting Standards Board (IASB) and analyzes the effect that any such changes to the standards may have on BMO’s financial Transactions with Related Parties In the ordinary course of business, we provide banking services to our key management personnel and their affiliated entities, joint ventures and equity-accounted investees on the same terms that we offer to our customers for those services. Key management personnel are defined as those persons having authority and responsibility for planning, directing and/or controlling the activities of an entity, being the directors and most senior executives of the bank. and the offsetting provisions of IFRS 7 Financial Instruments: Disclosures. The impact of adoption is discussed in Note 1 on page 128 of the finan- cial statements. reporting and accounting policies. New standards and amendments to existing standards that will be effective for BMO in the future are described in Note 1 on page 128 of the financial statements. Details of our investments in joint arrangements and associates and the compensation of key management personnel are disclosed in Note 29 on page 177 of the financial statements. A select suite of customer loan and mortgage products is offered to our employees at rates nor- mally made available to our preferred customers. We also offer employees a subsidy on annual credit card fees. Management’s Annual Report on Disclosure Controls and Procedures and Internal Control over Financial Reporting Disclosure Controls and Procedures Disclosure controls and procedures are designed to provide reasonable assurance that all relevant information is gathered and reported to senior management, including the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO), on a timely basis so that appropriate deci- sions can be made regarding public disclosure. CFO have concluded that, as of October 31, 2014, our disclosure controls and procedures, as defined in Canada by National Instrument 52-109, Certification of Disclosure in Issuers’ Annual and Interim Filings, and in the United States by Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act), are effective. An evaluation of the effectiveness of the design and operation of our disclosure controls and procedures was conducted as at October 31, 2014, by Bank of Montreal’s management under the super- vision of the CEO and the CFO. Based on this evaluation, the CEO and the Internal Control over Financial Reporting Internal control over financial reporting is designed to provide reason- able assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with IFRS and the BMO Financial Group 197th Annual Report 2014 73 MANAGEMENT’S DISCUSSION AND ANALYSIS requirements of the Securities and Exchange Commission (SEC) in the United States, as applicable. Management is responsible for establishing and maintaining adequate internal control over financial reporting for Bank of Montreal. Bank of Montreal’s internal control over financial reporting includes policies and procedures designed to provide assurance that records are maintained in reasonable detail to accurately and fairly reflect the transactions and dispositions of the assets of Bank of Mon- treal; and to provide reasonable assurance that transactions are recorded as necessary to permit preparation of the financial statements in accordance with IFRS and the requirements of the SEC in the United States, as applicable, receipts and expenditures of Bank of Montreal are being made only in accordance with authorizations by management and directors of Bank of Montreal, and unauthorized acquisition, use or disposition of Bank of Montreal’s assets that could have a material effect on the financial statements are prevented or detected in a timely manner. Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance and may not prevent or detect misstatements. Furthermore, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Bank of Montreal’s management, under the supervision of the CEO and the CFO, has evaluated the effectiveness of internal control over financial reporting using the framework and criteria established in Internal Control – Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission in May 2013 (2013 COSO Framework). Based on this evaluation, management has concluded that internal control over financial reporting was effective as of October 31, 2014. At the request of Bank of Montreal’s Audit and Conduct Review Committee, KPMG LLP (Shareholders’ Auditors), an independent regis- tered public accounting firm, has conducted an audit of the effectiveness of our internal control over financial reporting based on the 2013 COSO Framework. The audit report concludes that, in KPMG’s opinion, Bank of Montreal maintained, in all material respects, effective internal control over financial reporting as of October 31, 2014, in accordance with the criteria established in the 2013 COSO Framework. This audit report appears on page 121. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting in fiscal 2014 that have materially affected, or are reasonably likely to materially affect, the adequacy and effectiveness of our internal control over financial reporting. A & D M Pre-Approval Policies and Procedures As part of BMO Financial Group’s corporate governance practices, the ACRC oversees the application of BMO’s corporate policy limiting the services provided by the shareholders’ auditors that are not related to their role as auditors. The ACRC pre-approves the types of services (“permitted services”) that can be provided by the shareholders’ audi- tors as well as the annual audit plan, which includes fees for specific types of services. For permitted services that are not included in the pre- approved annual audit plan, confirmation to proceed with the engage- ment is obtained and the services are presented to the ACRC for ratification at its next meeting. All services comply with our Auditor Independence Policy, as well as professional standards and securities regulations governing auditor independence. Shareholders’ Auditors’ Fees Aggregate fees paid to the Shareholders’ Auditors during the fiscal years ended October 31, 2014 and 2013 were as follows: Fees ($ millions) (1) Audit fees Audit-related fees (2) Tax fees All other fees (3) Total 2014 17.3 1.9 – 1.2 20.4 2013 14.9 1.5 – 1.0 17.4 (1) The classification of fees is based on applicable Canadian securities laws and U.S. Securities and Exchange Commission definitions. (2) Audit-related fees for 2014 and 2013 relate to fees paid for accounting advice, specified procedures on our Proxy Circular and other specified procedures. (3) All other fees for 2014 and 2013 relate primarily to fees paid for reviews of compliance with regulatory requirements for financial information and reports on internal controls over services provided by various BMO Financial Group businesses. They also include costs of translation services. Shareholders’ Auditors’ Services and Fees Review of Shareholders’ Auditors The Audit and Conduct Review Committee (ACRC) is responsible for the appointment, compensation and oversight of the shareholders’ auditors and conducts an annual assessment of the shareholders’ auditors’ per- formance and effectiveness considering factors such as the: (i) quality of services provided by the shareholders’ auditors’ engagement team during the audit period, (ii) relevant qualifications, experience and geographical reach to serve BMO, (iii) quality of communications received from the shareholders’ auditors, and (iv) the shareholders’ auditors’ independence, objectivity and professional skepticism. The Board believes that it has a robust review processes in place to monitor audit quality and oversee the work of the shareholders’ auditors including the lead partner, including: ‰ annually reviewing the shareholders’ auditors’ audit plan, including considering the impact of business risks on the audit plan and assessing the reasonableness of the audit fee; ‰ monitoring the execution of the audit plan, with emphasis on the ‰ more complex and risky areas of the audit; reviewing and evaluating the audit findings including in camera sessions; ‰ evaluating audit quality and performance, including recent Canadian Public Accountability Board and Public Company Accounting Oversight Board inspection reports on the shareholders’ auditors and its peer firms; reviewing qualifications of senior engagement team members with the shareholders’ auditors; ‰ ‰ soliciting the opinion of management and the bank’s internal auditors on the performance of the engagement team; and ‰ at a minimum, holding quarterly meetings between the ACRC Chair and the lead audit partner to discuss audit issues independently of management. Independence of the shareholders’ auditors is overseen by the ACRC in accordance with the bank’s Auditor Independence Policy as outlined below. The ACRC also ensures that the lead audit partner rotates out of that role after 5 consecutive years and does not return to that role for a further 5 years. 74 BMO Financial Group 197th Annual Report 2014 Enhanced Disclosure Task Force On October 29, 2012, the Enhanced Disclosure Task Force (EDTF) of the Financial Stability Board published its first report, Enhancing the Risk Disclosures of Banks. We support the recommendations issued by the EDTF for the provision of high-quality, transparent risk disclosures. Disclosures related to the EDTF recommendations are detailed below. General Present all risk-related information in the Annual Report, Supplementary Financial Information and Supplementary Regulatory Capital Disclosure, and provide an index for easy navigation. Annual Report: Risk-related information is presented in the Enterprise- Wide Risk Management section on pages 77 to 105. An index for the MD&A is provided on page 26. An index for the notes to the financial statements is provided on page 128. Supplementary Financial Information: An index is provided in Supplementary Financial Information. Define the bank’s risk terminology and risk measures and present key parameters used. Annual Report: Specific risk definitions and key parameters underpinning BMO’s risk reporting are provided on pages 84 to 105. A glossary of financial terms (including risk terminology) can be found on pages 190 to 191. Discuss top and emerging risks for the bank. Annual Report: BMO’s top and emerging risks are discussed on page 78. 1 2 3 4 Capital Adequacy and Risk-Weighted Assets (RWA) 9 Provide minimum Pillar 1 capital requirements. Annual Report: Basel III Pillar 1 capital requirements are described on pages 64 to 66. Supplementary Financial Information: Basel III regulatory capital is disclosed on page 35. 10 Summarize information contained in the composition of capital templates adopted by the Basel Committee. M D & A Annual Report: An abridged version of the Regulatory Capital template is provided on page 67. Supplementary Financial Information: Basel III Pillar 3 disclosure is provided on pages 35, 36 and 38. A Main Features template can be found on BMO’s website at www.bmo.com under Investor Relations and Regulatory Filings. 11 Present a flow statement of movements in regulatory capital, including changes in Common Equity Tier 1, Additional Tier 1, and Tier 2 capital. Supplementary Financial Information: Regulatory capital flow statement is provided on page 40. 12 Discuss capital planning within a more general discussion of management’s strategic planning. Outline plans to meet new key regulatory ratios once the applicable rules are finalized. Annual Report: BMO’s capital planning process is discussed under Capital Management Framework on page 64. Annual Report: We outline BMO’s plans to meet new regulatory ratios on pages 65 to 66 (Leverage Ratio) and 99 to 100 (Net Stable Funding Ratio). Risk Governance 5 6 7 8 Summarize the bank’s risk management organization, processes, and key functions. Annual Report: BMO’s risk management organization, processes and key functions are summarized on pages 80 to 84. Describe the bank’s risk culture. Annual Report: BMO’s risk culture is described on page 81. Describe key risks that arise from the bank’s business model and activities. Annual Report: A diagram of BMO’s risk exposure by operating segment is provided on page 68. Describe the use of stress testing within the bank’s risk governance and capital frameworks. Annual Report: BMO’s stress testing process is described on page 84. 13 Provide granular information to explain how RWA relate to business activities. Annual Report: A diagram of BMO’s risk exposure, including RWA by operating segment, is provided on page 68. 14 Present a table showing the capital requirements for each method used for calculating RWA. Annual Report: Regulatory capital requirement, as a percentage of RWA, is outlined on page 65. Information about significant models is provided on pages 85 to 86. Supplementary Financial Information: A table showing RWA by model approaches and by risk type is provided on page 38. 15 Tabulate credit risk in the banking book for Basel asset classes. Supplementary Financial Information: Wholesale and retail credit exposures by internal rating grades are provided on page 47. 16 Present a flow statement that reconciles movements in RWA by credit risk and market risk. Supplementary Financial Information: RWA flow statements are provided on page 41, with a reconciliation on page 37. 17 Describe the bank’s Basel validation and back-testing process. Annual Report: BMO’s Basel validation and back-testing process is described on page 104 for credit and market risk. Supplementary Financial Information: A table showing Exposure at Default and RWA by model approaches and asset class is provided on page 38. A table showing estimated and actual loss parameters is provided on page 49. BMO Financial Group 197th Annual Report 2014 75 MANAGEMENT’S DISCUSSION AND ANALYSIS A & D M Liquidity Credit Risk 18 Describe how the bank manages its potential liquidity needs and the liquidity reserve held to meet those needs. Annual Report: BMO’s potential liquidity needs and the liquidity reserve held to meet those needs are described on page 96. Funding 19 Summarize encumbered and unencumbered assets in a table by balance sheet category. Annual Report: An Asset Encumbrance table is provided on page 98. Additional collateral requirement in the event of downgrades by rating agencies is disclosed in Note 10 on page 148 of the financial statements. Supplementary Financial Information: The Asset Encumbrance table by currency is provided on page 34. 20 Tabulate consolidated total assets, liabilities and off-balance sheet commitments by remaining contractual maturity. Annual Report: A Contractual Maturity table is presented in Note 32 on pages 186 to 189 of the financial statements. 21 Discuss the bank’s sources of funding and describe the bank’s funding strategy. Annual Report: BMO’s sources of funding and funding strategy are described on pages 98 to 99. A table showing the composition and maturity of wholesale funding is provided on page 99. Market Risk 22 Provide a breakdown of balance sheet positions into trading and non-trading market risk measures. 26 Provide information about the bank’s credit risk profile. Annual Report: Information about BMO’s credit risk profile is provided on pages 86 to 87 and in Notes 4 and 6 on pages 136 to 139 and 140 to 142 of the financial statements, respectively. Supplementary Financial Information: Tables detailing credit risk information are provided on pages 20 to 29 and 43 to 50. 27 Describe the bank’s policies related to impaired loans and renegotiated loans. Annual Report: Impaired and renegotiated loan policies are described in Note 4 on pages 136 and 138 of the financial statements, respectively. 28 Provide reconciliations of impaired loans and the allowance for credit losses. Annual Report: Continuity schedules for gross impaired loans and allowance for credit losses are provided on page 87 and in Note 4 on pages 137 to 138 of the financial statements. 29 Provide a quantitative and qualitative analysis of the bank’s counterparty credit risk that arises from its derivative transactions. Annual Report: Qualitative disclosures on collateralization agreements for over-the-counter (OTC) derivatives are provided on page 85 and quantitative disclosures are provided on page 90. Supplementary Financial Information: Quantitative disclosures for OTC derivatives are provided on page 32. 30 Provide a discussion of credit risk mitigation. Annual Report: A discussion of BMO’s collateral management is provided on pages 84 to 85. Other Risks Annual Report: A table linking balance sheet items to market risk measures is provided on page 94. 31 Describe other risks and discuss how each is identified, governed, measured and managed. Annual Report: A diagram illustrating the risk governance process that supports BMO’s risk culture is provided on page 80. Other risks are discussed on pages 101 to 105. 32 Discuss publicly known risk events related to other risks, where material or potentially material loss events have occurred. Annual Report: Other risks are discussed on pages 101 to 105. 23 Provide qualitative and quantitative breakdowns of significant trading and non-trading market risk factors. Annual Report: Trading market risk exposures are described and quantified on pages 91 to 93. Structural (non-trading) market risk exposures are described and quantified on pages 94 to 95. 24 Describe significant market risk measurement model validation procedures and back-testing and how these are used to enhance the parameters of the model. Annual Report: Market risk measurement model validation procedures and back-testing are described on page 104 for trading market risk and for structural (non-trading) market risk. 25 Describe the primary risk management techniques employed by the bank to measure and assess the risk of loss beyond reported risk measures. Annual Report: The use of stress testing, scenario analysis and stressed VaR for market risk management is described on pages 91 to 95. 76 BMO Financial Group 197th Annual Report 2014 Enterprise-Wide Risk Management As a diversified financial services company active in providing banking, investment, insurance and wealth management services, we are exposed to a variety of risks that are inherent in carrying out our business activities. As such, having a disciplined and integrated approach to managing risk is fundamental to the success of our operations. Our risk management framework provides independent risk oversight across the enterprise and is essential to building competitive advantage. Surjit Rajpal Chief Risk Officer BMO Financial Group Strengths and Value Drivers ‰ Disciplined approach to risk-taking. ‰ Comprehensive and consistent risk frameworks that address all risk types. ‰ Risk appetite and metrics that are clearly articulated and fully integrated into strategic planning and the ongoing management of risk. ‰ Sustained mindset of continuous improvement that drives consistency and efficiency in the management of risk. Challenges ‰ Heightened pace, volume and complexity of regulatory requirements. ‰ Balancing risk and return in an uncertain economic and geopolitical environment. M D & A Priorities ‰ Continue to enhance our risk management infrastructure with a focus ‰ on capital management, stress testing and market risk. Increase the efficiency and effectiveness of existing risk management processes. ‰ Strengthen risk culture by providing comprehensive risk training and developing enhanced tools to monitor and report risks. 2014 Accomplishments ‰ Significantly reduced our U.S. impaired loan portfolio. ‰ Received approval to use the Advanced Measurement Approach to manage operational risk. ‰ Further embedded our risk culture across the enterprise with the rota- tion of more than 100 employees and executives across risk management and the operating groups. ‰ Enhanced our risk appetite framework with stronger linkages to strategic planning, performance management and compensation. ‰ Continued to develop our risk infrastructure to support the efficiency and effectiveness of risk management. Gross Impaired Loan Formations ($ millions) Gross Impaired Loan Balances* ($ millions) Provision for Credit Losses ($ millions) Total Allowance for Credit Losses* ($ millions) 3,101 1,992 2,449 2,142 2,976 2,685 2,544 2,048 1,126 1,108 761 3 86 597 470 561 357 1,269 1,259 1,221 1,360 514 447 444 374 2011 2012 2013 2014 2011 2012 2013 2014 2011 2012 (10) 2013 2014 2011 2012 2013 2014 Level of new impaired loan formations was 13% lower year over year, reflecting decreases in the formations in both our consumer and commercial portfolios. Gross impaired loans were 19% lower year over year, reflecting lower levels in both Canada and the United States. *Excludes purchased credit impaired loans. Collective provision Specific provisions Adjusted specific provisions Collective allowance Specific allowances The total provision for credit losses was lower year over year, reflecting lower provisions in Canadian P&C, U.S. P&C and the purchased performing loan portfolio, offset in part by lower recoveries on the purchased credit impaired loan portfolio. The total allowance for credit losses increased slightly year over year and remains adequate. *Excludes allowances related to Other Credit Instruments. Adjusted results in this Enterprise-Wide Risk Management section are non-GAAP and are discussed in the Non-GAAP Measures section on page 32. Text and tables presented in a blue-tinted font in the Enterprise-Wide Risk Management section of the MD&A form an integral part of the 2014 annual consolidated finan- cial statements. They present required disclosures as set out by the International Accounting Standards Board in IFRS 7, Financial Instruments – Disclosures, which permits cross-referencing between the notes to the financial statements and the MD&A. See Note 1 on page 128 and Note 6 on page 140 of the financial statements. BMO Financial Group 197th Annual Report 2014 77 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Overview At BMO, we believe that risk management is every employee’s responsi- bility. We are guided by five core principles that drive our approach to managing risk across the enterprise. Approach to Risk Management ‰ Understand and manage. ‰ Protect our reputation. ‰ Diversify. Limit tail risk. ‰ Maintain strong capital and liquidity. ‰ Optimize risk return. Risks That May Affect Future Results Top and Emerging Risks That May Affect Future Results We are exposed to a variety of continually changing risks that have the potential to affect our business and financial condition. An essential mandate of our risk management process is to proactively identify, assess, monitor and manage a broad spectrum of top and emerging risks. Our top and emerging risk identification process consists of several forums for discussion with the Board, senior staff and business thought leaders, combining both bottom-up and top-down approaches to considering risk. Our assessment of top and emerging risks is used to develop action plans and stress tests of our exposure to certain events. In 2014, particular attention was given to the following top and emerging risks: Heightened Regulatory Requirements Regulatory requirements have increased and continue to increase sub- stantially and may materially alter the prevailing business model. Sig- nificant changes in laws and regulations relating to the financial services industry have been enacted or proposed, which can affect our oper- ations, pose strategic challenges and increase reputation risk. Regulatory requirements for higher levels of capital and liquidity may result in higher financing costs, as well as additional infrastructure costs related to compliance. Strategic challenges may arise from the uneven implementation of regulation across borders. To manage any potential business or financial impact of this risk, we stay abreast of evolving regulatory changes and monitor regulatory requirements to ensure that resources are prioritized appropriately, and we proactively engage with regulators. Regulations and regulatory developments are discussed in the Legal and Regulatory Risk section on page 102. Geopolitical Risks Ongoing conflict across the Middle East, North Africa and Eastern Europe continues to destabilize these regions, and in Europe, threatens the precarious economic recovery. These geopolitical risks are a threat to global economic growth and could cause significant market disruptions. We continually assess our portfolio and business strategies, and develop contingency plans for possible adverse developments. Further information on our direct and indirect European exposures is provided in the Select Geographic Exposures section on page 88. Cyber Security Risk Information security is integral to BMO’s business activities, brand and reputation. Given our pervasive use of the internet and reliance on digital technologies, particularly the mobile and online banking plat- forms that serve our customers, BMO faces heightened information security risks, including the threat of hacking, identity theft, corporate espionage, and denial of service, such as efforts targeted at causing 78 BMO Financial Group 197th Annual Report 2014 Our integrated and disciplined approach to risk management is funda- mental to the success of our business. All elements of our risk management framework work together in facilitating prudent and measured risk-taking, while striking an appropriate balance between risk and return. Our Enterprise Risk and Portfolio Management (ERPM) group develops our risk appetite, risk policies and limits, and provides independent review and oversight across the enterprise on risk-related issues to achieve prudent and measured risk-taking that is integrated with our business strategy. system failure and service disruption. BMO proactively maintains appro- priate defences and procedures to prevent, detect, respond to and manage cyber security threats. These include regular benchmarking and review of best practices, evaluation of the effectiveness of our key controls and development of new controls, as needed, and ongoing investments in both technology and human resources to defend BMO and its customers against these attacks. BMO also works with critical cyber security and software suppliers to bolster our internal resources and technology capabilities to ensure BMO remains resilient in the face of any such attacks in a rapidly evolving threat landscape. BMO has not experienced any material breaches of cyber security and has not incurred any material expenses with respect to the remediation of such events. Canadian Household Debt High levels of household debt have left Canadians vulnerable to neg- ative financial shocks. Households have moderated their spending, leading to a notable slowing in the expansion of non-mortgage consumer credit. We continue to closely monitor and review the Canadian consumer loan and credit card portfolio. We apply prudent and consistent credit underwriting practices and closely monitor stress testing under different scenarios. Further details on the risk rating systems applied to consumer portfolios can be found in the Credit and Counterparty Risk section on page 84. Other Factors That May Affect Future Results General Economic and Market Conditions in the Countries in which We Conduct Business We conduct business in Canada, the United States and a number of other countries. Factors such as the general health of capital and/or credit markets, including liquidity, level of business activity, volatility and stability, could have a material impact on our business. As well, interest rates, foreign exchange rates, consumer saving and spending, housing prices, consumer borrowing and repayment, business investment, government spending and the rate of inflation affect the business and economic environments in which we operate. Therefore, the amount of business we conduct in a specific geographic region and its local economic and business conditions may have an effect on our overall revenues and earnings. For example, a regional economic decline may result in an increase in credit losses, a decrease in loan growth and reduced capital markets activity. In addition, the financial services industry is characterized by interrelations among financial services companies. As a result, defaults by other financial services companies in Canada, the United States or other countries could adversely affect our earnings. M D & A Fiscal, Monetary and Interest Rate Policies Our earnings are affected by fiscal, monetary, interest rate and economic policies that are adopted by Canadian, U.S. and other regu- latory authorities. Such policies can have the effect of increasing or reducing competition and uncertainty in the markets. Such policies may also adversely affect our customers and counterparties in the countries in which we operate, contributing to a greater risk of default by these customers and counterparties. As well, expectations in the bond and money markets related to inflation and central bank monetary policy have an effect on the level of interest rates. Changes in market expect- ations and monetary policy are difficult to anticipate and predict. Fluctuations in interest rates that result from these changes can have an impact on our earnings. Refer to the Market Risk section on page 91 for a more complete discussion of our interest rate risk exposures. As dis- cussed in our Critical Accounting Estimates section, a reduction in income tax rates could lower the value of our deferred tax asset. Acquisitions and Strategic Plans We conduct thorough due diligence before completing an acquisition. However, it is possible that we could make an acquisition that subsequently does not perform in line with our financial or strategic objectives. Our ability to successfully complete an acquisition may be subject to regulatory and shareholder approvals and we may not be able to determine when or if, or on what terms, the necessary approvals will be granted. Changes in the competitive and economic environment, as well as other factors, may result in lower revenues, while higher than anticipated integration costs and failure to realize expected cost savings after an acquisition could also adversely affect our earnings. Integration costs may increase as a result of higher regulatory costs related to an acquisition, unanticipated costs that were not identified in the due diligence process or more significant demands on management time than anticipated, as well as unexpected delays in implementing certain plans that in turn lead to delays in achieving full integration. Our post- acquisition performance is also contingent on retaining the clients and key employees of acquired companies, and there can be no assurance that we will always succeed in doing so. Our financial performance is influenced by our ability to execute strategic plans developed by management. If these strategic plans do not meet with success or if there is a change in these strategic plans, our earnings could grow at a slower pace or decline. In addition, our ability to execute our strategic plans is dependent to a large extent on our ability to attract, develop and retain key executives, and there is no assurance we will continue to be able to do so. Level of Competition The level of competition among financial services companies is high. Furthermore, non-financial companies have increasingly been offering products and services traditionally provided by banks. Customer loyalty and retention can be influenced by a number of factors, including service levels, prices for products or services, our reputation and the actions of our competitors. Also, laws and regulations enacted by regu- latory authorities in the United States and other jurisdictions in which we operate may provide advantages to our international competitors that could affect our ability to compete. Changes in these factors or any subsequent loss of market share could adversely affect our earnings. Currency Rates The Canadian dollar equivalents of our revenues, expenses, assets and liabilities denominated in currencies other than the Canadian dollar are subject to fluctuations in the value of the Canadian dollar relative to those currencies. Changes in the value of the Canadian dollar relative to the U.S. dollar may also affect the earnings of our small business, corpo- rate and commercial clients in Canada. A strengthening of the U.S. dollar could increase the value of our risk-weighted assets, lowering our capital ratios. Refer to the Foreign Exchange section on page 36, the Enterprise-Wide Capital Management section on page 64 and the Market Risk section on page 91 for a more complete discussion of our foreign exchange risk exposures. Changes to Our Credit Ratings Credit ratings are important to our ability to raise both capital and funding in order to support our business operations. Maintaining strong credit ratings allows us to access the capital markets at competitive pricing. Should our credit ratings experience a material downgrade, our costs of funding would likely increase significantly and our access to funding and capital through capital markets could be reduced. A material downgrade of our ratings could also have other consequences, including those set out in Note 10 on page 146 of the financial statements. Operational and Infrastructure Risks We are exposed to many of the operational risks that may have a sig- nificant impact on large enterprises conducting business in multiple jurisdictions. Such risks include the risk of fraud by employees or others, unauthorized transactions by employees, and operational or human error. Given the high volume of transactions we process on a daily basis, certain errors may be repeated or compounded before they are dis- covered and rectified. Shortcomings or failures of our internal processes, employees or systems, or of services and products provided by third parties, including any of our financial, accounting or other data processing systems, could lead to financial loss and damage to our reputation. In addition, despite the contingency plans we have in place, our ability to conduct business may be adversely affected by a dis- ruption in the infrastructure that supports both our operations and the communities in which we do business, including but not limited to disruption caused by public health emergencies or terrorist acts. Legal Proceedings We are subject to litigation arising in the ordinary course of business. The unfavourable resolution of any such litigation could have a material adverse effect on our financial results. Damage to our reputation could also result, harming our future business prospects. Information about certain legal and regulatory proceedings we currently face is provided in Note 30 on page 178 of the financial statements. Critical Accounting Estimates and Accounting Standards We prepare our financial statements in accordance with International Financial Reporting Standards (IFRS). Changes by the International Accounting Standards Board to IFRS that govern the preparation of our financial statements can be difficult to anticipate and may materially affect how we record and report our financial results. Significant accounting policies and future changes in accounting policies are dis- cussed in Note 1 on page 128 of the financial statements. The application of IFRS requires that management make significant judgments and estimates that can affect when certain assets, liabilities, revenues and expenses are recorded in our financial statements and their recorded values. In making these judgments and estimates, we rely on the best information available at the time. However, it is possible that circumstances may change or new information may become available. Our financial results would be affected in the period in which any such new information or change in circumstances became apparent, and the extent of the impact could be significant. More information is included in the discussion of Critical Accounting Estimates on page 71. BMO Financial Group 197th Annual Report 2014 79 MANAGEMENT’S DISCUSSION AND ANALYSIS Accuracy and Completeness of Customer and Counterparty Information When deciding to extend credit or enter into other transactions with customers and counterparties, we may rely on information provided by or on behalf of those customers and counterparties, including audited financial statements and other financial information. We may also rely on representations made by customers and counterparties that the information they provide is accurate and complete. Our financial results could be adversely affected if the financial statements or other Framework and Risks financial information provided by customers or counterparties are materially misleading. Caution This Risks That May Affect Future Results section and the remainder of this Enterprise-Wide Risk Management section contain forward-looking statements. Other factors beyond our control that may affect our future results are noted in the Caution Regarding Forward-Looking Statements on page 29. We caution that the preceding discussion of risks that may affect future results is not exhaustive. A & D M Risk Culture Risk Governance Risk Principles Risk Appetite Risk Review and Approval Risk Monitoring Credit and Counterparty Market Liquidity and Funding Operational Insurance Legal and Regulatory Business Model Strategic Reputation Environmental and Social Our enterprise-wide risk management framework consists of our operating model and our risk governance structure, both of which are underpinned by our strong risk culture. Our robust framework provides for the management of each individual risk type: credit and counter- party, market, liquidity and funding, operational, insurance, legal and regulatory, business, model, strategic, reputation, and environmental and social. Our framework is anchored in the three-lines-of-defence approach to managing risk, which is fundamental to our operating model, as described below: Three Lines of Defence First Line ‰ Operating groups, which own the risk in their operations Responsibilities ‰ Own, measure and manage all risks in their lines of business. ‰ ‰ Establish appropriate internal control structures in accordance with our risk management Identify, monitor, quantify and report risks arising from their operating activities and initiatives. Second Line ‰ Enterprise Risk and Portfolio Management (ERPM) group ‰ Corporate Support areas Third Line ‰ Corporate Audit Division framework. ‰ Pursue suitable business opportunities within their established risk appetite. ‰ Act within their delegated risk-taking authority as set out in established corporate policies. ‰ Provide independent oversight, effective challenge and independent assessment of risk. ‰ Set enterprise risk management policies and establish infrastructure, processes and practices that address all significant risks across the enterprise. Independently assess, quantify, monitor, control and report all significant risks. ‰ ‰ Provide independent assessment as to the effectiveness of internal control within the enter- prise, including control, risk management and governance processes that support the enterprise, its objectives and the Board of Directors’ discharge of its responsibilities. 80 BMO Financial Group 197th Annual Report 2014 Risk Culture At BMO, we believe that risk management is the responsibility of every employee within the organization. This key tenet shapes and influences our risk culture and is evident in the actions and behaviours of our employees and leaders as they identify, interpret, discuss and make choices and decisions between risks and opportunities. Our risk culture is deeply rooted and is evident in every aspect of how we operate across the enterprise, including within our policies, risk management frame- works, risk appetite and tolerances, capital management and compensation. Our risk culture is grounded on a risk management system that encourages openness and builds confidence in how we engage stake- holders in key decisions and strategy discussions, thereby bringing rigour and discipline to decision-making. This not only leads to the timely identification, escalation and resolution of issues, but also encourages communication and understanding of the key risks faced by our organization, so that our employees are equipped to take action and make decisions in a coordinated and consistent manner. Also, our governance and leadership forums, committee structures and learning curriculums reinforce and inspire our risk culture. Certain elements of our risk culture that are embedded throughout the enterprise include: ‰ Risk appetite – promotes an understanding of the most prevalent risks that our businesses face and facilitates alignment of business strategies within the limits of our risk appetite, leading to sound business decision-making. ‰ Communication and escalation channels – encourages information sharing and engagement between ERPM and the operating groups, leading to greater transparency and open and effective communica- tion. We also foster and encourage a culture where concerns about potential or emerging risks are escalated to senior management so that they can be evaluated and appropriately addressed. ‰ Compensation philosophy – pay is aligned with prudent risk-taking to ensure that compensation rewards the appropriate use of capital and does not encourage excessive risk-taking. ‰ Training and education – our programs are designed to foster a deep understanding of BMO’s capital and risk management frameworks across the enterprise, providing employees and management with the tools and awareness they need to fulfill their responsibilities for independent oversight regardless of their position in the organization. Our education strategy has been developed in partnership with BMO’s Institute for Learning, our risk management professionals, external risk experts and teaching professionals. ‰ Rotation programs – two-way rotation allows employees to transfer between ERPM and the operating groups, thereby effectively embed- ding our strong risk culture across the enterprise. Risk Governance The foundation of our enterprise-wide risk management framework is a governance structure that includes a robust committee structure and a comprehensive set of corporate policies and limits, which are approved by the Board of Directors or its committees, as well as supporting corpo- rate standards and operating guidelines. This enterprise-wide risk management framework is governed through a hierarchy of committees and individual responsibilities as outlined in the diagram below. Our risk management framework is reviewed on a regular basis by the Risk Review Committee of the Board of Directors to provide guid- ance for the governance of our risk-taking activities. In each of our operating groups, management monitors governance activities, controls, and management processes and procedures. Management also oversees their effective operation within our overall risk management framework. Individual governance committees establish and monitor further risk management limits, consistent with and subordinate to the Board- approved limits. M D & A BMO Financial Group 197th Annual Report 2014 81 MANAGEMENT’S DISCUSSION AND ANALYSIS Enterprise-Wide Risk Management Framework Board of Directors Board Risk Review Committee Board Audit and Conduct Review Committee Risk Management Committee Chief Executive Officer Balance Sheet and Capital Management Reputation Risk Management Operational Risk A & D M Operating Groups Enterprise Risk and Portfolio Management Corporate Support Areas Corporate Audit Division First Line of Defence Second Line of Defence Third Line of Defence Board of Directors is responsible for supervising the management of the business and affairs of BMO. The Board, either directly or through its committees, is responsible for oversight in the following areas: strategic planning, defining risk appetite, identification and manage- ment of risk, capital management, promoting a culture of integrity, internal controls, succession planning and evaluation of senior management, communication, public disclosure and corporate governance. Risk Review Committee of the Board of Directors (RRC) assists the Board in fulfilling its oversight responsibilities in relation to BMO’s identification and management of risk, adherence to risk management corporate policies and procedures, compliance with risk- related regulatory requirements and evaluation of the Chief Risk Officer. Our risk management framework is reviewed on a regular basis by the RRC to provide guidance for the governance of our risk-taking activities. Audit and Conduct Review Committee of the Board of Directors assists the Board in fulfilling its oversight responsibilities for the integrity of BMO’s financial reporting, effectiveness of BMO’s internal controls and performance of its internal and external audit functions. Chief Executive Officer (CEO) is directly accountable to the Board for all of BMO’s risk-taking activities. The CEO is supported by the Risk Management Committee and its sub-committees, as well as ERPM. Chief Risk Officer (CRO) reports directly to the CEO and is head of ERPM. The CRO is responsible for providing independent review and oversight of enterprise-wide risks and leadership on risk issues, developing and maintaining a risk management framework and fostering a strong risk culture across the enterprise. Risk Management Committee (RMC) is BMO’s senior risk committee. RMC reviews and discusses significant risk issues and action plans that arise in executing the enterprise-wide strategy. RMC provides risk oversight and governance at the highest levels of management. This committee is chaired by the CRO and membership includes the CFO. RMC Sub-Committees have oversight responsibility for the risk implications and balance sheet impacts of management strategies, governance, risk measurement and contingency planning. RMC and its sub-committees provide oversight of the processes whereby the risks assumed across the enterprise are identified, measured, monitored and reported in accordance with policy guidelines, and are held within delegated limits. Enterprise Risk and Portfolio Management (ERPM) provides comprehensive risk management oversight. It promotes consistency in risk management practices and standards across the enterprise. ERPM facilitates a disciplined approach to risk-taking in fulfilling its responsibilities for independent transactional approval and portfolio management, policy formulation, risk reporting, stress testing, model- ling, vetting and risk education. This approach seeks to meet enter- prise objectives and to ensure that risks assumed are consistent with BMO’s risk appetite. Operating Groups are responsible for managing risk within their respective areas. They exercise business judgment and seek to ensure that policies, processes and internal controls are in place and that significant risk issues are appropriately escalated to ERPM. Individual governance committees establish and monitor further risk manage- ment limits that are consistent with and subordinate to the Board- approved limits. Risk Principles Risk-taking and risk management activities across the enterprise are guided by the following principles: ‰ ERPM provides independent oversight of risk-taking activities across the enterprise; ‰ management of risk is a responsibility at all levels of the organization, and employs the three-lines-of-defence approach; ‰ ERPM monitors our risk management framework to ensure that our risk profile is maintained within our established risk appetite and supported with adequate capital; 82 BMO Financial Group 197th Annual Report 2014 ‰ all material risks to which the enterprise is exposed are identified, measured, managed, monitored and reported; ‰ decision-making is based on a clear understanding of risk, accom- panied by robust metrics and analysis; and ‰ Economic Capital is used to measure and aggregate risk across all risk types and lines of business to facilitate the incorporation of risk into the measurement of business returns. M D & A Risk Appetite Our Risk Appetite Framework consists of our Risk Appetite Statement, as well as all supporting key risk metrics and corporate policies and stan- dards, including limits. Our risk appetite defines the amount of risk that BMO is willing to assume for all risk types, given our guiding principles and capital capacity, thereby supporting sound business initiatives and growth. Our risk appetite is integrated into our strategic and capital planning processes and performance management. On an annual basis, senior management recommends our Risk Appetite Statement and key risk metrics for approval by the RMC and the RRC. Our Risk Appetite Statement is articulated and applied consistently across the enterprise. Among other things, our risk appetite requires: ‰ that everything we do is guided by principles of honesty, integrity and respect, as well as high ethical standards; ‰ only taking risks that are transparent, understood, measured, moni- tored and managed; ‰ maintaining strong capital and liquidity and funding positions that meet or exceed regulatory requirements and the expectations of the market; ‰ subjecting new products and initiatives to a rigorous review and approval process in order to ensure all key risks and returns are understood and can be managed with appropriate controls; ‰ maintaining a robust recovery and resolution framework that enables ‰ ‰ ‰ an effective and efficient response in a severe crisis; targeting an investment grade credit rating at a level that allows competitive access to funding; limiting exposure to low-frequency, high-severity events that could jeopardize BMO’s credit ratings, capital position or reputation; incorporating risk measures into our performance management system; ‰ maintaining effective policies, procedures, guidelines, compliance standards and controls, training and management that guide the business practices and risk-taking activities of all employees to protect BMO’s reputation and adhere to all legal and regulatory obligations; and ‰ protecting the assets of BMO and BMO’s clients by maintaining a system of strong operational risk controls. Risk Limits Our risk limits are shaped by our risk principles and risk appetite, which also inform our business strategies and decisions. These limits are reviewed and approved by the Board of Directors and/or management committees and include: ‰ Credit and Counterparty Risk – limits on country, industry, portfolio/ product segments, and group and single-name exposures; ‰ Market Risk – limits on economic value and earnings exposures to stress scenarios; ‰ Liquidity and Funding Risk – limits on minimum levels of liquid assets and maximum levels of asset pledging and wholesale funding, as well as guidelines approved by senior management related to liability diversification, financial condition, and credit and liquidity exposure appetite; and Insurance Risk – limits on policy exposure and reinsurance arrangements. ‰ The Board of Directors, based on recommendations from the RRC and the RMC, annually reviews and approves risk limits and in turn delegates them to the CEO. The CEO then delegates more specific authorities to the senior executives (first line-of-defence), who are responsible for the management of risk in their respective areas, and the CRO (second line- of-defence). These delegated authorities allow the officers to set risk tolerances, approve geographic and industry sector exposure limits within defined parameters, and establish underwriting and inventory limits for trading and investment banking activities. The criteria whereby these authorities may be further delegated throughout the organization, as well as the requirements relating to documentation, communication and monitoring of delegated authorities, are set out in corporate policies and standards. Risk Review and Approval Risk review and approval processes are established based on the nature, size and complexity of the risks involved. Generally, this involves a formal review and approval of various categories by either an individual or a committee, independent of the originator. Delegated authorities and approvals by category are outlined below. Portfolio transactions – transactions are approved through risk assessment processes for all types of transactions, which include operating group recommendations and ERPM approval of credit risk, and transactional and position limits for market risk. Structured transactions – new structured products and transactions with significant legal, regulatory, accounting, tax or reputation risk are reviewed by the Reputation Risk Management Committee or the Trading Products Risk Committee, as appropriate. Investment initiatives – documentation of risk assessments is for- malized through our investment spending approval process, which is reviewed and approved by Corporate Support areas. New products and services – policies and procedures for the approval of new or modified products and services offered to our customers are reviewed and approved by Corporate Support areas, as well as by other senior management committees, including the Operational Risk Committee and Reputation Risk Management Committee, as appropriate. Risk Monitoring Enterprise-level risk transparency and monitoring and the associated reporting are critical components of our risk management framework and operating culture that help senior management, committees and the Board of Directors to effectively exercise their business manage- ment, risk management and oversight responsibilities. Internal reporting includes a synthesis of key risks and associated metrics that the orga- nization currently faces. This reporting highlights our most significant risks, including assessments of our top and emerging risks, to provide the Board of Directors, its committees and any other appropriate execu- tive and senior management committees with timely, actionable and forward-looking risk reporting. This reporting includes supporting metrics and material to facilitate assessments of these risks relative to our risk appetite and the relevant limits established within our Risk Appetite Framework. On a regular basis, reporting on risk is also provided to stake- holders, including regulators, external rating agencies and our share- holders, as well as to others in the investment community. Risk-Based Capital Assessment Two measures of risk-based capital are used by BMO: Economic Capital and Regulatory Capital. Both are aggregate measures of the risk that we take on in pursuit of our financial targets. Our operating model provides for the direct management of each type of risk, as well as the manage- ment of all on an integrated basis. Economic Capital is our internal assessment of the risks underlying BMO’s business activities. It repre- sents management’s estimate of the likely magnitude of economic losses that could occur if adverse situations arise, and allows returns to be measured on a basis that considers the risks undertaken. Economic Capital is calculated for various types of risk – credit, market (trading and non-trading), operational and business – with measures that are based on a time horizon of one year. Measuring the economic profitability of transactions or portfolios incorporates a combination of both expected BMO Financial Group 197th Annual Report 2014 83 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS and unexpected losses to assess the extent and correlation of risk before authorizing new exposures. Economic Capital methods and model inputs are reviewed and/or recalibrated on an annual basis, as appli- cable. Our Economic Capital models provide a forward-looking estimate of the difference between our maximum potential loss in economic (or market) value and our expected loss, measured over a specified time interval and using a defined confidence level. Both expected and unexpected loss measures for a transaction or a portfolio reflect current market conditions and credit quality. Stress Testing Stress testing is a key element of our risk and capital management frameworks. It is linked to our risk appetite and informs our strategy, business planning and decision-making processes. Governance of the stress testing framework resides with senior management, including the Enterprise Stress Testing Steering Committee. This committee is comprised of business, risk and finance executives and is accountable to the RMC for the oversight of BMO’s stress testing framework and for reviewing and challenging stress test results. Stress testing and enterprise-wide scenarios associated with the Internal Capital Adequacy Assessment Process (ICAAP), including recommended actions that the organization would likely take to manage the impact of the stress event, are presented to senior management and the Board of Directors. Stress testing associated with the Comprehensive Capital Analysis and Review (CCAR) and the mid- year Dodd-Frank Capital Stress Test (DFAST) – which are U.S. regulatory requirements for BMO Financial Corp. – is similarly governed. 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 exists in every lending activity that BMO enters into, as well as 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 defined in a series of corporate policies and standards, 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, ongoing management, monitoring and reporting 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 credit decisions and are accountable for providing an objective assessment of lending decisions and independent oversight of the risks assumed by the lending officers. All of these experienced and Enterprise Stress Testing Enterprise stress testing supports our internal capital adequacy assess- ment and target-setting through analysis of the potential effects of low-frequency, high-severity events on our balance sheet, earnings, liquidity and capital positions. Scenario selection is a multi-step process that considers the enterprise’s material and idiosyncratic risks and the potential impact of new or emerging risks on our risk profile, as well as the macroeconomic environment. Scenarios may be defined by senior management, the Board of Directors or regulators, and are developed in conjunction with the Economics group. The Economics group translates the scenarios into macroeconomic and market variables that include but are not limited to GDP growth, yield curve estimates, unemployment, housing starts, real estate prices, stock index growth and changes in corporate profits. The scenarios are then executed by our operating, risk and finance groups. Quantitative models and qualitative approaches are utilized to assess the impact of changes in the macroeconomic environment on our income statement and balance sheet and the resilience of our capital over a forecast horizon. Stress test results, including mitigating actions, are benchmarked and challenged by relevant business units and senior management, including the Enterprise Stress Testing Steering Committee. Ad Hoc Stress Testing Through our stress testing framework, we embed stress testing in our strategy, business planning and decision-making. Ad hoc stress testing is conducted regularly by our operating and risk groups to support risk identification, business analysis and strategic decision-making. 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, all of 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 for adherence to credit terms and conditions, as well as to governing policies, standards and procedures. All credit risk exposures are subject to regular monitoring. Per- forming 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 speci- alized account management groups for closer attention, when appro- priate. 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 ensure appropriate actions can be taken where necessary. Credit and Counterparty Risk Management Collateral Management Collateral is used for credit risk mitigation purposes and minimizes losses that would otherwise be incurred. 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 Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). 84 BMO Financial Group 197th Annual Report 2014 M D & A 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 an ongoing basis, collateral is subject to regular revaluation specific to asset type. For loans, collateral values are 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 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 completed. 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 if a full property appraisal is required. For high LTV ratio (greater than 80%) insured mortgages, BMO relies on the property valuation as determined by the default insurer based upon information supplied by BMO. 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 (ISDA) Master Agreement with a Credit Support Annex (CSA) included to document our collateralized contractual trading relationships with our counterparties for over-the-counter (OTC) derivatives. CSAs provide for the exchange of collateral between the parties where one party’s OTC derivatives exposure to the other party exceeds an agreed amount (threshold). The purpose of collateralization is to mitigate counterparty credit risk. Collateral can be exchanged as 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 counter- parties for repurchase transactions, we utilize master repurchase agreements and for securities lending transactions, we utilize master securities lending agreements. Portfolio Management BMO’s credit risk governance policies provide an acceptable level of diversification. Limits are in place 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. Our credit exposure diversification may be supple- mented by the purchase or sale of insurance through guarantees or credit default swaps. Credit and Counterparty Risk Measurement We quantify credit risk at both the individual borrower and portfolio levels. 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. LGD takes into consideration the amount and quality of any collateral held. Probability of Default (PD) represents the likelihood that a credit obliga- tion (loan) will not be repaid and will go into default over a one-year time horizon. A PD is assigned to each account, based on the type of facility, the product type and customer characteristics. The credit history of the counterparty/portfolio and the nature of the exposure are taken into account in the determination of a PD. 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 Basel II, 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 execute on 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 the 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 whole- sale models. 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 rates the borrower’s risk based on a narrow range of likely expected conditions, primarily more recent in nature, including delinquency, loan-to-value (LTV) ratio and loan uti- lization rate. Product lines within each of the retail risk areas are sepa- rately 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, capturing 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 sub- ject to uncertainty. During the calibration process, adjustments are made at the parameter level for each segment to account for uncertainty. Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). BMO Financial Group 197th Annual Report 2014 85 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS 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 Exceptionally low Very low Low Medium High Default Probability of default band ≤ 0.05% > 0.05% to 0.20% > 0.20% to 0.75% > 0.75% to 7.00% > 7.00% to 99.99% 100% Wholesale (Corporate and Commercial) Within the 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 risk ratings (BRRs) to help quantify potential credit risk. 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 factors associated with borrowers in different industries and portfolios. Risk ratings are assigned using the appropriate internal model. BRRs are assessed and assigned at loan inception and reviewed at least annually. More frequent reviews are performed for borrowers with higher risk ratings, accounts that trigger a review through a rating change or that experience covenant breaches, and accounts requiring or requesting changes to facilities. The assigned ratings are mapped to a PD over a one-year time horizon. As counter- parties migrate between risk ratings, the PD associated with the counterparty changes. BMO employs a master scale with 14 BRRs above default, and PDs are assigned to each grade within an asset class to reflect the long-run average of one-year default rates. PD estimates are based on internal default experience over a period of more than five years that covers at least one full economic cycle, supplemented by external benchmarking, as applicable. BMO also assigns an LGD estimate to each separate facility provided to an entity at origination. LGD estimates are a measure of the potential economic loss for the facility if the entity were to default during a period of economic distress. The LGD estimate provides an inverse measure of the protection from loss afforded by the assigned collateral, as appli- cable, and considers the supporting structural elements of the facility, including seniority, margin arrangements, and product and sectoral characteristics. LGD models have been developed for each asset class using internal data that covers a period of more than seven years, capturing a full economic cycle and are supplemented by external data, when necessary. As demonstrated in the table below, our internal risk rating system corresponds in a logical manner to those of the external rating agencies. Borrower Risk Rating Scale BMO rating Acceptable I-1 to I-3 I-4 to I-5 I-6 to I-7 S-1 to S-2 S-3 to S-4 Problem P-1 P-2 to P-3 Description of risk Moody’s Investors Service implied equivalent Standard & Poor’s implied equivalent Undoubted to minimal Modest Average Acceptable Marginal Aaa to Aa3 A1 to Baa1 Baa2 to Baa3 Ba1 to Ba2 Ba3 to B1 AAA to AA- A+ to BBB+ BBB to BBB- BB+ to BB BB- to B+ Deteriorating Watchlist B2 B3 to Ca B B- to CC Default and impaired D-1 to D-4 Default/default and impaired C D Credit Quality Information Portfolio Review Total enterprise-wide outstanding credit exposures were $546 billion at October 31, 2014, comprised of $331 billion in Canada, $184 billion in the United States and $31 billion in other jurisdictions. This represents an increase of $39 billion or 8% from the prior year. BMO’s loan book continues to be well diversified by industry and geographic region and, consistent with the prior year, the consumer portfolio represented the majority of loans. Gross loans and acceptances increased by $24 billion or 8% from the prior year to $305 billion at October 31, 2014. The geographic mix of our Canadian and U.S. portfo- lios was relatively consistent with the prior year, and represented 70.0% and 26.3% of total loans, respectively, compared with 72.4% and 24.4% in 2013. The consumer loan portfolio represented 56.8% of the total portfolio, a modest decrease from 59.8% in 2013. Approximately 88% of the Canadian consumer portfolio and 98% of the U.S. consumer portfolio is secured. Business and government loans represented 43.2% of the total portfolio, a modest increase from 40.2% in 2013. Our loan portfolio is well-diversified by industry and we continue to proactively monitor industry sectors that we consider warrant closer attention, including Canadian consumer loans and U.S. real estate. Further details on our loan book, including detailed breakdowns by industry and geographic region, can be found in Tables 7 to 15 on pages 112 to 118 and in Note 6 on page 140 of the financial state- ments. Details related to our credit exposures are discussed in Note 4 on page 136 of the financial statements. Real Estate Secured Lending Residential mortgage and home equity line of credit (HELOC) exposures continue to be areas of interest in the current environment. BMO regu- larly performs stress testing on its residential mortgage and HELOC portfolios to evaluate the potential effects of high-impact events. These stress tests incorporate moderate to severe adverse scenarios. The credit losses forecast in these tests vary depending on the severity of the scenario and are considered to be manageable. Since 2012, new residential real estate lending rules have been introduced for federally regulated lenders in Canada, including restrictions on LTV ratios for revolving HELOCs and requirements related to assessing a borrower’s capacity to service debt obligations on a timely basis, as well as a maximum amortization of 25 years and a maximum home value of $1 million for high LTV ratio (greater than 80%) insured mortgages. These regulatory changes resulted in some adjustments to loan underwriting practices, including reducing the maximum LTV ratio on revolving HELOCs to 65% from the previous maximum of 80%. Provision for Credit Losses (PCL) Total PCL was $561 million in the current year, down 4% from $587 million in 2013. Detailed discussion of our PCL, including historical trends in PCL, is provided on page 40, in Table 15 on page 118 and in Note 4 on page 136 of the financial statements. Gross Impaired Loans (GIL) Total GIL decreased by $496 million or 19% from 2013 to $2,048 million in 2014, with most of the decrease in the United States. GIL as a percentage of gross loans and acceptances also decreased over the prior year from 0.91% in 2013 to 0.67% in 2014. Factors contributing to the change in GIL are outlined in the following table. Loans classified as impaired during the year decreased from $2,449 million in 2013 to $2,142 million in 2014. On a geographic basis, the United States accounted for the majority of impaired loan formations, comprising 56.8% of total formations in 2014, compared with 64.0% in 2013. Further details on the breakdown of impaired loans by geographic region and industry can be found on Table 11 on page 114 and in Note 4 on page 136 of the financial statements. Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). 86 BMO Financial Group 197th Annual Report 2014 Changes in Gross Impaired Loans and Acceptances (GIL) (1) (Canadian $ in millions, except as noted) For the year ended October 31 GIL, beginning of year Classified as impaired during the year Transferred to not impaired during the year Net repayments Amounts written-off Disposals of loans Foreign exchange and other movements GIL, end of year 2014 2013 2012 2,544 2,142 (669) (1,059) (801) (220) 111 2,976 2,449 (728) (1,058) (939) (343) 187 2,685 3,101 (968) (517) (1,179) (197) 51 2,048 2,544 2,976 GIL as a % of gross loans and acceptances 0.67 0.91 1.17 (1) GIL excludes purchased credit impaired loans. Allowance for Credit Losses (ACL) Across all loan portfolios, BMO employs a disciplined approach to provi- sioning and loan loss evaluation, with the prompt identification of problem loans being a key risk management objective. BMO maintains both specific and collective allowances for credit losses. Specific allow- ances reduce the aggregate carrying value of credit assets for which there is evidence of deterioration in credit quality. We also maintain a collective allowance in order to cover any impairment in the existing loan portfolio that cannot yet be associated with individually identified impaired loans. Our approach to establishing and maintaining the collec- tive allowance is based on the requirements of IFRS, considering guide- lines issued by our regulator, OSFI. For the purposes of calculating the collective allowance, we group loans on the basis of similar credit risk characteristics. Our methodology incorporates both quantitative and qualitative components to determine an appropriate level for the collec- tive allowance. The quantitative component measures long-run expected losses based on PD and LGD risk parameters. For commercial and corporate loans, key factors that determine the incurred but not identified losses include the underlying risk rating of the borrower, industry sector, credit product and amount and quality of collateral held. For consumer and small business loans, exposures are pooled based on similar risk characteristics and the incurred loss parameters are determined from the long-run default and historical loss experience of each pool. The collective allowance is adjusted to reflect qualitative factors such as management’s credit judgment with respect to current and near-term macroeconomic and business conditions, portfolio- specific considerations, credit quality trends, changes in lending practices, model factors and the level of non-performing balances (impaired loans) for which a specific allowance has not yet been assessed. We review the collective allowance on a quarterly basis. BMO maintains the allowance for credit losses at a level that we consider adequate to absorb credit-related losses. As at October 31, 2014, the ACL was $1,966 million, comprised of $424 million of specific allowance and $1,542 million of collective allowance. This includes $50 million of specific allowance and $182 million of collective allowance related to undrawn commitments and letters of credit that are considered other credit instruments and recorded in other liabilities. Total ACL remained relatively stable year over year, decreasing by $4 million. Our coverage ratios are trending positively with ACL as a percentage of GIL, including and excluding purchased portfolios, increasing year over year. The collective allowance increased by $57 million from 2013 to $1,542 million in 2014 due to the strengthening U.S. dollar. The collec- tive allowance remains adequate and at year end represented 0.83% of credit risk-weighted assets, unchanged from 2013. Factors contributing to the change in ACL are outlined in the table below. Further details on changes in ACL by country and portfolio can be found in Tables 12 and 13 on page 116 and in Note 4 on page 136 of the financial statements. Changes in Allowance for Credit Losses (1) (Canadian $ in millions, except as noted) For the year ended October 31 Specific ACL, beginning of year Specific PCL (charge to income statement) Recoveries of amounts written off in previous years Write-offs Foreign exchange and other movements Specific ACL, end of year Collective ACL, beginning of year Collective PCL (charge to income statement) Foreign exchange and other movements Collective ACL, end of year Total ACL Comprised of: Loans Specific allowance for other credit instruments Collective allowance for other credit instruments ACL as a % of GIL (2) 2014 485 561 2013 476 597 2012 559 761 624 (1,149) (97) 772 (1,297) (63) 846 (1,593) (97) 424 485 476 1,485 – 57 1,460 (10) 35 1,452 3 5 1,542 1,485 1,460 1,966 1,970 1,936 1,734 1,665 1,706 50 41 29 182 93.6 264 75.8 201 64.1 (1) Includes allowances related to other credit instruments that are included in other liabilities. (2) Ratio excludes specific allowances for other credit instruments that are included in other liabilities. M D & A BMO Financial Group 197th Annual Report 2014 87 MANAGEMENT’S DISCUSSION AND ANALYSIS Select Geographic Exposures BMO’s geographic exposure is subject to a country risk management framework that incorporates economic and political assessments, and management of exposure within limits based on product, entity and the country of ultimate risk. We closely monitor our European exposure, and our risk management processes incorporate stress tests where appro- priate to assess our potential risk. Our exposure to European countries, as at October 31, 2014, including Greece, Ireland, Italy, Portugal and Spain (GIIPS), is set out in the tables that follow. The table below outlines total net portfolio exposures for funded lending, securities (inclusive of credit default swap (CDS) activity), repo- style transactions and derivatives. Funded lending is further broken down by counterparty type, as well as by total commitments compared to the funded amount, in the table on page 89. European Exposure by Country and Counterparty (9) (Canadian $ in millions) As at October 31, 2014 Funded lending (1) Securities (2)(8) Repo-style transactions and derivatives (3)(4) Total A & D M Country GIIPS Greece Ireland (5) Italy Portugal Spain Total – GIIPS Eurozone (excluding GIIPS) France Germany Netherlands Finland Other (6) Total – Eurozone (excluding GIIPS) Rest of Europe Denmark Norway Russian Federation Sweden Switzerland United Kingdom Other (6) Total – Rest of Europe Total – All of Europe (7) As at October 31, 2013 Country Total – GIIPS Total – Eurozone (excluding GIIPS) Total – Rest of Europe Total – All of Europe (7) Total Bank Corporate Sovereign Total Bank Corporate Sovereign Total – 8 69 – 52 129 26 85 239 – 201 551 12 15 330 93 215 497 – – – – – – – – – 711 – – 711 577 1,281 – 299 1 96 – 1,162 2,254 1,842 2,965 – – – – – – 15 24 8 – 6 53 – – – – – 44 – 44 97 – – – – – – – – – – – – 64 1,301 113 394 – 79 1,325 832 394 6 1,872 2,636 322 – – 12 – 203 – 899 1,281 – 311 1 343 – 537 2,835 – 42 5 1 7 55 205 52 78 – 44 379 – 28 – 1 199 486 – 714 2,409 5,471 1,148 – 2 5 – – 7 – – 1 – 48 49 – – – – – 14 – 14 70 – – – – – – – – – – 7 7 – – – – – 2 – 2 9 – 44 10 1 7 62 205 52 79 – 99 435 – 28 – 1 199 502 – 730 1,227 Net exposure – 52 79 1 59 191 310 1,462 1,150 394 306 3,622 911 1,324 330 405 415 1,342 – 4,727 8,540 Funded lending (1) Total 79 462 956 1,497 Securities (2) Repo-style transactions and derivatives (3)(4) Total Bank Corporate Sovereign Total Bank Corporate Sovereign Total – 626 2,058 2,684 – 42 40 82 – – 2,111 2,779 674 2,772 2,785 5,551 5 113 153 271 2 6 19 27 – 1 – 1 7 120 172 299 Net exposure 86 3,361 3,900 7,347 (1) Funded lending includes loans (primarily trade finance). (2) Securities include cash products, insurance investments and traded credit. (3) Repo-style transactions are primarily with bank counterparties for which BMO holds collateral ($15 billion for Europe as at October 31, 2014). (8) BMO’s total net notional CDS exposure (embedded as part of the securities exposure table) to Europe was $555 million, with no net single-name* CDS exposure to GIIPS countries as at October 31, 2014 (*includes a net position of $254 million (bought protection) on a CDS Index, of which 20% is comprised of GIIPS domiciled entities). (4) Derivatives amounts are marked-to-market, incorporating transaction netting and, for (9) BMO has the following indirect exposures to Europe as at October 31, 2014: counterparties where a Credit Support Annex is in effect, collateral offsets. (5) Does not include Irish subsidiary reserves we are required to maintain with the Irish Central Bank of $76 million as at October 31, 2014. (6) Includes countries with less than $300 million net exposure. (7) Of our total net direct exposure to Europe, approximately 89% was to counterparties in countries with a rating of Aaa/AAA from at least one of Moody’s and S&P. – – Collateral of €571 million to support trading activity in securities (€27 million from GIIPS) and €127 million of cash collateral being held. Guarantees of $986 million ($8 million to GIIPS). 88 BMO Financial Group 197th Annual Report 2014 European Lending Exposure by Country and Counterparty (9) (Canadian $ in millions) Country GIIPS Greece Ireland (5) Italy Portugal Spain Total – GIIPS Eurozone (excluding GIIPS) France Germany Netherlands Finland Other (6) Total – Eurozone (excluding GIIPS) Rest of Europe Denmark Norway Russian Federation Sweden Switzerland United Kingdom Other (6) Total – Rest of Europe Total – All of Europe (7) Refer to footnotes in the table on page 88. Funded lending as at October 31, 2014 As at October 31, 2014 As at October 31, 2013 Bank Corporate Sovereign Commitments Funded Commitments Funded Lending (1) – – 69 – 52 121 26 79 30 – 158 293 12 15 302 23 4 223 – 579 993 – 8 – – – 8 – 6 209 – 43 258 – – 28 70 211 274 – 583 849 – – – – – – – – – – – – – – – – – – – – – – 103 69 – 62 234 78 99 559 – 439 1,175 12 15 330 198 471 701 45 – 8 69 – 52 129 26 85 239 – 201 551 12 15 330 93 215 497 – – – 2 – 77 79 22 21 338 – 421 802 15 16 476 121 546 485 – 1,772 3,181 1,162 1,842 1,659 2,540 M D & A – – 2 – 77 79 22 21 163 – 256 462 15 16 476 64 163 222 – 956 1,497 BMO Financial Group 197th Annual Report 2014 89 MANAGEMENT’S DISCUSSION AND ANALYSIS Derivative Transactions The following table represents the notional amounts of our over-the- counter (OTC) derivative contracts, comprised of those which are cen- trally cleared and settled through a designated clearing house and those which are non-centrally cleared. The notional amounts of our derivatives represent the amount to which a rate or price is applied in order to Over-the-Counter Derivatives (Notional amounts) A & D M (Canadian $ in millions) As at October 31 Interest Rate Contracts Swaps Forward rate agreements Purchased options Written options Total interest rate contracts Foreign Exchange Contracts Cross-currency swaps Cross-currency interest rate swaps Forward foreign exchange contracts Purchased options Written options Total foreign exchange contracts Commodity Contracts Swaps Purchased options Written options Total commodity contracts Equity Contracts Credit Default Swaps Purchased Written Total credit default swaps Total calculate the amount of cash that must be exchanged under the con- tract. Notional amounts do not represent assets or liabilities and there- fore are not recorded in our Consolidated Balance Sheet. The fair values of OTC derivative contracts are recorded in our Consolidated Balance Sheet. Non-centrally cleared Centrally cleared Total 2014 2013 2014 2013 2014 2013 814,178 34,713 19,267 22,955 1,084,369 52,137 18,283 23,020 1,861,499 326,771 – – 1,140,417 347,614 – – 2,675,677 361,484 19,267 22,955 2,224,786 399,751 18,283 23,020 891,113 1,177,809 2,188,270 1,488,031 3,079,383 2,665,840 51,616 279,119 299,480 31,148 36,344 44,834 255,337 263,607 10,923 13,530 697,707 588,231 13,559 8,526 4,166 26,251 48,702 6,507 10,232 16,739 15,122 8,081 4,285 27,488 39,360 8,541 13,072 21,613 – – – – – – – – – – – – – – – – – – – – – – 2,294 1,751 4,045 294 216 510 51,616 279,119 299,480 31,148 36,344 44,834 255,337 263,607 10,923 13,530 697,707 588,231 13,559 8,526 4,166 26,251 48,702 8,801 11,983 20,784 15,122 8,081 4,285 27,488 39,360 8,835 13,288 22,123 1,680,512 1,854,501 2,192,315 1,488,541 3,872,827 3,343,042 90 BMO Financial Group 197th Annual Report 2014 Market Risk Market risk is the potential for adverse changes in the value of BMO’s assets and liabilities resulting from changes in market variables such as interest rates, foreign exchange rates, equity and commodity prices and their implied volatilities, and credit spreads, as well as the risk of credit migration and default. BMO incurs market risk in its trading and underwriting activities and structural banking activities. The importance and magnitude of these activities to the enterprise, along with the relative uncertainty of daily changes to market variables, require a strong and balanced market risk structure that incorporates appropriate and defensible governance, management and measurement. Trading and Underwriting Market Risk Governance As part of our enterprise-wide risk management framework, we apply extensive governance and management processes to our market risk- taking activities. The RRC has oversight of the management of market risk and approves the market risk corporate policy, along with limits governing market risk exposures. The RMC, which recommends the market risk corporate policy for approval, regularly reviews and dis- cusses significant market risk issues and positions and provides senior management oversight. These committees are informed of specific exposures or other factors that expose BMO to unusual, unexpected, inappropriate or otherwise not fully identified or quantified risks asso- ciated with market or traded credit exposures, as well as other relevant market risk topics. In addition, all individuals authorized to execute trading and underwriting activities on behalf of BMO are appropriately notified of BMO’s risk-taking governance, authority structure, procedures and processes, are given access to and guidance on the relevant corpo- rate policies and standards, and are expected to adhere to those standards. Trading and Underwriting Market Risk Management We have strong, independent risk oversight within a policy framework that mandates comprehensive controls for the management of market risk. We monitor an extensive range of risk metrics, including Value at Risk, Stressed Value at Risk, stress and scenario tests, risk sensitivities and operational metrics. We have a comprehensive set of limits that are applied to these metrics, with appropriate monitoring, reporting and escalation of limit breaches. Risk profiles of our trading and underwriting activities are maintained within our risk appetite, and are monitored and reported to traders, management, senior executives and Board commit- tees. Further key controls include the independent valuation of financial assets and liabilities and compliance with a model risk management framework to control for model risk. BMO’s Market Risk group also provides oversight of structural market risk, which is managed by BMO’s Corporate Treasury group and described on page 94. Valuation Product Control Within the Market Risk group, the Valuation Product Control (VPC) group is responsible for independent valuation of all trading and available-for- sale (AFS) portfolios within Capital Markets Trading Products and Corpo- rate Treasury, to ensure that they are materially accurate by: ‰ developing and maintaining valuation adjustment policies and proce- dures in accordance with regulatory requirements and IFRS; ‰ establishing official rate sources for valuation of all portfolios; and ‰ providing an independent review of portfolios where trader prices are used for valuation. M D & A Trader valuations are reviewed to determine whether they align with an independent assessment of the market value of the portfolio. If the valuation difference exceeds the prescribed tolerance threshold, a valu- ation adjustment is recorded in accordance with our accounting policy and regulatory requirements. Prior to the final month-end general ledger close, the Valuation Operating Committee, composed of key stakeholders from the lines of business, Market Risk, Capital Markets Finance and the Chief Accountant’s Group reviews all valuation adjust- ments that are proposed by the VPC group. The Valuation Steering Committee is BMO’s senior management valuation committee. It meets at least quarterly to address the more challenging material valuation issues in BMO’s portfolios, approves methodology changes related to valuation and acts as a key forum for discussing positions categorized as Level 3 for financial reporting pur- poses and their inherent uncertainty. At a minimum, the following are considered when determining appropriate valuation adjustments: credit valuation adjustments, closeout costs, uncertainty, funding valuation adjustments, and liquidity and model risk. Also, a fair value hierarchy is used to categorize the inputs used in the valuation of securities, liabilities, derivative assets and derivative liabilities. Level 1 inputs consist of quoted market prices, Level 2 inputs consist of models that use observable market information and Level 3 inputs consist of models without observable market information. Details of Level 1, Level 2 and Level 3 fair value measure- ments can be found in Note 31 on page 178 of the financial statements. Trading and Underwriting Market Risk Measurement To capture the multi-dimensional aspects of market risk effectively, a number of metrics are used, including VaR, SVaR, stress testing, sensitivities, position concentrations, market and notional values and revenue losses. Value at Risk (VaR) is measured for specific classes of risk in BMO’s trading and underwriting activities: interest rate, foreign exchange rate, credit spreads, equity and commodity prices and their implied volatilities. This measure calculates the maximum loss likely to be experienced in the portfolios, measured at a 99% con- fidence level over a specified holding period. Stressed Value at Risk (SVaR) is measured for specific classes of risk in BMO’s trading and underwriting activities: interest rate, foreign exchange rate, credit spreads, equity and commodity prices and their implied volatilities, where model inputs are calibrated to historical data from a period of significant financial stress. This measure calculates the maximum loss likely to be experienced in the portfolios, measured at a 99% confidence level over a specified holding period. Although a valuable guide to risk, VaR should always be viewed in the context of its limitations. Among the limitations of VaR is the assump- tion that all positions can be liquidated within the assigned one-day holding period (ten-day holding period for regulatory calculations), which may not be the case in illiquid market conditions, and that histor- ical data can be used as a proxy to predict future market events. Gen- erally, market liquidity horizons are reviewed for suitability and updated where appropriate for relevant risk metrics. Scenario analysis and probabilistic stress testing are performed daily to determine the impact of unusual and/or unexpected market changes on our portfolios. As well, historical and event stresses are tested on a weekly basis, including tests of scenarios such as the stock market crash of 1987 and the collapse of Lehman Brothers in 2008. Ad hoc analyses are run to Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). BMO Financial Group 197th Annual Report 2014 91 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS examine our sensitivity to low-frequency, high-severity hypothetical scenarios. Scenarios are amended, added or deleted to better reflect changes in underlying market conditions. The results are reported to the lines of business, RMC and RRC on a regular basis. Stress testing is lim- ited by the fact that not all downside scenarios can be predicted and effectively modelled. Neither VaR nor stress testing should be viewed as a definitive predictor of the maximum amount of losses that could occur in any one day, because both measures are computed at prescribed confidence levels and their results could be exceeded in highly volatile market conditions. On a daily basis, exposures are aggregated by lines of business and risk type and monitored against delegated limit levels, and the results are reported to the appropriate stakeholders. BMO has a robust governance process in place to ensure adherence to delegated market risk limits. Amounts exceeding established limits are communi- cated to senior management on a timely basis for resolution and appro- priate action. In addition, we measure the market risk for trading and under- writing portfolios that meet regulatory criteria for trading book capital treatment using the Internal Models Approach. We also apply this approach in measuring the market risk for portfolios that are subject to AFS accounting rules under IFRS and are accorded banking book regu- latory capital treatment. For trading and underwriting portfolios covered by the Internal Models Approach, VaR is computed using BMO’s Trading Book VaR model. This is a Monte Carlo scenario simulation model, and its results are used for market risk management and reporting of exposures. The model computes one-day VaR results using a 99% con- fidence level and reflects the correlations between the different classes of market risk factors. We use a variety of methods to verify the integrity of our risk models, including the application of back-testing against hypothetical losses. This process assumes there are no changes in the previous day’s closing positions and then isolates the effects of each day’s price movements against those closing positions. Models are validated by assessing how often the calculated hypothetical losses exceed the VaR measure over a defined period. This testing result is in line with regulatory-defined expectations and confirms the reliability of our models. The correlations and volatility data that underpin our models are updated monthly, so that VaR measures reflect current levels of volatility. Our models are used to determine market risk Economic Capital for each of our lines of business and to determine regulatory capital. For capital calculation purposes, longer holding periods and/or higher con- fidence levels are used than are employed in day-to-day risk manage- ment. Prior to use, models are subject to review under the Model Risk Corporate Policy & Guidelines by our Model Risk Validation group. The Model Risk Corporate Policy & Guidelines outline minimum requirements for the identification, assessment, monitoring and management of models and model risk across the enterprise and are described on page 103. Total Trading VaR decreased during the year due to active portfolio rebalancing within our equity books. The Total AFS VaR decrease was the result of position reductions in a number of portfolios and from the impact of parameter recalibrations. The increase in Total Trading SVaR during the year was attributable to client facilitation activities across a range of businesses. Total Trading Value at Risk (VaR) Summary (Canadian $ in millions) (1)(3) As at or for the year ended October 31 (pre-tax Canadian equivalent) Commodity VaR Equity VaR Foreign exchange VaR Interest rate VaR Credit VaR Diversification Total Trading VaR Total AFS VaR 2014 2013 Year-end Average High Low Year-end (0.5) (3.2) (0.5) (5.8) (5.5) 7.4 (0.6) (6.4) (1.2) (6.9) (5.3) 10.0 (0.9) (10.6) (3.5) (13.3) (6.4) nm (0.3) (3.1) (0.1) (4.1) (4.5) nm (8.1) (10.4) (14.5) (6.5) (0.4) (6.1) (0.5) (4.6) (5.0) 7.5 (9.1) (7.9) (11.3) (14.5) (7.7) (10.1) Total Trading Stressed Value at Risk (SVaR) Summary (Canadian $ in millions) (2)(3) 2014 2013 As at or for the year ended October 31 (pre-tax Canadian equivalent) Commodity SVaR Equity SVaR Foreign exchange SVaR Interest rate SVaR Credit SVaR Diversification Year-end Average High Low Year-end (3.2) (14.0) (0.7) (11.2) (13.6) 20.6 (4.3) (14.8) (3.6) (17.0) (13.3) 28.4 (7.9) (38.0) (11.3) (30.1) (17.5) nm (1.8) (6.1) (0.2) (8.5) (11.0) nm (4.7) (9.8) (0.8) (9.5) (11.0) 19.9 Total Trading SVaR (22.1) (24.6) (46.4) (11.5) (15.9) (1) Total Trading VaR and AFS VaR are subject to the BMO Capital Markets trading management framework. (2) Stressed VaR is produced weekly. (3) One-day measure using a 99% confidence interval. Losses are in brackets and benefits are presented as positive numbers. nm – not meaningful Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). 92 BMO Financial Group 197th Annual Report 2014 Trading Net Revenue The charts below present daily net revenues versus total trading and AFS VaR, along with a representation of daily net revenue distribution. During the current year, the largest loss occurred on October 31, and was the result of normal trading activity and valuation adjustments. The largest gain occurred on September 30, and was primarily due to normal trading and underwriting activity. Frequency Distribution of Daily Net Revenues November 1, 2013 to October 31, 2014 ($ millions) M D & A s y a d f o r e b m u n n i y c n e u q e r F 40 35 30 25 20 15 10 5 0 (11) (6) (4) (2) — 2 4 6 8 10 12 14 16 18 20 22 24 26 28 32 36 Daily net revenues (pre-tax) Trading Net Revenues versus Value at Risk November 1, 2013 to October 31, 2014 ($ millions) 50 30 10 N o v 1 (10) (30) J a n 3 1 A p r 3 0 J u l 3 1 O c t 3 1 Daily Revenues Total Trading VaR Total AFS VaR Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). BMO Financial Group 197th Annual Report 2014 93 MANAGEMENT’S DISCUSSION AND ANALYSIS Linkages between Balance Sheet Items and Market Risk Disclosures The table below presents items reported in our Consolidated Balance Sheet that are subject to market risk, comprised of balances that are subject to traded risk and non-traded risk measurement techniques. As at October 31, 2014 Subject to market risk As at October 31, 2013 Subject to market risk Consolidated Balance Sheet Traded risk (1) Non-traded risk (2) Not subject to market risk Consolidated Balance Sheet Traded risk (1) Non-traded risk (2) Not subject to market risk (Canadian $ in millions) Assets Subject to Market Risk Cash and cash equivalents Interest bearing deposits with banks Securities Trading Available-for-sale Held-to-maturity Other Securities borrowed or purchased under resale agreements Loans and acceptances (net of allowance for credit losses) A & D M 28,386 – 28,386 6,110 930 5,180 85,022 78,997 6,025 46,966 10,344 987 53,555 303,038 – – – – – 46,966 10,344 987 53,555 303,038 Derivative instruments 32,655 31,627 1,028 – – – – – – – – – 26,089 – 26,089 6,518 1,511 5,007 75,159 69,393 5,766 53,710 6,032 899 39,799 279,294 – – – – – 53,710 6,032 899 39,799 279,294 30,259 29,484 775 – – – – – – – – – Other assets Total Assets 21,596 – 7,787 588,659 111,554 463,296 13,809 13,809 19,285 – 7,692 537,044 100,388 425,063 11,593 11,593 Liabilities Subject to Market Risk Deposits 393,088 7,639 385,449 Derivative instruments 33,657 32,310 1,347 Acceptances Securities sold but not yet purchased Securities lent or sold under repurchase agreements Other liabilities Subordinated debt Total Liabilities 10,878 – 10,878 27,348 27,348 – 39,695 43,676 4,913 – – – 39,695 43,263 4,913 553,255 67,297 485,545 – – – – – 413 – 413 368,369 5,928 362,441 31,974 31,184 790 8,472 – 8,472 22,446 22,446 – 28,884 41,724 3,996 – – – 28,884 41,179 3,996 505,865 59,558 445,762 – – – – – 545 – 545 Main risk factors for non-traded risk balances Interest rate Interest rate Interest rate, credit spread Interest rate, credit spread Interest rate Equity Interest rate Interest rate, foreign exchange Interest rate, foreign exchange Interest rate Interest rate, foreign exchange Interest rate, foreign exchange Interest rate Interest rate Interest rate Interest rate Interest rate (1) Primarily comprised of BMO’s balance sheet items that are subject to the trading and underwriting risk management framework and fair valued through profit or loss. (2) Primarily comprised of BMO’s balance sheet items that are subject to the structural balance sheet and insurance risk management framework, or are available-for-sale securities. Certain comparative figures have been reclassified to conform to the current year’s presentation. Structural (Non-Trading) Market Risk Structural market risk is comprised of interest rate risk arising from our banking activities (loans and deposits) and foreign exchange risk arising from our foreign currency operations. Structural Market Risk Governance The RRC has oversight of the management of structural market risk, annually approves the structural market risk strategy and limits, and regularly reviews structural market risk positions. The RMC and Balance Sheet and Capital Management Committee (BSCMC) regularly review structural market risk positions and provide senior management oversight. In addition to Board-approved limits on earnings and economic value exposure, more granular management limits are in place to guide day-to-day management of this risk. BMO’s Corporate Treasury group is responsible for the ongoing management of structural market risk across the enterprise, with independent oversight provided by the Market Risk group. Structural Market Risk Measurement Interest Rate Risk Structural interest rate risk arises when changes in interest rates affect the cash flows, earnings and values of assets and liabilities from our banking activities. The objective of structural interest rate risk manage- ment is to maintain high-quality earnings and maximize sustainable product spreads. Structural interest rate risk is primarily comprised of interest rate mismatch risk and product embedded option risk. Interest rate mismatch risk arises when there are differences in the scheduled maturity, repricing dates or reference rates of assets, liabilities and derivatives. The net interest rate mismatch, representing residual assets funded by common shareholders’ equity, is managed to a target profile through interest rate swaps and securities. Product embedded option risk arises when product features allow customers to alter scheduled maturity or repricing dates. Product embedded options include loan prepayment, deposit redemption priv- ileges and committed rates on unadvanced mortgages. Product embedded options are managed to low risk levels through a dynamic hedging process or with purchased options. Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). 94 BMO Financial Group 197th Annual Report 2014 Structural interest rate risk is measured using simulations, earnings Structural Balance Sheet Interest Rate Sensitivity sensitivity and economic value sensitivity analysis, stress testing and gap analysis, in addition to other traditional risk metrics. (Canadian $ in millions) (1)(2) 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 the 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. These 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 19 on page 160 of the financial state- ments. During the year, economic value interest rate sensitivity increased and earnings interest rate sensitivity decreased primarily due to reduced short-term asset sensitivity and growth in capital. The asset-liability profile at the end of the year results in a structural earnings benefit from interest rate increases and structural earnings exposure to interest rate decreases. Liquidity and Funding Risk Liquidity and funding risk is the potential for loss if BMO is unable to meet financial commitments in a timely manner at reasonable prices as they fall due. Financial commitments include liabilities to depositors and suppliers, and lending, investment and pledging commitments. Managing liquidity and funding risk is essential to maintaining the safety and soundness of the enterprise, depositor confidence and stability in earnings. It is BMO’s policy to ensure that sufficient liquid assets and funding capacity are available to meet financial commitments, even in times of stress. As at October 31, 2014 As at October 31, 2013 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 100 basis point decrease 200 basis point increase 200 basis point decrease (715.1) 405.2 (1,579.4) 320.5 64.7 (503.1) (62.6) 340.1 85.8 (1,078.8) (68.1) 442.7 95.4 (90.8) 158.1 (113.7) (1) Losses are in brackets and benefits are presented as positive numbers. (2) For BMO’s Insurance businesses, a 100 basis point increase in interest rates at October 31, 2014, results in an increase in earnings after tax of $71 million and an increase in economic value before tax of $385 million ($81 million and $335 million, respectively, at October 31, 2013). A 100 basis point decrease in interest rates at October 31, 2014, results in a decrease in earnings after tax of $63 million and a decrease in economic value before tax of $414 million ($66 million and $399 million, respectively, at October 31, 2013). These impacts are not reflected in the table above. M D & A Foreign Exchange Risk Structural foreign exchange risk arises primarily from translation risk related to the net investment in our U.S. operations and from trans- action risk associated with our U.S.-dollar-denominated net income. Translation risk represents the impact 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 oper- ations, net of related hedging activities, are reported in other compre- hensive income in shareholders’ equity. In addition, the Canadian dollar equivalent of U.S.-dollar-denominated risk-weighted assets decreases. The reverse is true when the Canadian dollar depreciates relative to the U.S. dollar. Consequently, we may hedge our net investment in foreign operations to ensure translation risk does not 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 in which rev- enues, 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 2014, 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. Liquidity and Funding Risk Governance The RRC has oversight of liquidity and funding risk, annually approves applicable policies, limits and the contingency plan, and regularly reviews liquidity and funding positions. BMO’s Corporate Treasury group recommends the Liquidity and Funding Risk Management Framework and the related risk appetite, limits and guidelines, monitors compliance with policy requirements and assesses the impact of market events on liquidity requirements on an ongoing basis. The RMC and BSCMC provide senior management oversight and also review and discuss significant liquidity and funding policies, issues and action items that arise in the execution of our strategy. The Corporate Treasury group and the operating groups are respon- sible for the ongoing management of liquidity and funding risk across the enterprise. Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). BMO Financial Group 197th Annual Report 2014 95 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Liquidity and Funding Risk Management BMO’s Liquidity and Funding Risk Management Framework is defined and managed under Board-approved corporate policies and management-approved standards. These policies and standards outline key management principles, liquidity and funding management metrics and related limits and guidelines, as well as roles and responsibilities for the management of liquidity and funding risk across the enterprise. BMO has robust limits and guidelines in place to manage liquidity and funding risk. Limits establish the enterprise-level risk appetite for our key Net Liquidity Position (NLP) measure, secured and unsecured funding appetite for both trading and structural activities and risk appe- tite for enterprise pledging activity. Guidelines establish maturity concentration tolerances, counterparty liability diversification require- ments and business pledging activity. Guidelines are also established for the size and type of uncommitted and committed credit and liquidity facilities that may be outstanding to ensure liquidity and funding risk is appropriately managed. An enterprise-wide contingency plan that will facilitate effective management in the event of a disruption is also in place. Early warning indicators identified in the contingency plan are regularly monitored to identify early signs of increasing liquidity risk in the market or risks specific to BMO. BMO subsidiaries include regulated and foreign legal entities and branches, and therefore movements of funds between companies in the corporate group are subject to the liquidity, funding and capital adequacy requirements of the subsidiaries, as well as tax and regulatory considerations that apply to the subsidiaries. As such, liquidity and funding positions are managed on both a consolidated and key legal entity basis. Liquidity and funding risk management policies and limits are in place for key legal entities that are informed by legal and regu- latory requirements that apply to each entity, and positions are regularly reviewed at the legal entity level to ensure compliance with applicable requirements. BMO employs fund transfer pricing and liquidity transfer pricing practices to ensure the appropriate economic signals are provided to the lines of business for the pricing of products for customers and to assess the performance of each business. These practices capture both the cost of funding assets and the value of deposits under normal operating conditions, as well as the cost of supplemental liquid assets held to support contingent liquidity requirements. Liquidity and Funding Risk Measurement A key component of liquidity risk management is the measurement of liquidity and contingent liquidity risk under stress. BMO uses the Net Liquidity Position (NLP) as a key measure of liquidity risk. The NLP represents the amount by which liquid assets exceed potential funding needs under a severe combined enterprise-specific and systemic stress scenario. Potential funding needs may arise from obligations to repay retail, commercial and wholesale deposits that are withdrawn or not renewed, fund drawdowns on available credit and liquidity lines, or purchase collateral for pledging due to ratings downgrades or as a result of market volatility, as well as fund asset growth and strategic invest- ments. Potential funding needs are quantified by applying factors to various business activities based on management’s view of the relative liquidity risk of each activity. These factors vary depending on depositor classification (e.g., retail, small business, non-financial corporate or wholesale counterparties) and deposit type (e.g., insured, uninsured, operational or non-operational deposits) and by commitment type (e.g., uncommitted or committed credit or liquidity facilities by counterparty type). The stress scenario also considers the time horizon over which liquid assets can be monetized and the related haircuts that may occur under market stress. These funding needs are assessed under severely stressed systemic and enterprise-specific scenarios and a combination thereof. BMO targets to maintain a net liquidity position sufficient to withstand each scenario. Stress testing results are compared against BMO’s stated risk toler- ance and are considered in management decisions on limit or guideline setting and internal liquidity transfer pricing, and they also help to shape the design of business plans and contingency plans. The liquidity and funding risk framework is also integrated with enterprise-wide stress testing. In addition to the NLP, we regularly monitor positions against the limits and guidelines noted in the Liquidity and Funding Risk Manage- ment section above. This includes required regulatory metrics such as the Liquidity Coverage Ratio (LCR) and Net Cumulative Cash Flow (NCCF). Unencumbered Liquid Assets Unencumbered liquid assets include high-quality assets that are marketable, can be pledged as security for borrowings, and can be converted to cash in a time frame that meets our liquidity and funding requirements. Liquid assets are primarily held in our trading businesses, as well as in supplemental liquidity pools that are maintained for contingent liquidity risk management purposes. The amounts of liquidity recognized for different asset classes under our management framework are subject to haircuts reflecting management’s view of the liquidity value of those assets in a stress scenario. Liquid assets in the trading businesses include cash on deposit with central banks and short-term deposits with other financial institutions, highly-rated debt and equity securities and short- term reverse repurchase agreements. Supplemental liquidity pool assets are predominantly comprised of cash on deposit with central banks and securities and short-term reverse repurchase agreements of highly rated Canadian federal and provincial and U.S. federal government and agency debt. Substantially all supplemental liquidity pool assets meet the definition of liquid assets under Basel III. Approximately 75% of the supplemental liquidity pool is held at the parent bank level in Canadian- and U.S.-dollar-denominated assets, with the remaining supplemental liquidity pool held in BMO Harris Bank in U.S.-dollar-denominated assets. The size of the supplemental liquidity pool is highly integrated with our measurement of contingent liquidity risk, as the size is calibrated to meet the potential funding needs, outside of our trading businesses, in each of the parent bank and BMO Harris Bank and achieve BMO’s target NLP for each entity. To meet local regulatory requirements, certain of our legal entities maintain their own minimum liquidity positions. There may be legal and regulatory restrictions on our ability to use liquid assets held in one legal entity to support the liquidity requirements of another legal entity. In the ordinary course of business, BMO may encumber a portion of cash and securities holdings as collateral to support trading activities and participation in clearing and payment systems in Canada and abroad. In addition, BMO may receive liquid assets as collateral and may re-pledge these assets in exchange for cash or as collateral for trading activities. Net unencumbered liquid assets, defined as on-balance sheet assets such as BMO-owned cash and securities and securities borrowed or purchased under resale agreements, plus other off-balance sheet eligible collateral received, less collateral encumbered, totalled $171.0 billion at October 31, 2014. In addition to liquid assets, BMO retains access to the Bank of Canada’s emergency lending assistance programs, the Federal Reserve Bank discount window in the United States and European Central Bank standby liquidity facilities. BMO does not consider central bank facilities as a source of available liquidity when assessing its liquidity position. In addition to cash and securities holdings, BMO may also pledge other assets, including mortgages and loans, to raise long-term secured funding. As part of the Liquidity and Funding Risk Management Frame- work, a Pledging of Assets corporate policy is in place that sets out the framework and pledging limits for financial and non-financial assets. Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). 96 BMO Financial Group 197th Annual Report 2014 BMO’s total encumbered assets and unencumbered liquid assets are summarized in the table below. See Note 30 on page 178 of the financial statements for further information on pledged assets. Liquid Assets (Canadian $ in millions) Cash and cash equivalents Deposits with other banks Securities and securities borrowed or purchased under resale agreements Sovereigns / Central banks / Multilateral development banks Mortgage-backed securities and collateralized mortgage obligations Corporate debt Corporate equity Total securities and securities borrowed or purchased under resale agreements NHA mortgage-backed securities (reported as loans at amortized cost) (4) Total liquid assets Other eligible assets at central banks (not included above) (5) Undrawn credit lines granted by central banks Total liquid assets and other sources As at October 31, 2014 As at October 31, 2013 Carrying value/on- balance sheet assets (1) 28,386 6,110 Other cash and securities received Total gross assets (2) Encumbered assets Net unencumbered assets (3) Net unencumbered assets (3) – – 28,386 6,110 1,637 – 26,749 6,110 24,878 6,518 92,626 17,127 19,584 67,537 15,805 108,431 66,661 1,444 6,321 15,665 18,571 25,905 83,202 2,525 1,879 41,602 41,770 16,046 24,026 41,600 51,249 10,543 19,008 37,020 M D & A 196,874 39,235 236,109 112,667 123,442 117,820 17,852 249,222 109,812 – 359,034 – 17,852 3,172 39,235 288,457 117,476 – – 109,812 – 1,008 – 39,235 398,269 118,484 14,680 170,981 108,804 – 279,785 11,425 160,641 102,178 – 262,819 (1) The carrying values outlined in this table are consistent with the carrying values in BMO’s balance sheet as at October 31, 2014. (2) Gross assets include on-balance sheet and off-balance sheet assets. (3) Net unencumbered liquid assets are defined as on-balance sheet assets, such as BMO-owned cash and securities and securities borrowed or purchased under resale agreements, plus other off- balance sheet eligible collateral received, less encumbered assets. (4) Under IFRS, NHA mortgage-backed securities that include mortgages owned by BMO as the underlying collateral are classified as loans. Unencumbered NHA mortgage-backed securities have liquidity value and are included as liquid assets under BMO’s liquidity and funding management framework. This amount is shown as a separate line item, NHA mortgage-backed securities. (5) Represents loans currently lodged at central banks that could potentially be used to access central bank funding. Loans available for pledging as collateral do not include other sources of additional liquidity that may be realized from the loan portfolio, including incremental securitization, covered bond issuances and Federal Home Loan Bank (FHLB) advances. BMO Financial Group 197th Annual Report 2014 97 MANAGEMENT’S DISCUSSION AND ANALYSIS Asset Encumbrance (Canadian $ in millions) As at October 31, 2014 Cash and deposits with other banks Securities (5) Loans and acceptances Other assets Derivative instruments Premises and equipment Goodwill Intangible assets Current tax assets Deferred tax assets Other assets A & D M Total other assets Total assets As at October 31, 2013 Cash and deposits with other banks Securities (5) Loans and acceptances Other assets Derivative instruments Premises and equipment Goodwill Intangible assets Current tax assets Deferred tax assets Other assets Total other assets Total assets Encumbered (2) Net unencumbered Total gross assets (1) Pledged as collateral Other encumbered Other unencumbered (3) Available as collateral (4) 34,496 253,961 285,186 – 79,778 37,060 1,637 36,061 1,965 417 10,796 137,357 32,442 127,326 108,804 32,655 2,276 5,353 2,052 665 3,019 8,231 54,251 – – – – – – – – – – – – – – – – 32,655 2,276 5,353 2,052 665 3,019 8,231 54,251 – – – – – – – – 627,894 116,838 39,663 202,821 268,572 Encumbered (2) Net unencumbered Total gross assets (1) Pledged as collateral Other encumbered Other unencumbered (3) Available as collateral (4) 32,607 217,427 265,719 – 64,168 35,639 1,211 24,014 4,675 1,467 6,815 123,227 29,929 122,430 102,178 30,259 2,168 3,819 1,511 1,065 3,027 7,695 49,544 – – – – – – – – – – – – – – – – 30,259 2,168 3,819 1,511 1,065 3,027 7,695 49,544 – – – – – – – – 565,297 99,807 29,900 181,053 254,537 (1) Gross assets include on-balance sheet and off-balance sheet assets. (2) Pledged as collateral refers to the portion of on-balance sheet assets and other cash and securities received that is pledged through repurchase agreements, securities lent, derivative contracts, minimum required deposits at central banks and requirements associated with participation in clearing houses and payment systems. Other encumbered includes assets which are restricted from use for legal or other reasons, such as restricted cash and short sales. (3) Other unencumbered assets include select liquid asset holdings that management believes are not readily available to support BMO’s liquidity requirements. These include cash and securities of $11.2 billion as at October 31, 2014, which include securities held in BMO’s insurance subsidiary and credit protection vehicle, significant equity investments, and certain investments held in our merchant banking business. Other unencumbered assets also include mortgages and loans that may be securitized to access secured funding. (4) Loans included as available as collateral represent loans currently lodged at central banks that could potentially be used to access central bank funding. Loans available for pledging as collateral do not include other sources of additional liquidity that may be realized from the loan portfolio, including incremental securitization, covered bond issuances and FHLB advances. (5) Includes securities, securities borrowed or purchased under resale agreements and NHA mortgage-backed securities (reported as loans at amortized cost). Funding Strategy Our funding philosophy requires that secured and unsecured wholesale funding used to support loans and less liquid assets is longer term (typically maturing in two to ten years) to better match the term to maturity of these assets. Wholesale secured and unsecured funding for liquid trading assets is generally shorter term (maturing in one year or less), is aligned with the liquidity of the assets being funded, and is subject to limits on aggregate maturities that are permitted across different time periods. Supplemental liquidity pools are funded with a mix of wholesale term funding. BMO maintains a large and stable base of customer deposits that, in combination with our strong capital base, is a source of strength. It supports the maintenance of a sound liquidity position and reduces our reliance on wholesale funding. Customer deposits include core deposits and larger retail and commercial fixed-rate customer deposits. Customer deposits totalled $238.7 billion at the end of the year, up from $220.6 billion in 2013. BMO also receives deposits to facilitate certain trading activities, receives non-marketable deposits from corporate and institutional customers and issues structured notes primarily to retail investors. These deposits totalled $28.2 billion as at October 31, 2014. Customer Deposits-and- Capital-to-Customer-Loans Ratio (%) 99.8 98.6 94.6 94.5 Core and Customer Deposits ($ billions) 239 221 218 204 205 194 191 177 2011 2012 2013 2014 2011 2012 2013 2014 Customer deposits Core deposits Our large customer base and strong capital position reduce our reliance on wholesale funding. Core and customer deposits provide a strong funding base. Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). 98 BMO Financial Group 197th Annual Report 2014 M D & A Total wholesale funding outstanding, consisting of negotiable marketable securities, was $156.4 billion at October 31, 2014, with $35.6 billion sourced as secured funding and $120.8 billion sourced as unsecured funding. The mix and maturities of BMO’s wholesale term funding are outlined in the table below. Additional information on deposit maturities can be found in Note 32 on page 186. BMO maintains a sizeable portfolio of unencumbered liquid assets, totalling $171.0 billion as at October 31, 2014, that can be monetized to meet potential funding requirements, as described in the Unencumbered Liquid Assets section above. Diversification of our wholesale funding sources is an important part of our overall liquidity management strategy. BMO’s wholesale funding activities are well diversified by jurisdiction, currency, investor segment, instrument and maturity profile. BMO maintains ready access to long- term wholesale funding through various borrowing programs, including a European Note Issuance Program, Canadian and U.S. Medium-Term Note Programs, Canadian and U.S. mortgage securitizations, Canadian credit card securitizations, covered bonds and Canadian and U.S. senior (unsecured) deposits. BMO’s wholesale funding plan ensures sufficient funding capacity is available to execute business strategies. The funding plan considers expected maturities, as well as asset and liability growth projected for our businesses in our forecasting and planning process, and assesses funding needs against available potential sources. The funding plan is approved annually by the RRC and is regularly updated throughout the year to incorporate actual results and updated forecast information. Wholesale Funding Maturities (1) (Canadian $ in millions) As at October 31, 2014 Deposits from banks (2) Certificates of deposit and commercial paper Bearer deposit notes Asset-backed commercial paper (ABCP) Senior unsecured medium-term notes Senior unsecured structured notes (3) Covered bonds and Securitizations Mortgage securitizations Covered bonds Credit card securitizations Subordinated debt (4) Other (5) Total Of which: Secured Unsecured Total (6) Less than 1 month 7,885 13,348 1,037 866 – 13 – – – – – – 1 to 3 months 4,187 19,553 1,774 896 500 362 – 334 – – – – 3 to 6 months 674 12,906 15 1,105 3,779 15 – 1,510 – 42 – – 6 to 12 months 175 7,215 221 60 5,016 168 – 601 2,254 895 322 – Subtotal less than 1 year 12,921 53,022 3,047 2,927 9,295 558 – 2,445 2,254 937 322 – 1 to 2 years – 817 – – 12,561 49 – 2,110 1,691 1,880 – – Over 2 years – – – – 20,853 1,257 – 12,844 3,667 2,194 6,091 2,677 Total 12,921 53,839 3,047 2,927 42,709 1,864 – 17,399 7,612 5,011 6,413 2,677 23,149 27,606 20,046 16,927 87,728 19,108 49,583 156,419 – 866 22,283 – 1,230 26,376 – 2,657 17,389 – 3,810 13,117 – 8,563 79,165 – 5,681 13,427 – 21,382 28,201 – 35,626 120,793 23,149 27,606 20,046 16,927 87,728 19,108 49,583 156,419 (1) Wholesale funding excludes repo transactions and bankers’ acceptances, which are disclosed in the contractual maturity table in Note 32 of the financial statements. Wholesale funding also excludes ABCP issued by certain ABCP conduits that are not consolidated for financial reporting purposes. (2) Except for deposits from banks, which primarily consist of bank deposits sourced to support trading activities, unsecured funding refers to funding through the issuance of marketable, negotiable securities. (3) Primarily issued to non-institutional investors. (4) Includes certain subordinated debt instruments reported as deposits or other liabilities for accounting purposes. Subordinated debt is reported in this table in accordance with recommended EDTF disclosures. (5) Refers to FHLB advances. (6) Total wholesale funding consists of Canadian-dollar-denominated funding of $53.9 billion and U.S.-dollar and other foreign-denominated funding of $102.5 billion as at October 31, 2014. Regulatory Developments In 2014, OSFI finalized its Liquidity Adequacy Requirements (LAR) guide- line. The guideline outlines the approach and methodology for a number of liquidity metrics and tools that OSFI will use to monitor and assess the adequacy of Canadian banks’ liquidity, including the Liquidity Coverage Ratio (LCR), Net Cumulative Cash Flow (NCCF) and others. Under the guideline, Canadian banks will be required to maintain an LCR above 100% effective January 1, 2015. As at October 31, 2014, the bank comfortably exceeds the LCR minimum. In 2014, the Basel Committee on Banking Supervision (BCBS) issued its final paper on LCR disclosure standards and OSFI published a LCR common disclosure template. Canadian banks are required to comply with the new disclosure standards beginning in the second quarter of the 2015 fiscal year reporting period. In October 2014, BCBS published its final Net Stable Funding Ratio (NSFR) rules. The NSFR is the ratio of the available amount of stable funding (one year or greater) to the required amount of stable funding. BMO believes OSFI will engage with the industry to discuss domestic implementation of the NSFR in 2015. The NSFR is effective January 1, 2018. Canada’s Department of Finance issued for comment in August 2014 a Consultation Paper outlining the proposed bail-in regime applicable to Canada’s domestic systemically important banks (D-SIBs), including BMO. The proposed bail-in regime would grant to the Government of Canada the power to permanently convert “eligible liabilities” of the D-SIB into common equity and to permanently cancel existing common shares if certain preconditions are met. Under the proposed bail-in regime, eligible liabilities would consist only of senior unsecured debt that is issued after the implementation date of the bail-in regime, tradable and transferable, and with an original term of over 400 days. D-SIBs would be subject to a Higher Loss Absorbency (HLA) requirement to be met through the sum of regulatory capital and long-term senior debt that is directly issued by the parent bank of between 17% and 23% of risk- weighted assets (RWA). The Consultation Paper also requested com- ments with respect to potentially instituting a bank holding company structure in Canada to better support the regime for bank resolutions. Comments on the Consultation Paper were due in September 2014. Material presented in a blue-tinted font above is an integral part of the 2014 annual consolidated financial statements (see page 77). BMO Financial Group 197th Annual Report 2014 99 MANAGEMENT’S DISCUSSION AND ANALYSIS In November 2014, the Financial Stability Board (FSB) issued a Consultation Paper to enhance the loss-absorbing capacity of global systemically important banks (G-SIBs) in resolution. Under the proposal, G-SIBs would be required to maintain Total Loss Absorbency Capacity (TLAC) in excess of prescribed minimum thresholds. TLAC would include regulatory capital and eligible liabilities that can absorb losses in reso- lution. The minimum amount of TLAC banks would need to hold would be equal to 16% to 20% of RWA (plus applicable regulatory buffers) or two times the Basel III Leverage Ratio minimum requirement of 3%. Conformance with TLAC requirements will not be required before Jan- uary 1, 2019. Comments on the Consultation Paper are due in February 2015 and a quantitative impact study is planned for early 2015. The FSB is planning to finalize the proposal in late 2015. Credit Ratings The credit ratings assigned to BMO’s short-term and senior long-term debt securities by external rating agencies are important in the raising of both capital and funding to support our business operations. Maintaining strong credit ratings allows us to access the capital markets at competitive pricing levels. Should our credit ratings experience a material downgrade, our cost of funds would likely increase significantly and our access to funding and capital through capital markets could be reduced. A material downgrade of our ratings could have additional A & D M consequences, including those set out in Note 10 on page 146 of the financial statements. The credit ratings assigned to BMO’s senior debt by rating agencies are indicative of high-grade, high-quality issues. In June 2014, Moody’s affirmed its long-term ratings and changed its outlook to “negative” from “stable” on the supported senior debt and uninsured deposit rat- ings of BMO and six other large Canadian banks in light of previously announced plans by the Canadian federal government to implement a bail-in regime for domestic systemically important banks. In August 2014, S&P affirmed its long-term and short-term issuer credit ratings of BMO and revised its outlook for BMO and other Canadian banks to “negative” from “stable”, reflecting the possible impact of a bail-in policy proposal from the Canadian federal government. As at October 31, 2014 Rating agency Short-term debt Senior long- term debt Subordinated debt(1) Moody’s S&P Fitch DBRS P-1 A-1 F1+ R-1 (high) Aa3 A+ AA- AA A3 BBB+ A+ AA (low) Outlook Negative Negative Stable Stable (1) NVCC subordinated debt is rated Baa1 by Moody’s, BBB by S&P and A(low) by DBRS. 100 BMO Financial Group 197th Annual Report 2014 Operational Risk Operational risk is the potential for loss resulting from inadequate or failed internal processes or systems, human interactions or external events, but excludes business risk. BMO is exposed to potential losses arising from a variety of operational risks, including process failure, theft and fraud, regulatory non- compliance, business disruption, information security breaches and exposure related to outsourcing, as well as damage to physical assets. Operational risk is inherent in all our business activities, including the processes and controls used to manage all risks we face. While opera- tional risk can never be fully eliminated, it can be managed to reduce exposure to financial loss, reputational harm or regulatory sanctions. Operational Risk Governance Operational risk management is governed by a robust committee struc- ture supported by a comprehensive set of policies, standards and operating guidelines. The Operational Risk Committee (ORC), a sub- committee of the RMC, is the main decision-making committee for all operational risk management matters and has responsibility for the oversight of operational risk strategy, management and governance. The ORC provides advice and guidance to the lines of business on opera- tional risk assessments, measurement and mitigation, and related monitoring of change initiatives. The ORC also oversees the develop- ment of policies, standards and operating guidelines that give effect to the governing principles of the Operational Risk Management Frame- work (ORMF). These governance documents incorporate industry leading practices and are reviewed on a regular basis to ensure they are current and consistent with our risk appetite. We continue to enhance gover- nance by increasing the number of Corporate Support areas that can provide additional oversight for specific operational risks. Regular reporting and analysis of our enterprise operational risk profile to the various committees (ORC, RMC and RRC) are important elements of our ORMF. Enterprise reporting provides an integrated view of top and emerging risks, loss trending, capital consumption, key risk indicators and operating group portfolio profiles. A critical aspect of this reporting is the quality of underlying sources and systems. Timely and comprehensive operational risk reporting enhances risk transparency and facilitates the proactive management of operational risk exposures. The operating groups are responsible for the day-to-day manage- ment of operational risk in a manner consistent with our enterprise- wide principles. Independent risk management oversight is provided by operating group Chief Risk Officers and Operational Risk Officers, Corpo- rate Support areas and Corporate Operational Risk Management. Opera- tional Risk Officers independently assess group operational risk profiles, identify material exposures and potential weaknesses in controls, and recommend appropriate mitigation strategies and actions. Corporate Support areas develop tools and processes for the management of specific operational risks across the enterprise. Corporate Operational Risk Management establishes the ORMF and the necessary governance framework, with operating group Chief Risk Officers providing gover- nance and oversight for their respective business units. Operational Risk Management The ORMF defines the processes we use to identify, measure, manage, mitigate, monitor and report key operational risk exposures. A primary objective of the ORMF is to ensure that our operational risk profile is consistent with our risk appetite and supported by adequate capital. Executing our ORMF strategy also involves continuing to embed our risk culture by promoting greater awareness and understanding of opera- tional risk to our first line of defence through training and communica- tion. In addition, we continue to invest in talent to further strengthen our second line of defence capabilities. The key programs, method- M D & A ologies and processes we have developed to support the framework are highlighted below: ‰ Risk Control Assessment (RCA) is an established process used by our operating groups to identify the key risks associated with their busi- nesses and the controls required for risk mitigation. The RCA process provides a forward-looking view of the impact of the business environment and internal controls on operating group risk profiles, enabling the proactive management, mitigation and prevention of risk. On an aggregate basis, RCA results also provide an enterprise- level view of operational risks relative to risk appetite, to ensure key risks are adequately managed and mitigated. ‰ Process Risk Assessment (PRA) provides a deeper focus in identifying key risks and controls in our business processes and can span across multiple business units. The PRA enables a greater understanding of our key processes in order to facilitate more effective oversight and ensure risks are appropriately mitigated. ‰ BMO’s initiative assessment and approval process is used to assess, document and approve qualifying initiatives when new business, services and products are developed or existing services and products are enhanced. The process ensures that due diligence, approval, monitoring and reporting requirements are appropriately addressed at all levels of the organization. ‰ ‰ Key Risk Indicators (KRIs) provide an early indication of any adverse changes in risk exposure. Operating groups and Corporate Support areas identify metrics related to their material operational risks. These KRIs are used in monitoring operational risk profiles and their overall relation to our risk appetite, and are linked to thresholds that trigger management action. Internal loss data serves as an important means of assessing our operational risk exposure and identifying opportunities for future risk prevention measures. Under this process, internal loss data is ana- lyzed and benchmarked against external data. Material trends are regularly reported to the ORC, RMC and RRC to ensure preventative and corrective action can be taken where appropriate. BMO is a member of the Operational Risk Data Exchange Association, the American Bankers Association and other international and national associations of banks that share loss data information anonymously to assist in risk identification, assessment and modelling. ‰ BMO’s operational risk management training programs ensure employees are qualified and equipped to execute the ORMF strategy consistently, effectively and efficiently. ‰ Effective business continuity management ensures that we have the capability to sustain, manage and recover critical operations and processes in the event of a business disruption, thereby minimizing any adverse effects on our customers and other stakeholders. ‰ BMO’s Corporate Risk & Insurance team provides a second level of mitigation for certain operational risk exposures. We purchase insurance in amounts that are expected to provide adequate protection against unexpected material loss and where insurance is required by law, regulation or contractual agreement. There have been no material operational risk loss events during the year ended October 31, 2014. ‰ During the year, BMO received approval to use the Advanced Measurement Approach (AMA), a risk-sensitive capital model, to determine Basel II regulatory capital requirements for managing operational risk. ‰ Stress testing measures the potential impact of plausible operational, economic, market and credit events on our operations and capital. Scenario analysis provides management with a better understanding of low-frequency, high-severity events and assesses enterprise preparedness for events that could create risks that exceed our risk appetite. Under the AMA, we use scenario analysis for stress testing, to manage tail risk exposure to low-frequency, high severity events and to validate operational risk capital adequacy. BMO Financial Group 197th Annual Report 2014 101 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS Insurance Risk Insurance risk is the risk of loss due to actual experience being different from that assumed when an insurance product was designed and priced. It generally entails inherent unpredictability that can arise from assuming long-term policy liabilities or from the uncertainty of future events. Insurance risk exists in all our insurance products, including annuities and life, accident and sickness, and creditor insurance, as well as in our reinsurance business. Insurance risk consists of: ‰ Claims risk – the risk that the actual magnitude or frequency of claims will differ from those assumed in the pricing or underwriting process, including mortality risk, morbidity risk, longevity risk and catastrophe risk; ‰ Policyholder behaviour risk – the risk that the behaviour of policy- holders related to premium payments, withdrawals or loans, policy lapses and surrenders and other voluntary terminations will differ from the behaviour assumed in the pricing calculations; and ‰ Expense risk – the risk that actual expenses associated with acquiring and administering policies and processing claims will exceed the expenses assumed in the pricing calculations. A robust product approval process is a cornerstone of the framework for identifying, assessing and mitigating risks associated with new insurance products or changes to existing products. This process, com- bined with guidelines and practices for underwriting and claims Legal and Regulatory Risk Legal and regulatory risk is the risk of not complying with laws, contractual undertakings or other legal requirements, as well as regulatory requirements and regulators’ expectations. Failure to properly manage legal and regulatory risk may result in litigation, financial losses, regulatory sanctions, an inability to execute our business strategies and harm to our reputation. BMO’s success relies in part on our ability to prudently manage our exposure to judgments, fines or losses arising from the risk of not complying with laws or contractual undertakings, or not meeting regu- latory requirements or regulator expectations. The financial services industry is highly regulated, and we anticipate more intense scrutiny from our supervisors in the oversight process and strong enforcement of regulatory requirements as governments and regulators around the world continue major reforms to strengthen the stability of the financial system. The current environment is one in which banks globally have recently been subject to fines in relation to a number of regulatory and market conduct issues at unprecedented levels. As rulemaking evolves, we monitor developments to ensure BMO is well-positioned to respond to and implement any required changes. Under the direction of the General Counsel, the Legal and Com- pliance Group (LCG) maintains enterprise-wide frameworks to identify, measure, manage, monitor and report on legal and regulatory risk. LCG also works with operating groups and Corporate Support areas to identify legal and regulatory requirements, trends and potential risks, recommend mitigation strategies and actions, and oversee litigation involving BMO. Another area of focus for legal and compliance management and operating groups’ risk committees is oversight of fiduciary risk related to BMO’s businesses that provide products or serv- ices giving rise to fiduciary duties to clients. Of particular importance are the policies and practices that address the responsibilities of a business to a client, including service requirements and expectations, client suit- ability determinations, and disclosure obligations and communications. Failure to properly manage these risks may result in harm to our reputa- tion, cause a decline in investor confidence, and affect our ability to execute our business strategies. 102 BMO Financial Group 197th Annual Report 2014 management, promotes the effective identification, measurement and management of insurance risk. Reinsurance, which involves transactions that transfer insurance risk to independent reinsurance companies, is also used to manage our exposure to insurance risk by diversifying risk and limiting claims. Actuarial liabilities are estimates of the amounts required to meet insurance obligations. Liabilities are established in accordance with the standards of practice of the Canadian Institute of Actuaries and the Char- tered Professional Accountants of Canada’s Accounting Standards Board. These liabilities are validated through extensive internal and external reviews and audits. Assumptions underlying actuarial liabilities are regularly updated to reflect emerging actual experience. The Appointed Actuaries of our insurance subsidiaries are appointed by those sub- sidiaries’ boards of directors and have statutory responsibility for providing opinions on the adequacy of provisions for policyholder liabilities, the solvency of the insurance companies and the fairness of treatment of participating policyholders. In addition, the work of each Appointed Actuary is subject to an external, independent review by a qualified actuary every three years, in accordance with OSFI Guideline E-15. As of the current year, we commenced the assessment of risks, capital needs and solvency position through the Own Risk and Solvency Assessment (ORSA) as required by OSFI. Under the direction of the Chief Anti-Money Laundering Officer, the Anti-Money Laundering Office is responsible for the governance, over- sight and assessment of the principles and procedures established by the enterprise to ensure compliance with regulatory requirements and risk parameters related to anti-money laundering, anti-terrorist financing and sanctions measures. International regulators continue to focus on anti-money laundering and related efforts, to raise their expectations concerning the quality and efficacy of anti-money laundering and related programs and to penalize institutions that fail to meet these expectations. All of these frameworks reflect the three-lines-of-defence operating model described previously. The operating groups and Corporate Support areas manage day-to-day risks in compliance with corporate policies, while LCG teams specifically aligned with designated operating groups provide advice and independent legal and regulatory risk management oversight. Heightened regulatory and supervisory scrutiny has had a sig- nificant impact on how we conduct business. Working with the operating groups and other Corporate Support areas, LCG continues to diligently assess and analyze the implications of regulatory changes, and devote substantial resources to implement systems and processes required to comply with new regulations while helping the operating groups meet BMO customers’ needs and demands. We continue to respond to other global regulatory developments, including capital and liquidity requirements under the Basel Committee on Banking Supervision global standards (Basel III), over-the-counter (OTC) derivatives reform, consumer protection measures and specific financial reforms, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). For additional discussion on regulatory developments relating to capital management, please refer to the Enterprise-Wide Capital Management section starting on page 64. Cross-Border Resolution and Bail-in. The Financial Stability Board (FSB) published a consultative document concerning cross-border recognition of resolution actions and the removal of impediments to the resolution of systemically important financial institutions (Proposal). The Proposal encourages jurisdictions to include in their resolution frameworks fea- tures designed to enable prompt effect to be given to foreign resolution actions. It also recommends two types of arrangements between con- tracting parties to address areas critical for orderly cross-border reso- lution: (1) temporary restrictions or stays on early termination rights in financial contracts; and (2) write-down or conversion of debt instru- ments in resolution, or “bail-in” provisions, where the instruments are governed by the laws of a jurisdiction other than that of the issuing entity. Under the Proposal, FSB member governments are to take official action to promote adoption of these two contractual solutions, and FSB would finalize guidance on core elements of statutory recognition frameworks by the end of 2015. Canada has proposed a “bail-in” framework to apply to Canada’s domestic systemically important banks, including BMO. Please refer to page 99 in the Liquidity and Funding Risk section for further information on the proposed “bail-in” framework and other related regulatory developments. Dodd-Frank. Dodd-Frank reforms include heightened consumer pro- tection, revised regulation of the OTC derivatives markets, restrictions on proprietary trading and ownership and sponsorship of private invest- ment funds by banks and their affiliates (referred to as the Volcker Rule), imposition of heightened prudential standards and broader appli- cation of leverage and risk-based capital requirements. Dodd-Frank rulemaking will continue over the next several years. In December 2013, U.S. regulators issued the final Volcker Rule. Banking entities have until July 21, 2015 to conform most of their activities and investments. In addition, under Dodd-Frank, most OTC derivatives are now subject to a comprehensive regulatory regime. Certain derivatives are now required to be centrally cleared and traded on an exchange and are subject to reporting and business conduct requirements. Capital and margin requirements relating to derivatives are currently being considered by U.S. and international regulators. In Canada, OTC derivative transactions must now be reported to designated trade repositories. Indirect Auto Lenders. The Consumer Financial Protection Bureau (CFPB), which enforces certain U.S. federal consumer finance laws, is closely scrutinizing indirect auto lenders to focus on compliance, including with fair lending laws. Business Risk Business risk arises from the specific business activities of a company and the effects these could have on its earnings. Business risk encompasses the potential causes of earnings volatility that are distinct from credit, market or operational risk factors. The management of business risk identifies and addresses factors related to the risk that volumes will decrease or margins will shrink without the company having the ability to compensate for this decline by cut- ting costs. Model Risk FBO Rule. In February 2014, the Federal Reserve Board approved a final rule for strengthening supervision and regulation of foreign banking organizations (FBO Rule) that implements Dodd-Frank’s enhanced prudential standards for the U.S. operations of non-U.S. banks, such as BMO. The FBO Rule establishes new requirements relating to risk-based capital, leverage limits, liquidity standards, risk-management frame- works, concentration and credit exposure limits, resolution planning and credit exposure reporting. We must file, by January 1, 2015, an outline of our implementation plan for meeting these requirements by the effec- tive date (July 1, 2016). BMO is preparing for the impact of the FBO Rule on its operations. Risk Governance Framework. The Office of the Comptroller of Currency issued for comment proposed guidelines for the design and implementation of a risk governance framework for large national banks, and board of director oversight of the framework’s design and implementation. These guidelines would apply to our principal U.S. subsidiary bank, BMO Harris Bank N.A. (BHB), and establish specific roles and responsibilities focused on risk management for BHB’s front-line units, risk management, internal audit, board and CEO. The General Counsel and the Chief Compliance Officer (CCO) regu- larly report to the Audit and Conduct Review Committee (ACRC) of the Board and senior management on the effectiveness of our Enterprise Compliance Program (ECP) which, using a risk-based approach, identi- fies, assesses and manages compliance with applicable legal and regu- latory requirements. The ECP directs operating groups and Corporate Support areas to maintain compliance policies, procedures and controls to meet these requirements. Under the direction of the CCO, LCG identi- fies and reports on gaps and deficiencies and tracks remedial action plans. The Chief Anti-Money Laundering Officer also regularly reports to the ACRC. All BMO employees are required to annually complete legal and regulatory training on topics such as anti-corruption, anti-money laundering and privacy. This is done in conjunction with our code of conduct training, which tests employees’ knowledge and understanding of how they are required to behave. M D & A BMO faces many risks that are similar to those faced by non- financial firms, principally that our profitability, and hence value, may be eroded by changes in the business environment or by failures of strategy or execution. Sources of these risks include, but are not limited to, changing client expectations, adverse business developments and relatively ineffective responses to industry changes. Within BMO, each operating group is responsible for controlling its respective business risk by assessing, managing and mitigating the risks arising from changes in business volumes and cost structures, among other factors. Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs. The adverse con- sequences can be financial loss, poor business decision-making or damage to reputation. BMO uses models that range from very simple models for basic trans- actions to highly complicated models that value complex transactions and measure sophisticated portfolio risk and capital. These models are used to inform strategic decision-making and to assist in making daily lending, trading, underwriting, funding, invest- ment and operational decisions. BMO also uses models as a core risk management tool, to measure exposure to specific risks and to measure total risk on an integrated basis using Economic Capital. BMO maintains strong controls over the development, implementation and application of models, which can be grouped within seven main categories: ‰ valuation models for the valuation of assets, liabilities or reserves; ‰ risk exposure estimation models for measuring credit risk, market risk, liquidity risk and operational risk, which also address expected loss and its applications; BMO Financial Group 197th Annual Report 2014 103 A & D M MANAGEMENT’S DISCUSSION AND ANALYSIS ‰ adjudication and underwriting models for adjudicating and under- writing transactions; ‰ capital and stress testing models for measuring capital, allocating capital and managing regulatory capital and Economic Capital; fiduciary models for asset allocation, asset optimization and portfolio management; ‰ ‰ major business managed application models for material business- making where model outcomes play material roles; and ‰ models driven by regulatory and other stakeholder requirements. Model Risk Governance The Model Risk Management Committee, a cross-functional group repre- senting all key stakeholders across the enterprise (Model Users, Model Developers, the Model Risk Governance group and the Model Risk Vali- dation (MRV) group), meets regularly to provide input into the development, implementation and maintenance of the Model Risk Management Framework and the requirements governing all models that are used across the enterprise. Model Risk is governed by the enterprise-wide Model Risk Manage- ment Framework, which sets out end-to-end risk governance across the model activity cycle and ensures that model risk remains consistent with BMO’s enterprise-wide risk appetite. The framework includes BMO’s Model Risk Corporate Policy & Guidelines, which outlines explicit princi- ples for managing model risk, details model risk processes and clearly defines roles and responsibilities of all stakeholders. The Model Risk Corporate Policy, which is approved by the RRC, outlines the requirements for the oversight, identification, development, independent validation, implementation, use, monitoring and reporting of models and model risk across the enterprise. Prior to use, all models must receive approval based on an independent assessment of their specific model risk by the MRV group. All models are assigned a risk rating as part of the validation process, which determines the materiality of model risk and the frequency of ongoing review. In addition to regularly scheduled model validation and review, BMO uses model risk monitoring and oversight reporting and procedures to inform management that models are managed and used, and perform as expected. This oversight also mitigates model risk by increasing the likelihood of early detection of emerging issues. Model Validation, Outcome Analysis & Back-Testing Once the models are validated, approved and in production they are subject to ongoing validation, which includes ongoing monitoring and outcomes analysis. As a key component of the outcomes analysis, back- testing measures model output against actual observed outcomes. This analysis is used to confirm the validity and performance of each model over time while ensuring that right level of controls are in place to address identified issues and enhance a model’s overall performance. Credit Risk – Credit Risk Model Validation Guidelines are an important subset of BMO’s Model Risk Guidelines. These Credit Risk Model Vali- Strategic Risk Strategic risk is the potential for loss due to fluctuations in the external business environment and/or failure to properly respond to these fluctuations as a result of inaction, ineffective strategies or poor implementation of strategies. Strategic risk arises from external risks inherent in the business environ- ment within which BMO operates, as well as the risk of potential loss if BMO is unable to address those external risks effectively. While external strategic risks – including economic, political, regulatory, technological, social and competitive risks – cannot be controlled, the likelihood and 104 BMO Financial Group 197th Annual Report 2014 dation Guidelines include clear requirements for how BMO back-tests credit risk models. The process for back-testing for the Probability of Default (PD) includes comparing a credit risk model estimated probabilities of default against the actual or realized default rates across all obligor ratings. This process also includes testing for statistical evidence that default rates accurately represent sampling variability over time. The comprehensive validation of a risk rating system includes various prescribed tests and analyses that measure discriminatory power, calibration and dynamic properties, with support from migration analysis. Additional tests or analyses are used to validate borrower risk rating grades and probability of default. As with any analysis, BMO applies human judgment to determine which factors, such as data limitations, may impact the overall relevance of a given validation approach or interpretation of statistical analysis. A similar back-testing is applied to the Loss Given Default (LGD) and Exposure at Default (EAD). Annual Validations of in-production models are conducted to ensure they perform as intended and to confirm the adequacy of their design. An annual Validation includes an ongoing qualitative validation conducted by model developers and a quantitative Validation conducted by the MRV group with all conclusions reported back to senior management. Trading and Underwriting Market Risk – All internal models used to calculate regulatory capital for trading and underwriting market risk must have their Value at Risk (VaR) results back-tested regularly. The bank’s internal VaR model is back-tested daily, and the 1-day 99% confidence level VaR at the local and consolidated BMO levels are compared against the realized theoretical Profit & Loss (P&L) which is the daily change in portfolio value that would occur if the portfolio composition remained unchanged. If the theoretical P&L is negative and its absolute value is greater than the previous day’s VaR, a back-testing exception occurs. Each exception is investigated, explained and docu- mented, and the back-testing results are reviewed by the Board and regulators. This process monitors the quality and accuracy of the internal VaR model and assists in refining overall risk measurement procedures. Structural Market Risk – Model back-testing is performed monthly and reported quarterly. For products with scheduled term such as mortgages and term deposits, the model-predicted prepayments or redemptions are compared against the actual observed outcomes. For products without a scheduled term such as credit card loans and chequing accounts the modelled balance run-off profiles are compared against actual balance trends. The variances between model predictions and actual experienced outcomes are measured against pre-defined risk materiality thresholds. To ensure variances are within the tolerance range, actions such as model review and parameter recalibration are taken. Performance is assessed by analyzing model overrides and tests conducted during model development, such as back-testing and sensitivity testing. magnitude of their impact can be mitigated through an effective strategic risk management framework. BMO’s Strategy Group oversees our strategic planning processes and works with the lines of business, along with Risk, Finance and other Corporate Support areas, to identify, monitor and mitigate strategic risk across the enterprise. Our rigorous strategic risk management framework encourages a consistent approach to the development of strategies and incorporates financial information linked to financial commitments. The Strategy Group works with the lines of business and key corpo- rate stakeholders during the strategy development process to promote consistency and adherence to strategic management standards. The potential impacts of changes in the business environment, such as broad industry trends and the actions of competitors, are considered as part of this process and inform strategic decisions within each of our lines of business. Enterprise and group strategies are reviewed with the Execu- tive Committee and the Board of Directors annually in interactive ses- sions that challenge assumptions and strategies in the context of current and potential future business environments. Performance objectives established through the strategic manage- ment process are monitored regularly and are reported upon quarterly, using both leading and lagging indicators of performance, so that strat- egies can be reviewed and adjusted where necessary. Regular strategic and financial updates are also monitored closely to identify any sig- nificant emerging risk issues. Reputation Risk Reputation risk is the risk of a negative impact to BMO that results from the deterioration of BMO’s reputation. Potential negative impacts include revenue loss, decline in client loyalty, litigation, regulatory sanction or additional oversight, or decline in BMO’s share price. BMO’s reputation is one of its most valuable assets. By protecting and maintaining our reputation, we can increase shareholder value, reduce our cost of capital and improve employee engagement and customer loyalty. Our reputation is built on our commitment to high standards of business conduct and ethics. FirstPrinciples, our code of conduct, is the basis for fostering a cul- ture of integrity and trust and provides all employees and directors with guidance on expected behaviour. Environmental and Social Risk Environmental and social risk is the risk of loss or damage to BMO’s reputation resulting from environmental and social concerns related to BMO or its customers. Environmental and social risk is often associated with credit, operational and reputation risk. In order to manage our business responsibly we consider factors that can give rise to environmental and social risk. This concept is embedded in our Board approved Code of Business Conduct and Ethics. Environmental and social risk management activities are overseen by the Environmental, Social and Governance (ESG) group and the Environmental Sustainability group, with support from our lines of business and other Corporate Support areas. BMO’s Sustainability Council, which is comprised of execu- tives representing various areas of the organization, provides insight and guidance for our environmental and social initiatives. As part of our enterprise risk management framework, we evaluate the environmental and social impact of our clients’ operations, as well as the impact of their industry sectors. Environmental and social risk covers a broad spectrum of issues, such as climate change, biodiversity and ecosystem health, pollution, waste and the unsustainable use of water and resources, as well as risks to the livelihoods, health and rights of communities and their cultural heritage. We work with external stakeholders to understand the impact of our operations and financing decisions in the context of these issues, and we use this understanding to determine the consequences for our businesses. BMO has developed and implemented specific financing guidelines on environmental and social risk for specific lines of business. Environmental and social risks associated with credit transactions are managed within BMO’s credit and All employees and directors are responsible for conducting them- selves in accordance with FirstPrinciples, thus building and maintaining BMO’s reputation. We believe that active, ongoing and effective management of reputation risk is best achieved by considering reputation risk issues in the course of strategy development, strategic and operational implementation, and transactional or initiative decision-making, as well as in making day-to-day business decisions. Reputation risk is also managed through our corporate governance practices and risk management framework. The Reputation Risk Management Committee reviews instances of significant or heightened reputation risk to BMO, including those that may arise from complex credit or structured-finance transactions. M D & A counterparty risk framework. Enhanced due diligence is applied to trans- actions with clients operating in environmentally sensitive industry sectors. BMO applies the Equator Principles, a voluntary credit risk manage- ment framework for determining, assessing and managing environ- mental and social risk in project finance transactions. These principles have been integrated into our credit risk framework. We are also a signatory to and participate in the Carbon Disclosure Project, which provides corporate disclosure on greenhouse gas emissions and climate change management. BMO implemented ESG training for BMO Capital Markets employees as part of a program to reinforce a consistent understanding of environmental and social risk across the enterprise. The training includes identification of emerging issues, an overview of BMO’s due diligence procedures and tools to assist employees in identifying and managing environmental, social and governance risks. We review our environ- mental and social risk policies and procedures on a periodic basis. BMO is a signatory to the UN Principles for Responsible Investment, a framework designed to encourage sustainable investing through the integration of ESG issues in investment, decision-making and ownership practices. To ensure that we are informed of emerging issues, we participate in global forums with our peers, maintain an open dialogue with our stakeholders and continuously monitor and evaluate policy and legis- lative changes in the jurisdictions in which we operate. Our environ- mental and social policies and practices are outlined in detail in our annual Environmental, Social and Governance Report and Public Accountability Statement, and on our Corporate Responsibility website. BMO Financial Group 197th Annual Report 2014 105 SUPPLEMENTAL INFORMATION Supplemental Information Certain comparative figures have been reclassified to conform to the current period’s presentation and for changes in accounting policies. Refer to Note 1 of the consolidated financial statements. In addition, on November 1, 2011, BMO’s financial statements have been reported in accordance with IFRS. Results for years prior to 2011 have not been restated and are presented in accordance with Canadian GAAP as defined at that time (CGAAP). As a result of these changes, certain growth rates and compound annual growth rates (CAGR) may not be meaningful. Adjusted results in this section are non-GAAP measures. Refer to the non-GAAP Measures section on page 32. Table 1: Shareholder Value and Other Statistical Information As at or for the year ended October 31 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 Market Price per Common Share ($) High Low Close Common Share Dividends Dividends declared per share ($) Dividend payout ratio (%) Dividend yield (%) Dividends declared ($ millions) Total Shareholder Return (%) Five-year average annual return Three-year average annual return One-year return Common Share Information Number outstanding (in thousands) End of year Average basic Average diluted Number of shareholder accounts Book value per share ($) Total market value of shares ($ billions) Price-to-earnings multiple Price-to-adjusted earnings multiple Market-to-book value multiple Balances As at assets Average daily assets Average daily net loans and acceptances n o i t a m r o f n I l a t n e m e l p p u S 85.71 67.04 81.73 3.08 47.8 3.8 1,991 15.5 16.7 17.1 73.90 56.74 72.62 2.94 47.5 4.0 1,904 17.0 11.5 28.8 61.29 53.15 59.02 2.82 46.0 4.8 1,820 4.2 10.8 5.2 63.94 55.02 58.89 2.80 57.1 4.8 1,690 1.9 17.4 2.4 65.71 49.78 60.23 2.80 58.6 4.6 1,571 5.9 4.5 26.4 54.75 24.05 50.06 2.80 90.6 5.6 1,530 63.44 35.65 43.02 2.80 73.9 6.5 1,409 72.75 60.21 63.00 2.71 64.8 4.3 1,354 1.8 (5.3) 25.1 0.9 (5.6) (27.9) 14.2 6.6 (5.8) 70.24 56.86 69.45 2.26 43.0 3.3 1,133 19.1 15.6 24.1 62.44 53.05 57.81 1.85 39.1 3.2 925 13.8 18.4 3.7 649,050 645,860 648,475 55,610 48.18 53.0 12.8 12.4 1.70 644,130 648,476 649,806 56,241 43.22 46.8 11.8 11.7 1.66 650,730 644,407 648,615 59,238 39.41 38.4 9.7 9.9 1.47 639,000 591,403 607,068 58,769 36.76 37.6 12.2 11.5 1.49 566,468 559,822 563,125 36,612 34.09 34.1 12.7 12.5 1.77 551,716 540,294 542,313 37,061 31.95 27.6 16.3 12.5 1.57 504,575 502,062 506,697 37,250 32.02 21.7 11.4 9.2 1.34 498,563 499,950 508,614 37,165 28.29 31.4 15.3 11.6 2.23 500,726 501,257 511,173 38,360 28.89 34.8 13.5 13.4 2.40 500,219 500,060 510,845 40,104 26.48 28.9 12.5 12.9 2.18 588,659 593,928 292,098 537,044 555,431 266,107 524,684 543,931 246,129 500,575 469,934 215,414 411,640 398,474 171,554 388,458 438,548 182,097 416,050 397,609 175,079 366,524 360,575 165,783 319,978 309,131 153,282 293,862 296,502 139,414 Return on Equity and Assets Return on equity (%) Adjusted return on equity (%) Return on average assets (%) Adjusted return on average assets (%) Return on average risk-weighted assets (%) (1) Adjusted return on average risk-weighted assets (%) (1) Average equity to average total assets (%) 14.0 14.4 0.72 0.74 1.85 1.91 0.05 14.9 15.0 0.74 0.75 1.93 1.94 0.05 15.9 15.5 0.75 0.73 1.96 1.92 0.05 15.1 16.0 0.65 0.68 1.70 1.79 0.04 14.9 15.0 0.71 0.71 1.74 1.76 0.05 9.9 12.9 0.41 0.52 0.97 1.25 0.04 13.0 16.2 0.50 0.61 1.07 1.32 0.04 14.4 19.0 0.59 0.78 1.20 1.58 0.04 19.2 19.3 0.86 0.87 1.71 1.71 0.04 18.8 18.3 0.81 0.78 1.63 1.58 0.04 Other Statistical Information Employees (2) Canada United States Other Total Bank branches Canada United States Other Total Automated banking machines Canada United States Total 30,596 14,836 1,346 30,301 14,696 634 30,797 14,963 512 31,351 15,184 440 29,821 7,445 363 29,118 6,732 323 29,529 7,256 288 28,944 6,595 288 27,922 6,785 234 26,684 6,901 200 46,778 45,631 46,272 46,975 37,629 36,173 37,073 35,827 34,941 33,785 934 615 4 933 626 4 930 638 3 920 688 3 910 321 3 900 290 5 983 292 5 977 243 4 963 215 4 968 208 4 1,553 1,563 1,571 1,611 1,234 1,195 1,280 1,224 1,182 1,180 3,016 1,322 4,338 2,900 1,325 4,225 2,596 1,375 3,971 2,235 1,366 3,601 2,076 905 2,981 2,030 636 2,666 2,026 640 2,666 1,978 583 2,561 1,936 547 2,483 1,952 539 2,491 2010 and prior based on CGAAP. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. (1) Beginning in 2008, return on average risk-weighted assets has been calculated under the Basel II guidelines; for all prior periods, return on average risk-weighted assets has been calculated using the Basel I methodology. (2) Reflects full-time equivalent number of employees, comprising full-time and part-time employees and adjustments for overtime hours. 106 BMO Financial Group 197th Annual Report 2014 Table 2: Summary Income Statement and Growth Statistics ($ millions, except as noted) For the year ended October 31 Income Statement – Reported Results Net interest income Non-interest revenue Total revenue Provision for credit losses Non-interest expense Income before provision for income taxes Provision for income taxes Non-controlling interest in subsidiaries (1) Net income Attributable to bank shareholders Attributable to non-controlling interest in subsidiaries (1) Net income Income Statement – Adjusted Results Net interest income Non-interest revenue Total revenue Provision for credit losses Non-interest expense Income before provision for income taxes Provision for income taxes Non-controlling interest in subsidiaries (1) Adjusted net income Attributable to bank shareholders Attributable to non-controlling interest in subsidiaries (1) Adjusted net income Earnings per Share (EPS) ($) Basic Diluted Adjusted diluted Year-over-Year Growth-Based Statistical Information (%) Net income growth Adjusted net income growth Diluted EPS growth Adjusted diluted EPS growth 2014 2013 2012 2011 2010 5-year CAGR 10-year CAGR 8,461 8,257 16,718 561 10,921 5,236 903 na 4,333 4,277 56 4,333 8,461 8,257 16,718 561 10,761 5,396 943 na 4,453 4,397 56 4,453 6.44 6.41 6.59 3.3 5.4 3.9 6.1 8,677 7,386 16,063 587 10,226 5,250 1,055 na 4,195 4,130 65 4,195 8,020 7,352 15,372 357 9,755 5,260 1,037 na 4,223 4,158 65 4,223 6.19 6.17 6.21 0.9 4.1 1.1 4.4 8,937 6,992 15,929 764 10,135 5,030 874 na 4,156 4,082 74 4,156 8,158 6,708 14,866 470 9,410 4,986 927 na 4,059 3,985 74 4,059 6.13 6.10 5.95 33.5 23.9 26.0 16.7 7,474 6,469 13,943 1,212 8,741 3,990 876 na 3,114 3,041 73 3,114 7,248 6,494 13,742 1,108 8,453 4,181 906 na 3,275 3,202 73 3,275 4.90 4.84 5.10 8.0 12.3 1.9 6.0 6,235 6,004 12,239 1,049 7,619 3,571 687 74 2,810 2,810 na 2,810 6,235 6,004 12,239 1,049 7,583 3,607 691 74 2,916 2,916 na 2,916 4.78 4.75 4.81 54.8 22.9 54.2 19.7 8.7 8.5 8.6 nm 8.1 20.3 nm nm 19.4 19.1 nm 19.4 8.7 6.5 7.6 nm 8.3 13.8 16.0 nm 13.4 13.1 nm 13.4 15.8 15.8 10.4 na na na na 5.8 6.1 6.0 nm 5.9 4.8 (0.7) nm 6.6 6.4 nm 6.6 5.8 6.1 6.0 nm 5.9 4.8 (1.7) nm 7.0 6.9 nm 7.0 3.6 3.8 4.4 na na na na S u p p l e m e n t a l I n f o r m a t i o n 2010 and prior based on CGAAP. Five-year and ten-year CAGR based on CGAAP in 2009 and 2004, respectively, and on IFRS in 2014. 2011 growth rates based on CGAAP in 2010 and IFRS in 2011. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. (1) Prior to 2011, under CGAAP, non-controlling interest in subsidiaries was deducted in the determination of net income. nm – not meaningful na – not applicable BMO Financial Group 197th Annual Report 2014 107 SUPPLEMENTAL INFORMATION Table 3: Revenue and Revenue Growth ($ millions, except as noted) For the year ended October 31 Net Interest Income Year-over-year growth (%) Adjusted Net Interest Income Year-over-year growth (%) Net Interest Margin (1) Average earning assets Net interest margin (%) Adjusted net interest margin (%) Canadian dollar net interest margin (%) U.S. dollar and other currencies net interest margin (%) Non-Interest Revenue Securities commissions and fees Deposit and payment service charges Trading revenues Lending fees Card fees Investment management and custodial fees Mutual fund revenues Securitization revenues Underwriting and advisory fees Securities gains (losses), other than trading Foreign exchange, other than trading Insurance income Other revenues Total Non-Interest Revenue Year-over-year growth (%) Non-interest revenue as a % of total revenue Adjusted Non-Interest Revenue Year-over-year adjusted non-interest revenue growth (%) Adjusted non-interest revenue as a % of total adjusted revenue Total Revenue Year-over-year total revenue growth (%) Total Adjusted Revenue Year-over-year total adjusted revenue growth (%) n o i t a m r o f n I l a t n e m e l p p u S 2014 2013 8,461 (2.5) 8,461 5.5 8,677 (2.9) 8,020 (1.7) 2012 8,937 19.6 8,158 12.6 2011 7,474 19.9 7,248 16.2 2010 6,235 11.9 6,235 11.9 528,786 1.60 1.60 1.74 1.41 485,191 1.79 1.65 1.82 1.74 461,018 1.94 1.77 1.89 2.01 404,195 1.85 1.79 1.99 1.61 332,468 1.88 1.88 2.12 1.47 934 1,002 949 680 462 1,246 1,073 – 744 162 179 503 323 8,257 11.8 49.4 8,257 12.3 49.4 16,718 4.1 16,718 8.7 846 916 849 603 461 971 832 – 659 285 172 445 347 7,386 5.6 46.0 7,352 9.6 47.8 16,063 0.8 15,372 3.4 825 929 1,025 544 441 967 665 – 600 152 153 335 356 6,992 8.1 43.9 6,708 3.3 45.1 1,215 834 549 593 689 496 633 – 512 189 130 283 346 6,469 7.7 46.4 6,494 8.1 47.3 15,929 14.2 14,866 8.2 13,943 13.9 13,742 12.3 1,077 802 504 572 233 355 550 678 445 150 93 321 224 6,004 9.3 49.1 6,004 (0.2) 49.1 12,239 10.6 12,239 5.7 5-year CAGR 10-year CAGR 8.7 na 8.7 na 9.1 na na na na (0.8) 4.1 5.6 4.1 30.6 29.4 18.1 nm 13.4 nm 27.8 11.3 13.7 8.5 na na 6.5 na na 8.6 na 7.6 na 5.8 na 5.8 na 8.9 na na na na (1.2) 3.0 16.8 7.9 5.9 15.0 11.0 nm 8.0 nm 0.1 13.8 1.6 6.1 na na 6.1 na na 6.0 na 6.0 na 2010 and prior based on CGAAP. Five-year and ten-year CAGR based on CGAAP in 2009 and 2004, respectively, and on IFRS in 2014. 2011 growth rates based on CGAAP in 2010 and IFRS in 2011. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. (1) Net interest margin is calculated based on average earning assets. na – not applicable nm – not meaningful 108 BMO Financial Group 197th Annual Report 2014 Table 4: Non-Interest Expense and Expense-to-Revenue Ratio ($ millions, except as noted) 2014 2013 2012 2011 2010 5-year CAGR 10-year CAGR For the year ended October 31 Non-Interest Expense Employee compensation Salaries Performance-based compensation Employee benefits Total employee compensation Premises and equipment Rental of real estate Premises, furniture and fixtures Property taxes Computers and equipment (1) Total premises and equipment (1) Other expenses Amortization of intangible assets (1) Communications Business and capital taxes Professional fees Travel and business development Other Total other expenses Total Non-Interest Expense Year-over-year total non-interest expense growth (%) Total Adjusted Non-Interest Expense Year-over-year total adjusted non-interest expense growth (%) Non-interest expense-to-revenue ratio (Efficiency ratio) (%) Adjusted non-interest expense-to-revenue ratio (Efficiency ratio) (%) Efficiency ratio, excluding PBCAE (2) Adjusted efficiency ratio, excluding PBCAE (2) Government Levies and Taxes (3) Government levies other than income taxes Payroll levies Property taxes Provincial capital taxes Business taxes Harmonized sales tax, GST and other sales taxes Sundry taxes Total government levies other than income taxes Provision for income taxes Total Government Levies and Taxes Total government levies and taxes as a % of income available to pay government levies and taxes Effective income tax rate (%) Adjusted effective income tax rate (%) 2,646 1,560 621 4,827 360 310 30 878 2,285 1,455 624 4,364 319 269 28 727 1,578 1,343 231 259 51 624 382 789 2,336 8,741 14.7 8,453 11.5 62.7 61.5 – – 203 30 44 7 235 1 520 876 203 229 52 401 343 684 1,912 7,619 3.2 7,583 5.0 62.2 62.0 – – 175 28 45 7 146 1 402 687 3,388 1,946 908 6,242 415 261 39 1,193 1,908 382 289 39 622 542 897 3,259 1,686 897 5,842 416 377 37 1,003 1,833 346 291 39 527 514 834 3,148 1,657 808 5,613 400 368 36 1,071 1,875 331 301 46 593 491 885 2,771 2,551 2,647 10,135 15.9 9,410 11.3 63.6 63.3 59.3 58.7 250 36 37 9 249 2 583 874 10,921 6.8 10,761 10.3 65.3 64.4 59.9 59.1 252 39 27 9 273 2 602 903 1,505 25.0 17.2 17.5 10,226 0.9 9,755 3.7 63.7 63.5 60.8 60.4 249 37 30 7 262 1 586 1,055 1,641 28.7 20.1 19.7 1,457 1,396 1,089 26.6 17.4 18.6 31.0 22.0 21.7 27.4 19.2 19.2 7.2 7.8 6.9 7.3 6.2 (0.8) 5.9 12.1 8.3 13.6 5.5 (3.1) 11.4 11.9 9.2 10.1 8.1 na 8.3 na na na na na 8.0 5.9 (5.3) 0.3 18.7 nm 10.6 nm 20.9 na na na 6.0 5.3 4.5 5.5 8.6 (0.1) (2.8) 5.8 nm nm 7.6 (9.0) 9.0 8.5 7.6 8.6 5.9 na 5.9 na na na na na 4.4 (2.8) (11.3) 1.4 6.2 nm 2.6 (0.7) 0.5 na na na S u p p l e m e n t a l I n f o r m a t i o n 2010 and prior based on CGAAP. Five-year and ten-year CAGR based on CGAAP in 2009 and 2004, respectively, and on IFRS in 2014. 2011 growth rates based on CGAAP in 2010 and IFRS in 2011. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. (1) In 2009, we adopted new accounting requirements for intangible assets and reclassified certain computer equipment from premises and equipment to intangible assets. Computer and equipment expense and the amortization of intangible assets were restated, but not for years prior to 2007. As such, ten-year growth rates for these expense categories are not meaningful. Together, computer and equipment expense and the amortization of intangible assets increased at a compound annual growth rate of 6.2% over ten years. Together, total premises and equipment expense and the amortization of intangible assets increased at a compound annual growth rate of 5.4% over ten years. (2) This ratio is calculated excluding insurance policyholder benefits, claims and acquisition expenses (PBCAE). (3) Government levies are included in various non-interest expense categories. na – not applicable nm – not meaningful BMO Financial Group 197th Annual Report 2014 109 SUPPLEMENTAL INFORMATION Table 5: Average Assets, Liabilities and Interest Rates ($ millions, except as noted) For the year ended October 31 Assets Canadian Dollar Deposits with other banks Securities Securities borrowed or purchased under resale agreements Loans Residential mortgages Non-residential mortgages Personal and credit cards Businesses and governments Total loans Total Canadian dollar U.S. Dollar and Other Currencies Deposits with other banks Securities Securities borrowed or purchased under resale agreements Loans Residential mortgages Non-residential mortgages Personal and credit cards Businesses and governments Total loans Total U.S. dollar and other currencies Other non-interest bearing assets Total All Currencies Total assets and interest income Liabilities Canadian Dollar Deposits Banks Businesses and governments Individuals Total deposits n o i t a m r o f n I l a t n e m e l p p u S Securities sold but not yet purchased and securities lent or sold (1) Subordinated debt and other interest bearing liabilities Total Canadian dollar U.S. Dollar and Other Currencies Deposits Banks Businesses and governments Individuals Total deposits Securities sold but not yet purchased and securities lent or sold (1) Subordinated debt and other interest bearing liabilities Total U.S. dollar and other currencies Other non-interest bearing liabilities Total All Currencies Total liabilities and interest expense Shareholders’ equity Average balances Average interest rate (%) 2013 Interest income/ expense Average balances Average interest rate (%) 2012 Interest income/ expense Average balances Average interest rate (%) 1,632 94,234 23,027 90,134 6,276 55,719 40,250 192,379 311,272 38,815 53,921 32,629 7,753 4,859 15,812 61,402 89,826 215,191 67,465 1.52 1.46 0.47 3.08 4.08 5.13 4.34 3.97 2.94 0.63 1.11 0.12 3.37 2.48 3.32 3.42 3.35 1.81 2014 Interest income/ expense 25 1,373 109 2,778 256 2,860 1,748 2,461 83,605 22,309 81,693 6,285 54,845 37,380 7,642 180,203 9,149 288,578 245 601 38 261 121 524 2,102 3,008 35,093 48,488 32,578 8,897 5,558 14,862 47,821 77,138 3,892 193,297 73,556 1.28 1.96 0.54 3.15 4.29 4.97 4.68 4.06 3.16 0.61 1.32 0.17 4.31 3.01 3.59 4.52 4.21 2.15 32 1,636 121 2,576 269 2,728 1,749 7,322 9,111 213 640 57 383 167 533 2,161 3,244 4,154 2,418 81,486 20,898 71,282 6,282 53,217 34,038 164,819 269,621 38,666 47,839 27,907 9,722 6,423 14,374 43,083 73,602 188,014 86,396 1.22 1.98 1.11 3.38 4.67 5.06 5.19 4.34 3.35 0.54 1.63 0.32 4.67 6.61 4.69 4.90 4.98 2.52 30 1,617 232 2,406 293 2,691 1,766 7,156 9,035 209 779 89 454 425 674 2,111 3,664 4,741 593,928 2.20 13,041 555,431 2.39 13,265 544,031 2.53 13,776 5,416 98,090 89,007 192,513 40,713 24,712 257,938 19,048 145,355 41,675 206,078 33,650 4,901 244,629 59,139 561,706 32,222 0.39 1.38 0.97 1.16 1.74 3.11 1.44 0.23 0.34 0.22 0.30 0.21 3.34 0.35 21 1,353 863 5,921 88,603 82,248 2,237 176,772 710 769 36,077 28,004 3,716 240,853 44 494 90 628 72 164 864 17,135 123,129 40,694 180,958 33,486 4,325 218,769 66,523 526,145 29,286 0.34 1.53 0.96 1.22 1.96 3.25 1.57 0.33 0.32 0.29 0.31 0.30 3.32 0.37 20 1,352 788 2,160 4,233 77,605 81,117 162,955 708 911 44,214 34,368 3,779 241,537 56 392 119 567 99 143 809 17,131 102,373 40,511 160,015 33,335 3,830 197,180 77,858 516,575 27,456 0.82 4,580 0.87 4,588 0.34 1.60 1.00 1.27 1.55 3.23 1.60 0.34 0.38 0.41 0.38 0.51 5.26 0.50 14 1,242 808 2,064 686 1,109 3,859 58 384 167 609 170 201 980 0.94 4,839 Total Liabilities, Interest Expense and Shareholders’ Equity 593,928 0.77 4,580 555,431 0.83 4,588 544,031 0.89 4,839 Net interest margin – based on earning assets – based on total assets Net interest income based on total assets Adjusted net interest margin – based on earning assets – based on total assets Adjusted net interest income based on total assets 1.60 1.42 1.60 1.42 8,461 8,461 1.79 1.56 1.65 1.44 8,677 8,020 1.94 1.64 1.77 1.50 8,937 8,158 Comparative periods have been reclassified to conform with the current year’s presentation and for changes in accounting policies. Refer to Note 1 of the consolidated financial statements. (1) For the years ended October 31, 2014, 2013 and 2012, the maximum amount of securities lent or sold under repurchase agreements at any month end amounted to $50,138 million, $53,898 million and $62,038 million, respectively. 110 BMO Financial Group 197th Annual Report 2014 Table 6: Volume/Rate Analysis of Changes in Net Interest Income ($ millions) For the year ended October 31 Assets Canadian Dollar Deposits with other banks Securities Securities borrowed or purchased under resale agreements Loans Residential mortgages Non-residential mortgages Personal and credit cards Businesses and governments Total loans Change in Canadian dollar interest income U.S. Dollar and Other Currencies Deposits with other banks Securities Securities borrowed or purchased under resale agreements Loans Residential mortgages Non-residential mortgages Personal and credit cards Businesses and governments Total loans Change in U.S. dollar and other currencies interest income Total All Currencies Change in total interest income (a) Liabilities Canadian Dollar Deposits Banks Businesses and governments Individuals Total deposits Securities sold but not yet purchased and securities lent or sold Subordinated debt and other interest bearing liabilities Change in Canadian dollar interest expense U.S. Dollar and Other Currencies Deposits Banks Businesses and governments Individuals Total deposits Securities sold but not yet purchased and securities lent or sold Subordinated debt and other interest bearing liabilities Change in U.S. dollar and other currencies interest expense Total All Currencies Change in total interest expense (b) Change in total net interest income (a - b) 2014/2013 2013/2012 Increase (decrease) due to change in Increase (decrease) due to change in Average balance Average rate (11) 208 4 266 – 44 134 444 645 23 72 – (49) (21) 34 614 578 673 4 (471) (16) (63) (13) 88 (136) (124) (607) 10 (111) (19) (73) (26) (43) (672) (814) (934) Total (7) (263) (12) 203 (13) 132 (2) 320 38 33 (39) (19) (122) (47) (9) (58) (236) (261) Average balance Average rate 1 42 16 352 – 82 173 607 666 (19) 10 15 (39) (57) 23 232 159 165 1 (23) (127) (182) (24) (45) (190) (441) (590) 23 (149) (47) (32) (200) (164) (182) (578) (751) Total 2 19 (111) 170 (24) 37 (17) 166 76 4 (139) (32) (71) (257) (141) 50 (419) (586) 1,318 (1,541) (223) 831 (1,341) (510) (2) 145 65 208 91 (107) 192 6 71 3 80 1 19 100 3 (143) 10 (130) (89) (34) (253) (18) 31 (32) (19) (28) 1 (46) 292 (299) 1,026 (1,242) 1 2 75 78 2 (141) (61) (12) 102 (29) 61 (27) 20 54 (7) (216) 6 176 11 193 (126) (205) (138) – 78 1 79 1 26 106 – (66) (31) (97) 148 7 58 (2) (70) (48) (120) (72) (84) (276) (32) (218) 863 (1,123) 6 110 (20) 96 22 (198) (80) (2) 8 (47) (41) (71) (58) (170) (250) (260) S u p p l e m e n t a l I n f o r m a t i o n BMO Financial Group 197th Annual Report 2014 111 SUPPLEMENTAL INFORMATION Table 7: Net Loans and Acceptances – Segmented Information ($ millions) (6) (8) As at October 31 Consumer Residential mortgages Credit cards Consumer instalment and other personal loans Total consumer Total businesses and governments Canada United States Other countries Total 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 92,972 7,476 88,677 7,413 76,729 7,381 68,190 7,564 40,730 3,056 7,955 496 7,636 457 7,416 433 7,945 474 4,982 252 48,955 49,195 47,955 45,584 41,112 15,113 14,374 13,419 13,802 10,000 149,403 145,285 132,065 121,338 84,898 23,564 22,467 21,268 22,221 15,234 – – 1 1 – – – – – – – – – – – – – – – – 100,927 7,972 96,313 7,870 84,145 7,814 76,135 8,038 45,712 3,308 64,069 63,569 61,374 59,386 51,112 172,968 167,752 153,333 143,559 100,132 63,896 57,967 53,069 50,737 49,414 56,389 45,842 42,955 41,209 19,148 11,145 8,954 5,748 4,649 9,246 131,430 112,763 101,772 96,595 77,808 Total loans and acceptances, net of specific allowances Collective allowance 213,299 (795) 203,252 185,134 172,075 134,312 79,953 68,309 64,223 63,430 34,382 11,146 8,954 5,748 4,649 9,246 – (747) (791) (705) (694) (702) (755) (765) (595) (687) – – – – 304,398 280,515 255,105 240,154 177,940 (1,297) (1,542) (1,452) (1,485) (1,460) Total net loans and acceptances 212,504 202,461 184,429 171,388 133,717 79,206 67,615 63,468 62,665 33,680 11,146 8,954 5,748 4,649 9,246 302,856 279,030 253,645 238,702 176,643 Table 8: Net Impaired Loans and Acceptances – Segmented Information ($ millions, except as noted) n o i t a m r o f n I l a t n e m e l p p u S As at October 31 Consumer Residential mortgages Consumer instalment and other personal loans Total consumer Businesses and governments Total impaired loans and acceptances, net of specific allowances Collective allowance Total net impaired loans and Canada United States Other countries Total 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 168 136 304 247 157 100 257 253 182 64 246 377 178 101 279 433 227 278 359 335 221 220 96 323 372 334 612 507 284 643 944 275 128 79 610 1,271 349 1,108 299 1,279 551 (795) 510 (791) 623 (705) 712 (687) 695 (595) 1,119 (747) 1,587 (694) 1,881 (755) 1,457 (765) 1,578 (702) – – – 4 4 – 4 – – – 3 3 – 3 – – – 25 25 – 25 – – – 2 2 – 2 – – – 40 40 – 40 446 470 916 758 516 384 517 339 399 447 229 175 900 1,200 856 1,673 628 1,543 622 1,691 1,674 (1,542) 2,100 (1,485) 2,529 (1,460) 2,171 (1,452) 2,313 (1,297) 132 615 1,069 719 1,016 acceptances (NIL) (244) (281) (82) 25 100 372 893 1,126 692 876 Condition Ratios (6) NIL as a % of net loans and acceptances (1) (2) NIL as a % of net loans and acceptances (1) (2) (9) Consumer Businesses and governments (0.12) (0.14) (0.04) 0.01 0.07 0.48 1.34 1.81 1.15 2.62 0.04 0.03 0.43 0.04 0.43 0.04 0.22 0.42 0.30 0.57 0.20 0.39 0.18 0.43 0.19 0.66 0.23 0.85 0.38 0.76 2.60 0.90 2.87 2.08 2.87 2.99 1.57 2.69 1.96 6.78 – 0.04 – 0.03 – 0.43 – 0.04 – 0.43 0.53 0.58 0.54 1.07 0.56 1.67 0.44 1.63 0.62 2.18 2010 in Tables 7 – 15 based on CGAAP. 2011 has not been restated to reflect the new IFRS standards adopted in 2014. (1) Aggregate balances are net of specific and collective allowances; the consumer and businesses and governments categories are stated net of specific allowances only. (2) Ratio is presented including purchased portfolios and prior periods have been restated. (3) Includes amounts returning to performing status, sales, repayments, the impact of foreign exchange, and offsets for consumer write-offs that are not recognized as formations. (4) Results for 2010 have not been restated under IFRS and are presented in accordance with Canadian GAAP as defined at the time. For 2011, the allowance for credit losses at the beginning of year has been restated to comply with the requirements of IFRS. (5) Effective in 2011, total equity includes non-controlling interest in subsidiaries. In addition, geographic allocations are not available, as equity is not allocated on a country of risk basis. (6) Certain balances and ratios (coverage, condition and performance) for fiscal 2012 were restated in the first quarter of 2013 to conform to the current period’s presentation. (7) Amounts for 2014 exclude specific allowances of $50 million related to Other Credit Instruments (2013 – $41 million, 2012 – $29 million, 2011 – $45 million, 2010 – $9 million) included in Other Liabilities. (8) Fiscal 2013, 2012, 2011 and 2010 balances were reclassified in the first quarter of 2014 to conform to the current period’s presentation. (9) Certain condition and performance ratios for 2013 and 2012 were restated in the first quarter of 2014 to conform to the current period’s presentation. un – unavailable 112 BMO Financial Group 197th Annual Report 2014 Table 9: Net Loans and Acceptances – Segmented Information ($ millions) (6) (8) As at October 31 2014 2013 2012 2011 2010 Net Loans and Acceptances by Province Atlantic provinces Quebec Ontario Prairie provinces British Columbia and territories 11,331 36,758 82,068 42,316 40,031 11,244 33,746 80,726 38,825 37,920 11,801 35,650 69,014 34,431 33,533 10,638 28,489 68,556 32,162 31,543 8,438 22,090 53,821 25,045 24,323 Total net loans and acceptances in Canada 212,504 202,461 184,429 171,388 133,717 Net Businesses and Governments Loans by Industry Commercial real estate Construction (non-real estate) Retail trade Wholesale trade Agriculture Communications Manufacturing Mining Oil and gas Transportation Utilities Forest products Service industries Financial institutions Government Other 17,636 3,101 12,580 8,281 9,155 831 13,612 1,085 5,943 2,532 1,670 587 22,114 24,096 2,076 6,131 17,606 2,934 10,229 7,345 8,380 729 11,250 959 3,908 2,152 1,309 631 18,321 19,019 1,719 6,272 18,720 2,539 9,084 6,821 7,312 513 9,870 662 3,466 2,109 1,170 592 14,992 15,113 1,295 7,514 20,468 2,460 7,829 5,854 6,653 564 9,368 683 3,477 2,009 842 529 13,872 14,709 810 6,468 12,633 1,905 6,042 3,356 5,550 935 6,517 267 3,688 1,341 1,104 419 9,906 17,267 614 6,264 131,430 112,763 101,772 96,595 77,808 Table 10: Net Impaired Loans and Acceptances – Segmented Information ($ in millions) (8) As at October 31 2014 2013 2012 2011 2010 S u p p l e m e n t a l I n f o r m a t i o n Net Impaired Businesses and Governments Loans Commercial real estate Construction (non-real estate) Retail trade Wholesale trade Agriculture Communications Manufacturing Mining Oil and gas Transportation Utilities Forest products Service industries Financial institutions Government Other 159 84 38 35 103 59 100 2 1 7 – 13 145 9 2 1 379 32 74 64 118 – 74 5 30 23 – 19 246 – 61 75 803 51 68 58 131 5 126 5 1 41 6 24 263 – 68 23 637 45 98 32 135 7 87 3 2 42 2 36 169 181 1 66 651 79 92 45 86 1 141 – 9 29 6 72 205 219 2 54 758 1,200 1,673 1,543 1,691 BMO Financial Group 197th Annual Report 2014 113 n o i t a m r o f n I l a t n e m e l p p u S Gross impaired loans and acceptances, end of year Consumer Businesses and governments Total GIL, end of year Condition Ratios GIL as a % of Gross Loans (6) Consumer Businesses and governments SUPPLEMENTAL INFORMATION Table 11: Changes in Gross Impaired Loans – Segmented Information ($ millions) As at October 31 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 Canada United States Other countries Total Gross impaired loans and acceptances (GIL), beginning of year Consumer Businesses and governments Total GIL, beginning of year Additions to impaired loans and acceptances Consumer Businesses and governments Total additions Reductions to impaired loans and acceptances (3) Consumer Businesses and governments Total reductions due to net repayments and other Write-offs 348 406 754 643 285 928 338 548 886 584 294 878 371 586 957 533 352 885 412 540 952 573 424 997 417 533 950 567 410 977 702 1,081 646 1,401 388 1,326 309 1,551 194 1,967 1,783 2,047 1,714 1,860 2,161 529 685 637 931 764 1,416 1,214 1,568 2,180 333 661 994 374 978 1,352 – 7 7 – – – – 43 43 – 3 3 – 14 14 – 36 36 – 82 82 – 1 1 – 186 186 – 1 1 1,050 1,494 984 1,992 759 1,926 721 2,173 611 2,686 2,544 2,976 2,685 2,894 3,297 1,172 970 1,221 1,228 1,297 1,804 906 1,086 941 1,389 2,142 2,449 3,101 1,992 2,330 (431) (224) (416) (274) (386) (314) (413) (242) (352) (287) (321) (859) (243) (973) (45) (880) 7 (597) 44 (1,052) – (2) – (36) – (6) – (40) – (103) (752) (431) (659) (1,085) (1,283) (1,200) (406) (879) (308) (1,442) (655) (690) (700) (655) (639) (1,180) (1,216) (925) (590) (1,008) (2) (36) (6) (40) (103) (1,837) (1,942) (1,631) (1,285) (1,750) Consumer Businesses and governments (162) (123) (158) (162) (180) (76) (201) (136) (220) (116) (232) (284) (338) (278) (461) (461) (261) (289) (303) (342) Total write-offs (285) (320) (256) (337) (336) (516) (616) (922) (550) (645) 398 344 742 348 406 754 338 548 886 371 586 957 412 540 952 678 623 702 1,081 646 1,401 388 1,326 309 1,551 1,301 1,783 2,047 1,714 1,860 – – – – 5 5 – (3) (3) – 7 7 – (1) (1) – (29) (29) – 43 43 – 14 14 – (2) (2) – 82 82 (394) (407) (496) (443) (641) (538) (462) (454) (523) (460) (801) (939) (1,179) (916) (983) 1,076 972 1,050 1,494 984 1,992 759 1,926 721 2,173 2,048 2,544 2,976 2,685 2,894 Total Loans and Acceptances 0.35 0.37 0.47 0.56 0.71 0.27 0.54 0.24 0.68 0.26 1.00 0.31 1.15 0.48 1.11 2.87 1.10 1.62 3.12 2.34 2.60 3.03 3.28 3.20 1.74 3.20 2.69 2.03 7.99 – 0.04 – 0.10 – 0.91 – 0.30 – 0.88 5.37 0.04 0.10 0.91 0.30 0.88 0.62 0.74 0.67 0.63 1.32 0.91 0.64 1.95 1.17 0.53 1.99 1.12 0.71 2.80 1.62 GIL as a % of equity and allowance for credit losses (2) (5) (9) un un un un un un un un un un un un un un un 5.49 7.68 9.46 8.98 12.18 114 BMO Financial Group 197th Annual Report 2014 115 SUPPLEMENTAL INFORMATION Table 12: Changes in Allowance for Credit Losses – Segmented Information ($ millions, except as noted) (8) As at October 31 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 Canada United States Other countries Total Allowance for credit losses (ACL), beginning of year Consumer Businesses and governments Total ACL, beginning of year Provision for credit losses Consumer Businesses and governments Total provision for credit losses Recoveries Consumer Businesses and governments Total recoveries Write-offs 602 433 1,035 436 97 533 99 15 114 518 450 968 521 133 654 81 (1) 80 464 468 932 543 90 633 91 4 95 454 473 927 527 152 679 80 1 81 327 503 830 359 126 485 278 653 931 291 659 950 270 797 145 859 41 970 1,067 1,004 1,011 202 (172) 262 (327) 401 (267) 30 (65) 134 76 (3) 73 102 408 510 95 597 692 125 626 751 350 184 534 61 99 324 249 573 61 49 160 110 Consumer Businesses and governments (500) (122) (507) (160) (563) (76) (587) (136) (430) (114) (242) (285) (347) (280) (492) (461) (289) (289) (322) (348) Total write-offs (622) (667) (639) (723) (544) (527) (627) (953) (578) (670) – 4 4 – (2) (2) – – – – – – n o i t a m r o f n I l a t n e m e l p p u S Other, including foreign exchange rate changes Consumer Businesses and governments Total Other, including foreign exchange rate changes ACL, end of year (4) Consumer Businesses and governments Total ACL, end of year Allocation of Write-offs by Market Consumer Businesses and governments Allocation of Recoveries by Market Consumer Businesses and governments Net write-offs as a % of average loans and acceptances (2) (6) (22) (52) (11) 11 (17) (36) (10) (22) (14) 22 (7) 42 (23) 4 (13) (36) 3 (56) 39 (70) – (1) (74) – (53) (32) 8 35 (19) (49) (53) (31) (1) (9) 10 615 371 986 602 433 1,035 518 450 968 464 468 932 318 534 852 333 646 979 278 653 931 291 659 950 270 797 1,067 143 850 993 (500) (122) (507) (160) (563) (76) (587) (136) (430) (114) (242) (285) (347) (280) (492) (461) (289) (289) (322) (348) 99 15 81 (1) 91 4 80 1 76 (3) 102 408 95 597 125 626 61 99 61 49 – 1 1 – – – – – 4 4 – (3) – – – 18 18 – (2) (2) – – – – (3) (3) – (9) – 12 12 – (3) (3) – – – – 42 42 – (1) (1) – – – – (1) (1) – (29) (29) – 10 – 18 18 – – – – 12 12 – (1) – (29) – – – – – 61 61 – (9) (9) – – – – (2) (2) – (8) (8) – 42 42 – (2) – – 880 1,090 809 1,127 734 1,277 599 1,374 368 1,534 1,970 1,936 2,011 1,973 1,902 638 (77) 561 201 423 624 783 (196) 944 (180) 877 335 683 366 587 764 1,212 1,049 176 596 772 216 630 846 141 100 241 137 46 183 (742) (407) (854) (1,055) (538) (443) (876) (454) (752) (464) (1,149) (1,297) (1,593) (1,330) (1,216) (7) (33) (34) 6 (30) (62) (7) (78) 25 (56) (40) (28) (92) (85) (31) 948 1,018 880 1,090 809 1,127 734 1,277 461 1,426 1,966 1,970 1,936 2,011 1,887 (741) (408) (854) (1,055) (538) (443) (876) (454) (752) (464) 201 423 176 596 216 630 141 100 137 46 un un un un un un un un un un un un un un un 0.18 0.20 0.30 0.51 0.60 Table 13: Allocation of Allowance for Credit Losses – Segmented Information ($ millions, except as noted) As at October 31 Consumer Residential mortgages Consumer instalment and other personal loans Total consumer Businesses and governments Off-balance sheet Total specific allowances Collective allowance Allowance for credit losses Coverage Ratios Allowance for credit losses as a % of gross impaired loans and acceptances (GIL) (2) Total Consumer Businesses and governments Canada United States Other countries 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 2012 2011 2010 2014 2013 20 74 94 97 – 191 795 986 27 64 91 153 – 244 791 1,035 36 55 91 172 – 263 705 968 38 54 92 153 – 245 687 932 42 47 89 168 – 257 595 852 66 – 66 116 50 232 747 979 52 7 59 137 41 237 694 931 30 7 37 129 29 195 755 950 34 5 39 218 45 302 765 1,067 10 – 10 272 9 291 702 993 – – – 1 – 1 – 1 – – – 4 – 4 – 4 – – – 18 – 18 – 18 – – – 12 – 12 – 12 – – – 42 – 42 – 42 Total 2012 66 62 128 319 29 2011 2010 72 59 131 383 45 52 47 99 482 9 86 74 160 214 50 79 71 150 294 41 424 1,542 485 1,485 476 1,460 559 1,452 590 1,297 1,966 1,970 1,936 2,011 1,887 132.9 23.6 28.2 137.3 26.2 37.7 109.3 27.0 31.3 97.4 24.8 26.1 89.5 21.6 31.1 71.4 9.9 18.5 49.9 8.4 12.7 45.0 5.7 9.2 59.6 10.1 16.4 52.9 3.2 17.5 20.0 – 20.0 57.1 – 57.1 41.9 – 41.9 85.7 – 85.7 51.2 – 51.2 93.6 14.9 22.0 75.8 14.3 19.7 64.1 13.1 16.0 73.2 17.3 19.9 64.9 13.7 22.2 116 BMO Financial Group 197th Annual Report 2014 117 n o i t a m r o f n I l a t n e m e l p p u S SUPPLEMENTAL INFORMATION Table 14: Specific Allowances for Credit Losses – Segmented Information ($ millions) (8) As at October 31 Businesses and Governments Specific Allowances by Industry Commercial real estate Construction (non-real estate) Retail trade Wholesale trade Agriculture Communications Manufacturing Mining Oil and gas Transportation Utilities Forest products Service industries Financial institutions Government Other Total specific allowances for credit losses on businesses and governments loans (7) Table 15: Provision for Credit Losses – Segmented Information ($ millions) (8) For the year ended October 31 Consumer Residential mortgages Cards Consumer instalment and other personal loans Total consumer Businesses and Governments Commercial real estate Construction (non-real estate) Retail trade Wholesale trade Agriculture Communications Manufacturing Mining Oil and gas Transportation Utilities Forest products Service industries Financial institutions Government Other Total businesses and governments Total specific provisions Collective provision for credit losses Total provision for credit losses Performance Ratios (%) PCL-to-average net loans and acceptances (2) (6) PCL-to-segmented average net loans and acceptances (6) Consumer Businesses and governments Specific PCL-to-average net loans and acceptances 118 BMO Financial Group 197th Annual Report 2014 2014 2013 2012 2011 2010 13 16 8 10 8 – 33 10 – 2 – 9 100 2 – 3 214 46 26 13 25 9 – 36 3 1 4 – 11 59 29 1 31 79 22 17 6 11 1 67 – 2 2 1 15 75 8 1 12 294 319 136 19 15 8 8 – 37 – 3 9 – 14 51 63 2 18 383 98 42 14 24 18 1 87 – 2 11 – 15 61 101 2 6 482 2014 2013 2012 2011 2010 77 268 251 596 (141) 7 1 29 15 – 44 7 – 10 – (1) 80 (34) (3) (49) (35) 561 – 561 129 305 313 747 (185) 36 (4) 10 8 (6) 2 2 – (9) – 3 (37) (15) (6) 51 (150) 597 (10) 587 132 355 387 874 (108) (14) – (16) 4 (5) 25 (1) – 5 – 7 23 (29) – (4) (113) 761 3 764 0.19 0.22 0.31 0.37 (0.06) 0.19 0.49 (0.18) 0.23 0.62 (0.15) 0.31 109 376 291 776 132 21 7 (1) 7 (9) 47 – 1 8 – 4 76 45 – 12 350 1,126 86 1,212 0.56 0.57 0.45 0.52 107 194 329 630 140 49 22 9 8 8 9 – (1) 19 – (4) 95 66 – (1) 419 1,049 – 1,049 0.61 0.66 0.55 0.61 Table 16: Risk-Weighted Assets ($ millions) Exposure at Default Risk-weighted assets Exposure at Default Risk-weighted assets Standardized Approach Advanced Approach 2014 Total Standardized Approach Advanced Approach (2) 2014 Total Standardized Approach Advanced Approach 2013 Total Standardized Approach Advanced Approach (2) 2013 Total Basel III 16,890 179,737 196,627 16,942 64,398 81,340 15,501 141,345 156,846 16,559 62,112 78,671 – 124 326 59,821 67,616 33,187 59,821 67,740 33,513 – 63 328 33,644 1,549 3,858 33,644 1,612 4,186 – 67 219 57,406 67,810 29,825 57,406 67,877 30,044 – – 44 26,594 904 4,404 26,594 904 4,448 3,298 1,095 – 90,303 41,337 28,895 93,601 42,432 28,895 1,736 809 – 5,882 5,732 4,000 7,618 6,541 4,000 4,163 1,532 – 84,434 41,291 33,314 88,597 42,823 33,314 2,225 841 – 6,486 5,738 4,580 8,711 6,579 4,580 2,199 17,824 20,023 1,519 8,307 9,826 3,206 23,962 27,168 2,097 10,313 12,410 292 – 3,554 3,262 1,924 1,924 122 133,942 134,064 28,115 28,115 – – – 30,746 30,746 – – 24,346 716,709 741,055 – – – – – – 231 – 122 – – – 1,373 1,362 7,237 3,098 1,604 1,362 7,359 3,098 14,946 14,946 8,251 8,251 21,750 1,719 3,791 163,637 185,387 9,002 27,703 7,283 23,912 337 – 58 – 3,220 1,887 72,239 22,407 3,557 1,887 72,297 22,407 – – 73,229 73,229 – – 25,083 652,369 677,452 – – – – – – 266 – 50 – – – 1,269 1,366 6,087 4,598 1,535 1,366 6,137 4,598 14,822 14,822 7,934 7,934 22,082 2,358 26,651 157,207 179,289 9,154 26,651 6,796 – As at October 31 Credit Risk Wholesale Corporate, including specialized lending Corporate small and medium-sized enterprises Sovereign Bank Retail Residential mortgages, excluding home equity line of credit Home equity line of credit Qualifying revolving retail Other retail, excluding small and medium-sized enterprises Retail small and medium-sized enterprises Equity Trading book Securitization Other credit risk assets – non- counterparty managed assets Scaling factor for credit risk assets under AIRB Approach (1) Total Credit Risk Market Risk Operational Risk Common Equity Tier 1 (CET1) Capital Risk-Weighted Assets 24,346 716,709 741,055 27,260 194,832 222,092 25,083 652,369 677,452 51,091 164,003 215,094 Additional Credit Valuation Adjustment (CVA), prescribed by OSFI, for Tier 1 Capital Tier 1 Capital Risk-Weighted Assets Additional CVA, prescribed by OSFI, for Total Capital Total Capital Risk-Weighted Assets – – – – – – – 336 336 27,260 195,168 222,428 – 503 503 27,260 195,671 222,931 – – – – – – – – – 51,091 164,003 215,094 – – – 51,091 164,003 215,094 (1) The scaling factor is applied to the risk-weighted assets amounts for credit risk under the AIRB Approach. (2) The AIRB Approach RWA for BMO Harris Bank is adjusted to a transitional floor based on the Standardized Approach. Table 17: Average Deposits ($ millions, except as noted) Deposits Booked in Canada Demand deposits – interest bearing Demand deposits – non-interest bearing Payable after notice Payable on a fixed date Total deposits booked in Canada Deposits Booked in the United States and Other Countries Banks located in the United States and other countries Governments and institutions in the United States and other countries Other demand deposits Other deposits payable after notice or on a fixed date Total deposits booked in the United States and other countries Total average deposits 2014 2013 2012 Average balance Average rate paid (%) Average balance Average rate paid (%) Average balance Average rate paid (%) 16,469 26,702 76,903 118,094 238,168 8,195 12,095 12,744 127,389 160,423 398,591 0.45 – 0.70 1.44 16,050 24,400 71,820 100,118 0.47 – 0.67 1.63 15,292 23,402 60,117 93,807 0.97 212,388 1.03 192,618 0.28 0.36 0.02 0.38 9,308 9,283 9,305 117,446 0.35 0.42 0.03 0.39 9,212 8,381 7,546 105,213 0.35 145,342 0.36 130,352 0.72 357,730 0.76 322,970 0.55 – 0.56 1.75 1.07 0.50 0.35 0.02 0.51 0.47 0.83 As at October 31, 2014, 2013 and 2012: deposits by foreign depositors in our Canadian bank offices amounted to $30,622 million, $19,248 million and $24,665 million, respectively; total deposits payable after notice included $33,109 million, $33,014 million and $30,240 million, respectively, of chequing accounts that would have been classified as demand deposits under U.S. reporting requirements; and total deposits payable on a fixed date included $17,738 million, $19,044 million and $14,271 million, respectively, of federal funds purchased, commercial paper issued and other deposit liabilities. These amounts would have been classified as short-term borrowings for U.S. reporting purposes. BMO Financial Group 197th Annual Report 2014 119 S u p p l e m e n t a l I n f o r m a t i o n Statement of Management’s Responsibility for Financial Information Management of Bank of Montreal (the “bank”) is responsible for the preparation and presentation of the annual consolidated financial statements, Management’s Discussion and Analysis (“MD&A”) and all other information in the Annual Report. The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board and meet the applicable requirements of the Canadian Securities Administrators (“CSA”) and the Securities and Exchange Commission (“SEC”) in the United States. The financial statements also comply with the provisions of the Bank Act (Canada) and related regulations, including interpretations of IFRS by our regulator, the Office of the Superintendent of Financial Institutions Canada. The MD&A has been prepared in accordance with the requirements of securities regulators, including National Instrument 51-102, Continuous Disclosure Obligations of the CSA, as well as Item 303, Management’s discussion and analysis of financial condition and results of operations of Regulation S-K under the United States Securities Act of 1933 and the Securities Exchange Act of 1934, and their related published requirements. The consolidated financial statements and information in the MD&A necessarily include amounts based on informed judgments and estimates of the expected effects of current events and transactions with appropriate consideration to materiality. In addition, in preparing the financial information we must interpret the requirements described above, make determinations as to the relevancy of information to be included, and make estimates and assumptions that affect reported information. The MD&A also includes information regarding the impact of current transactions and events, sources of liquidity and capital resources, operating trends, and risks and uncertainties. Actual results in the future may differ materially from our present assessment of this information because events and circumstances in the future may not occur as expected. The financial information presented in the bank’s Annual Report is consistent with that in the consolidated financial statements. In meeting our responsibility for the reliability and timeliness of financial information, we maintain and rely on a comprehensive system of internal controls, including organizational and procedural controls, disclosure controls and procedures, and internal control over financial reporting. Our system of internal controls includes written communication of our policies and procedures governing corporate conduct and risk management; comprehensive business planning; effective segregation of duties; delegation of authority and personal accountability; escalation of relevant information for decisions regarding public disclosure; careful selection and training of personnel; and accounting policies that we regularly update. Our internal controls are designed to provide reasonable assurance that transactions are authorized, assets are safeguarded and proper records are maintained, and that we are in compliance with all regulatory requirements. The system of internal controls is further supported by a compliance function, which is designed to ensure that we and our employees comply with securities legislation and conflict of interest rules, and by an internal audit staff, who conduct periodic audits of all aspects of our operations. As of October 31, 2014, we, as the bank’s Chief Executive Officer and Chief Financial Officer, have determined that the bank’s internal control over financial reporting is effective. We have certified Bank of Montreal’s annual filings with the CSA and with the SEC pursuant to National Instrument 52-109, Certification of Disclosure in Issuers’ Annual and Interim Filings and the Securities Exchange Act of 1934. In order to provide their audit opinions on our consolidated financial statements and on the bank’s internal control over financial reporting, the Shareholders’ Auditors audit our system of internal controls over financial reporting and conduct work to the extent that they consider appropriate. Their audit opinion on the bank’s internal control over financial reporting as of October 31, 2014 is set forth on page 122. The Board of Directors, based on recommendations from its Audit and Conduct Review Committee, reviews and approves the financial information contained in the Annual Report, including the MD&A. The Board of Directors and its relevant committees oversee management’s responsibilities for the preparation and presentation of financial information, maintenance of appropriate internal controls, compliance with legal and regulatory requirements, management and control of major risk areas, and assessment of significant and related party transactions. The Audit and Conduct Review Committee, which is comprised entirely of independent directors, is also responsible for selecting the Shareholders’ Auditors and for reviewing the qualifications, independence and performance of both the Shareholders’ Auditors and internal audit. The Shareholders’ Auditors and the bank’s Chief Auditor have full and free access to the Board of Directors, its Audit and Conduct Review Committee and other relevant committees to discuss audit, financial reporting and related matters. The Office of the Superintendent of Financial Institutions Canada conducts examinations and inquiries into the affairs of the bank as are deemed necessary to ensure that the provisions of the Bank Act, with respect to the safety of the depositors, are being duly observed and that the bank is in sound financial condition. William A. Downe Chief Executive Officer Thomas E. Flynn Chief Financial Officer Toronto, Canada December 2, 2014 120 BMO Financial Group 197th Annual Report 2014 Independent Auditors’ Report of Registered Public Accounting Firm To the Shareholders and Board of Directors of Bank of Montreal We have audited the accompanying consolidated financial statements of Bank of Montreal (the “Bank”), which comprise the consolidated balance sheets as at October 31, 2014 and October 31, 2013, the consolidated statements of income, comprehensive income, changes in equity and cash flows for each of the years in the three-year period ended October 31, 2014, and notes, comprising a summary of significant accounting policies and other explanatory information. Management’s Responsibility for the Consolidated Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors’ Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on our judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, we consider internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of the Bank as at October 31, 2014 and October 31, 2013, and its consolidated financial performance and its consolidated cash flows for each of the years in the three-year period ended October 31, 2014 in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board. Other Matter We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Bank’s internal control over financial reporting as of October 31, 2014, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated December 2, 2014 expressed an unmodified (unqualified) opinion on the effectiveness of the Bank’s internal control over financial reporting. Chartered Professional Accountants, Licensed Public Accountants December 2, 2014 Toronto, Canada BMO Financial Group 197th Annual Report 2014 121 Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors of Bank of Montreal We have audited Bank of Montreal’s (the “Bank”) internal control over financial reporting as of October 31, 2014, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Bank’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included under the heading “Management’s Annual Report on Disclosure Controls and Procedures and Internal Control over Financial Reporting” in the accompanying Management’s Discussion and Analysis. Our responsibility is to express an opinion on the Bank’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Bank maintained, in all material respects, effective internal control over financial reporting as of October 31, 2014, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We also have audited, in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Bank as at October 31, 2014 and 2013, the consolidated statements of income, comprehensive income, changes in equity and cash flows for each of the years in the three-year period ended October 31, 2014, and notes, comprising a summary of significant accounting policies and other explanatory information, and our report dated December 2, 2014 expressed an unmodified (unqualified) opinion on those consolidated financial statements. Chartered Professional Accountants, Licensed Public Accountants December 2, 2014 Toronto, Canada 122 BMO Financial Group 197th Annual Report 2014 Consolidated Statement of Income For the Year Ended October 31 (Canadian $ in millions, except as noted) 2014 2013 2012 Interest, Dividend and Fee Income Loans Securities (Note 3) Deposits with banks Interest Expense Deposits Subordinated debt Other liabilities Net Interest Income Non-Interest Revenue Securities commissions and fees Deposit and payment service charges Trading revenues Lending fees Card fees Investment management and custodial fees Mutual fund revenues Underwriting and advisory fees Securities gains, other than trading (Note 3) Foreign exchange, other than trading Insurance income Other Total Revenue Provision for Credit Losses (Note 4) Non-Interest Expense Employee compensation (Notes 23 and 24) Premises and equipment (Note 11) Amortization of intangible assets (Note 13) Travel and business development Communications Business and capital taxes Professional fees Other Income Before Provision for Income Taxes Provision for income taxes (Note 25) Net Income Attributable to: Bank shareholders Non-controlling interest in subsidiaries (Notes 18 and 20) Net Income Earnings Per Share (Canadian $) (Note 26) Basic Diluted $ $ 10,777 1,994 270 13,041 2,865 150 1,565 4,580 8,461 934 1,002 949 680 462 1,246 1,073 744 162 179 503 323 8,257 16,718 561 6,242 1,908 382 542 289 39 622 897 10,921 5,236 903 $ 4,333 $ 4,277 56 4,333 6.44 6.41 $ $ $ $ 10,745 2,276 244 13,265 2,727 145 1,716 4,588 8,677 846 916 849 603 461 971 832 659 285 172 445 347 7,386 16,063 587 5,842 1,833 346 514 291 39 527 834 10,226 5,250 1,055 4,195 4,130 65 4,195 6.19 6.17 $ 11,142 2,396 238 13,776 2,672 165 2,002 4,839 8,937 825 929 1,025 544 441 967 665 600 152 153 335 356 6,992 15,929 764 5,613 1,875 331 491 301 46 593 885 10,135 5,030 874 4,156 4,082 74 4,156 6.13 6.10 $ $ $ C o n s o l i d a t e d F i n a n c i a l S t a t e m e n t s The accompanying notes are an integral part of these consolidated financial statements. Certain comparative figures have been reclassified to conform with the current year’s presentation and for changes in accounting policies – see Note 1. William A. Downe Chief Executive Officer Philip S. Orsino Chairman, Audit and Conduct Review Committee BMO Financial Group 197th Annual Report 2014 123 CONSOLIDATED FINANCIAL STATEMENTS Consolidated Statement of Comprehensive Income For the Year Ended October 31 (Canadian $ in millions) Net income Other Comprehensive Income (Loss) Items that will not be reclassified to net income Re-measurement of pension and other employee future benefit plans (1) Items that may subsequently be reclassified to net income Net change in unrealized gains (losses) on available-for-sale securities Unrealized gains (losses) on available-for-sale securities arising during the year (2) Reclassification to earnings of (gains) in the year (3) Net change in unrealized gains (losses) on cash flow hedges Gains (losses) on cash flow hedges arising during the year (4) Reclassification to earnings of (gains) on cash flow hedges (5) Net gain on translation of net foreign operations Unrealized gain on translation of net foreign operations Impact of hedging unrealized (loss) on translation of net foreign operations (6) Other Comprehensive Income (Loss) Total Comprehensive Income Attributable to: Bank shareholders Non-controlling interest in subsidiaries (Notes 18 and 20) Total Comprehensive Income 2014 2013 2012 $ 4,333 $ 4,195 $ 4,156 (125) (125) 28 (77) (49) 247 (98) 149 1,378 (415) 963 938 298 298 (10) (50) (60) (25) (125) (150) 741 (409) 332 420 (440) (440) 24 (81) (57) (62) (107) (169) 75 (35) 40 (626) $ 5,271 $ 4,615 $ 3,530 5,215 56 $ 5,271 $ 4,550 65 4,615 3,456 74 3,530 $ (1) Net of income tax (provision) recovery of $63 million, ($126) million and $177 million for (5) Net of income tax provision of $28 million, $45 million and $38 million for the year ended, the year ended, respectively. respectively. (2) Net of income tax (provision) recovery of $(22) million, $9 million and $(13) million for the (6) Net of income tax recovery of $144 million, $146 million and $13 million for the year ended, year ended, respectively. respectively. (3) Net of income tax provision of $37 million, $22 million and $39 million for the year ended, respectively. (4) Net of income tax (provision) recovery of $(79) million, $12 million and $10 million for the year ended, respectively. The accompanying notes are an integral part of these consolidated financial statements. Certain comparative figures have been reclassified to conform with the current year’s presentation and for changes in accounting policies – see Note 1. s t n e m e t a t S l a i c n a n i F d e t a d i l o s n o C 124 BMO Financial Group 197th Annual Report 2014 Consolidated Balance Sheet As at October 31 (Canadian $ in millions) Assets Cash and Cash Equivalents (Note 2) Interest Bearing Deposits with Banks (Note 2) Securities (Note 3) Trading Available-for-sale Held-to-maturity Other Securities Borrowed or Purchased Under Resale Agreements (Note 4) Loans (Notes 4 and 8) Residential mortgages Consumer instalment and other personal Credit cards Businesses and governments Customers’ liability under acceptances Allowance for credit losses (Note 4) Other Assets Derivative instruments (Note 10) Premises and equipment (Note 11) Goodwill (Note 13) Intangible assets (Note 13) Current tax assets Deferred tax assets (Note 25) Other (Note 14) Total Assets Liabilities and Equity Deposits (Note 15) Banks Businesses and governments Individuals Other Liabilities Derivative instruments (Note 10) Acceptances (Note 16) Securities sold but not yet purchased (Note 16) Securities lent or sold under repurchase agreements (Note 16) Current tax liabilities Deferred tax liabilities (Note 25) Other (Note 16) Subordinated Debt (Note 17) Equity Share capital (Note 20) Contributed surplus Retained earnings Accumulated other comprehensive income Total shareholders’ equity Non-controlling interest in subsidiaries (Notes 18 and 20) Total Equity Total Liabilities and Equity 2014 2013 $ 28,386 $ 26,089 6,110 6,518 85,022 46,966 10,344 987 143,319 53,555 101,013 64,143 7,972 120,766 293,894 10,878 (1,734) 303,038 32,655 2,276 5,353 2,052 665 3,019 8,231 54,251 588,659 18,243 239,139 135,706 393,088 33,657 10,878 27,348 39,695 235 178 43,263 155,254 4,913 15,397 304 17,237 1,375 34,313 1,091 35,404 $ $ 75,159 53,710 6,032 899 135,800 39,799 96,392 63,640 7,870 104,585 272,487 8,472 (1,665) 279,294 30,259 2,168 3,819 1,511 1,065 3,027 7,695 49,544 537,044 20,591 222,346 125,432 368,369 31,974 8,472 22,446 28,884 438 107 41,179 133,500 3,996 14,268 315 15,087 437 30,107 1,072 31,179 $ $ $ 588,659 $ 537,044 C o n s o l i d a t e d F i n a n c i a l S t a t e m e n t s The accompanying notes are an integral part of these consolidated financial statements. Certain comparative figures have been reclassified to conform with the current year’s presentation and for changes in accounting policies – see Note 1. BMO Financial Group 197th Annual Report 2014 125 CONSOLIDATED FINANCIAL STATEMENTS Consolidated Statement of Changes in Equity For the Year Ended October 31 (Canadian $ in millions) 2014 2013 2012 Preferred Shares (Note 20) Balance at beginning of year Issued during the year Redeemed during the year Balance at End of Year Common Shares (Note 20) Balance at beginning of year Issued under the Shareholder Dividend Reinvestment and Share Purchase Plan (Note 20) Issued under the Stock Option Plan (Note 23) Repurchased for cancellation (Note 20) Issued on the exchange of shares of a subsidiary corporation Balance at End of Year Contributed Surplus Balance at beginning of year Stock option expense/exercised (Note 23) Foreign exchange on redemption of preferred shares (Note 20) Other Balance at End of Year Retained Earnings Balance at beginning of year Net income attributable to bank shareholders Dividends – Preferred shares (Note 20) – Common shares (Note 20) Common shares repurchased for cancellation (Note 20) Share issue expense Balance at End of Year Accumulated Other Comprehensive Income on Pension and Other Post-Employment Plans Balance at beginning of year Re-measurement of pension and other post-employment plans (1) Balance at End of Year Accumulated Other Comprehensive Income on Available-for-Sale Securities Balance at beginning of year Unrealized gains (losses) on available-for-sale securities arising during the year (2) Reclassification to earnings of (gains) in the year (3) Balance at End of Year Accumulated Other Comprehensive Income on Cash Flow Hedges Balance at beginning of year Gains (losses) on cash flow hedges arising during the year (4) Reclassification to earnings of (gains) in the year (5) Balance at End of Year Accumulated Other Comprehensive Income on Translation of Net Foreign Operations Balance at beginning of year Unrealized gain on translation of net foreign operations Impact of hedging unrealized (loss) on translation of net foreign operations (6) Balance at End of Year Total Accumulated Other Comprehensive Income Total Shareholders’ Equity Non-controlling Interest in Subsidiaries Balance at beginning of year Net income attributable to non-controlling interest Dividends to non-controlling interest Preferred share redemption (Note 20) Acquisitions (Note 12) Other Balance at End of Year Total Equity s t n e m e t a t S l a i c n a n i F d e t a d i l o s n o C $ $ 2,265 1,200 (425) 3,040 $ 2,465 – (200) 2,265 2,861 – (396) 2,465 12,003 223 131 – – 12,357 315 (7) – (4) 304 15,087 4,277 (120) (1,991) – (16) 17,237 (165) (125) (290) 205 28 (77) 156 (8) 247 (98) 141 405 1,378 (415) 1,368 1,375 11,957 130 116 (200) – 12,003 213 (5) 107 – 315 13,456 4,130 (120) (1,904) (475) – 15,087 (463) 298 (165) 265 (10) (50) 205 142 (25) (125) (8) 73 741 (409) 405 437 11,332 543 80 – 2 11,957 113 4 96 – 213 11,330 4,082 (136) (1,820) – – 13,456 (23) (440) (463) 322 24 (81) 265 311 (62) (107) 142 33 75 (35) 73 17 $ 34,313 $ 30,107 $ 28,108 1,072 56 (52) – 22 (7) 1,091 1,435 65 (73) (359) – 4 1,072 1,483 74 (73) – – (49) 1,435 $ 35,404 $ 31,179 $ 29,543 (1) Net of income tax (provision) recovery of $63 million, $(126) million and $177 million for (5) Net of income tax provision of $28 million, $45 million and $38 million for the year ended, the year ended, respectively. respectively. (2) Net of income tax (provision) recovery of $(22) million, $9 million and $(13) million for the (6) Net of income tax recovery of $144 million, $146 million and $13 million for the year ended, year ended, respectively. respectively. (3) Net of income tax provision of $37 million, $22 million and $39 million for the year ended, respectively. (4) Net of income tax (provision) recovery of $(79) million, $12 million and $10 million for the year ended, respectively. The accompanying notes are an integral part of these consolidated financial statements. Certain comparative figures have been reclassified to conform with the current year’s presentation and for changes in accounting policies – see Note 1. 126 BMO Financial Group 197th Annual Report 2014 Consolidated Statement of Cash Flows For the Year Ended October 31 (Canadian $ in millions) 2014 2013 2012 Cash Flows from Operating Activities Net Income Adjustments to determine net cash flows provided by (used in) operating activities Impairment write-down of securities, other than trading (Note 3) Net (gain) on securities, other than trading (Note 3) Net (increase) in trading securities Provision for credit losses (Note 4) Change in derivative instruments – (Increase) decrease in derivative asset – Increase (decrease) in derivative liability Amortization of premises and equipment (Note 11) Amortization of intangible assets (Note 13) Net decrease in deferred income tax asset Net (decrease) in deferred income tax liability Net decrease in current income tax asset Net increase (decrease) in current income tax liability Change in accrued interest – (Increase) decrease in interest receivable – Increase (decrease) in interest payable Changes in other items and accruals, net Net increase in deposits Net (increase) in loans Net increase (decrease) in securities sold but not yet purchased Net increase (decrease) in securities lent or sold under repurchase agreements Net (increase) decrease in securities borrowed or purchased under resale agreements Net Cash Provided by (Used in) Operating Activities Cash Flows from Financing Activities Net (decrease) in liabilities of subsidiaries Proceeds from issuance and (maturities) of Covered Bonds (Note 15) Proceeds from issuance (repayment) of subordinated debt (Note 17) Proceeds from issuance of preferred shares (Note 20) Redemption of preferred shares (Note 20) Redemption of securities of a subsidiary (Note 20) Redemption of Capital Trust Securities Share issue expense Proceeds from issuance of common shares (Note 20) Common shares repurchased for cancellation (Note 20) Cash dividends paid Cash dividends paid to non-controlling interest Net Cash (Used in) Financing Activities Cash Flows from Investing Activities Net (increase) decrease in interest bearing deposits with banks Purchases of securities, other than trading Maturities of securities, other than trading Proceeds from sales of securities, other than trading Premises and equipment – net purchases Purchased and developed software – net purchases Acquisitions (Note 12) Net Cash Provided by (Used in) Investing Activities Effect of Exchange Rate Changes on Cash and Cash Equivalents Net increase in Cash and Cash Equivalents Cash and Cash Equivalents at Beginning of Year Cash and Cash Equivalents at End of Year Represented by: Cash and non-interest bearing deposits with Bank of Canada and other banks Cheques and other items in transit, net Supplemental Disclosure of Cash Flow Information Net cash provided by operating activities includes: Amount of interest paid in the year Amount of income taxes paid in the year Amount of interest and dividend income received in the year $ 4,333 $ 4,195 $ 4,156 8 (170) (8,470) 561 (2,822) 1,402 365 382 241 (42) 546 (226) (36) 160 4,094 9,814 (15,207) 4,429 9,073 (11,362) (2,927) (48) (406) 1,000 1,200 (425) – – (16) 133 – (1,851) (52) (465) 778 (24,674) 11,698 17,184 (355) (382) (956) 3,293 2,396 2,297 26,089 28,386 27,056 1,330 28,386 17 (302) (4,392) 587 20,240 (19,195) 348 346 203 (65) 389 21 122 (129) (364) 35,739 (21,665) (1,221) (12,090) 8,660 11,444 (397) (1,354) – – (200) (359) – – 122 (675) (1,896) (73) (4,832) 43 (32,007) 13,233 17,288 (361) (254) 140 (1,918) 1,480 6,174 19,915 26,089 24,679 1,410 26,089 $ $ $ 5 (157) (251) 764 6,646 (1,826) 351 331 263 (143) 109 (185) 9 (89) (6,165) 19,413 (14,896) 3,438 7,848 (9,360) 10,261 (634) 2,000 (1,200) – (396) – (400) – 88 – (1,419) (73) (2,034) (347) (37,960) 12,672 18,868 (366) (298) (21) (7,452) (489) 286 19,629 19,915 18,363 1,552 19,915 $ $ $ 4,407$ 264 12,849 4,708 $ 4,930 $ $ 577 13,283 $ $ 654 13,685 $ $ $ $ $ $ C o n s o l i d a t e d F i n a n c i a l S t a t e m e n t s The accompanying notes are an integral part of these consolidated financial statements. Certain comparative figures have been reclassified to conform with the current year’s presentation and for changes in accounting policies – see Note 1. BMO Financial Group 197th Annual Report 2014 127 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Notes to Consolidated Financial Statements Note 1: Basis of Presentation Bank of Montreal (“the bank”) is a public company incorporated in Canada having its registered office in Montreal, Canada. We are a highly diversified financial services company and provide a broad range of retail banking, wealth management and investment banking products and services. The bank is a chartered bank under the Bank Act (Canada). We have prepared these financial statements in accordance with Specific Accounting Policies To facilitate a better understanding of our consolidated financial statements, we have disclosed our significant accounting policies throughout the following notes with the related financial disclosures by major caption: International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). We also comply with interpretations of IFRS by our regulator, the Office of the Superintendent of Financial Institutions Canada (“OSFI”). Our consolidated financial statements have been prepared on a historic cost basis, except the revaluation of the following items: assets and liabilities held for trading; financial instruments designated at fair value through profit or loss; available-for-sale financial assets; financial assets and financial liabilities designated as hedged items in qualifying fair value hedge relationships; cash-settled share-based payment liabilities; defined benefit pension and other employee future benefit liabilities; and insurance-related liabilities. These consolidated financial statements were authorized for issue by the Board of Directors on December 2, 2014. Basis of Consolidation These consolidated financial statements are inclusive of the financial statements of our subsidiaries as at October 31, 2014. We conduct business through a variety of corporate structures, including subsidiaries, joint ventures, associates and structured entities (“SEs”). Subsidiaries are those entities where we exercise control through our ownership of the majority of the voting shares. Joint ventures are those entities where we exercise joint control through an agreement with other shareholders. We also hold interests in SEs, which we consolidate where we control the SE. These are more fully described in Note 9. All of the assets, liabilities, revenues and expenses of our subsidiaries and consolidated SEs are included in our consolidated financial statements. Joint ventures are accounted for using the equity method, with our investment recorded in securities, other in our Consolidated Balance Sheet and our portion of earnings recorded in interest, dividend and fee income, securities in our Consolidated Statement of Income. All significant intercompany transactions and balances are eliminated on consolidation. We hold investments in associates, where we exert significant influence over operating, investing and financing decisions (generally companies in which we own between 20% and 50% of the voting shares). These are recorded at cost and are adjusted for our proportionate share of any net income or loss, other comprehensive income or loss and dividends. They are recorded as securities, other in our Consolidated Balance Sheet and our proportionate share of the net income or loss of these companies is recorded in interest, dividend and fee income, securities, in our Consolidated Statement of Income. Non-controlling interest in subsidiaries is presented in our Consolidated Balance Sheet as a separate component of equity that is distinct from our shareholders’ equity. The net income attributable to non-controlling interest in subsidiaries is presented separately in our Consolidated Statement of Income. s e t o N 128 BMO Financial Group 197th Annual Report 2014 Note Topic 1 2 Basis of Presentation Cash Resources and Interest Page 128 Bearing Deposits with Banks Securities Loans, Customers’ Liability under Acceptances and Allowance for Credit Losses Other Credit Instruments Risk Management Guarantees Asset Securitization Structured Entities Derivative Instruments Premises and Equipment Acquisitions Goodwill and Intangible Assets Other Assets Deposits Other Liabilities Subordinated Debt Capital Trust Securities Interest Rate Risk 132 132 136 139 140 142 143 144 146 153 153 154 156 156 157 158 159 160 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Note Topic Equity 20 Offsetting of Financial Assets 21 and Financial Liabilities Capital Management Employee Compensation – Stock-Based Compensation Employee Compensation – Pension and Other Employee Future Benefits Income Taxes Earnings Per Share Operating and Geographic Segmentation Significant Subsidiaries Related Party Transactions Provisions and Contingent Liabilities Fair Value of Financial Instruments 22 23 24 25 26 27 28 29 30 31 32 Page 161 163 163 164 166 171 173 173 176 177 178 178 Contractual Maturities of Assets and Liabilities and Off-Balance Sheet Commitments 186 Translation of Foreign Currencies We conduct business in a variety of foreign currencies and present our consolidated financial statements in Canadian dollars, which is our functional currency. Monetary assets and liabilities, as well as non- monetary assets and liabilities measured at fair value that are denominated in foreign currencies, are translated into Canadian dollars at the exchange rate in effect at the balance sheet date. Non-monetary assets and liabilities not measured at fair value are translated into Canadian dollars at historical rates. Revenues and expenses denominated in foreign currencies are translated using the average exchange rate for the year. Unrealized gains and losses arising from translating our net investment in foreign operations into Canadian dollars, net of related hedging activities and applicable income taxes, are included in our Consolidated Statement of Comprehensive Income within net gain (loss) on translation of net foreign operations. When we dispose of a foreign operation such that control, significant influence or joint control is lost, the cumulative amount of the translation gain (loss) and any applicable hedging activities and related income taxes are reclassified to profit or loss as part of the gain or loss on disposition. All other foreign currency translation gains and losses are included in foreign exchange, other than trading, in our Consolidated Statement of Income as they arise. Foreign currency translation gains and losses on available-for-sale debt securities that are denominated in foreign currencies are included in foreign exchange, other than trading, in our Consolidated Statement of Income. From time to time, we enter into foreign exchange hedge contracts to reduce our exposure to changes in the value of foreign currencies. Realized and unrealized gains and losses that arise on the mark-to- market of foreign exchange contracts related to economic hedges are included in foreign exchange, other than trading, in our Consolidated Statement of Income. Changes in the fair value of forward contracts that qualify as accounting hedges are recorded in our Consolidated Statement of Comprehensive Income, with the spot/forward differential (the difference between the foreign currency rate at the inception of the contract and the rate at the end of the contract) being recorded in interest income (expense) over the term of the hedge. Offsetting Financial Assets and Financial Liabilities Financial assets and financial liabilities are offset and the net amount is reported in the Consolidated Balance Sheet when there is a legally enforceable right to offset the recognized amounts and there is an intention to settle on a net basis, or realize the asset and settle the liability simultaneously. Dividend and Fee Income Dividend Income Dividend income is recognized when the right to receive payment is established. This is the ex-dividend date for listed equity securities. Fee Income Fee income (including commissions) is recognized based on the services or products for which the fee is paid. See Note 4 for the accounting treatment for lending fees. Securities commissions and fees and underwriting and advisory fees are recorded as revenue when the related services are completed. Deposit and payment service charges and insurance fees are recognized over the period that the related services are provided. Card fees primarily include interchange income, late fees, cash advance fees and annual fees. Card fees are recorded as billed, except for annual fees, which are recorded evenly throughout the year. Use of Estimates and Judgments The preparation of the consolidated financial statements requires management to use estimates and assumptions that affect the carrying amounts of certain assets and liabilities, certain amounts reported in net income and other related disclosures. The most significant assets and liabilities for which we must make estimates include allowance for credit losses; pension and other employee future benefits; impairment; income taxes; goodwill and intangible assets; insurance-related liabilities; purchased loans; acquired deposits and provisions. 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 8 and 9, respectively. Note 31 discusses the judgments made in determining the fair value of financial instruments. If actual results were to differ from the estimates, the impact would be recorded in future periods. We have 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 our 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 circumstances 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. Pension and other employee future benefits expense, plan assets and defined benefit obligations are also sensitive to changes in discount rates. We determine discount rates at each year end for our Canadian and U.S. plans using high-quality AA rated corporate bonds with terms matching the plans’ specific cash flows. Additional information regarding our accounting for pension and other employee future benefits is included in Note 24. Impairment of Securities We review held-to-maturity, available-for-sale and other securities at each quarter-end reporting period to identify and evaluate investments that show indications of possible impairment. For held-to-maturity, available-for-sale and other securities, impairment losses are recognized if there is objective evidence of impairment as a result of an event that reduces the estimated future cash flows from the security and the impact can be reliably estimated. Objective evidence of impairment includes default or delinquency by a debtor, restructuring of an amount due to us on terms that we would not otherwise consider, indications that a debtor or issuer will enter bankruptcy, or the disappearance of an active market for a security. In addition, for equity securities, a significant or prolonged decline in the fair value of a security below its cost is objective evidence of impairment. The decision to record a write-down, the amount and the period in which it is recorded could change if management’s assessment of the factors changes. We do not record impairment write-downs on debt securities when impairment is due to changes in market interest rates, if future contractual cash flows associated with the debt security are still expected to be recovered. Additional information regarding our accounting for held-to- maturity securities, available-for-sale securities and other securities and the determination of fair value is included in Note 3 and Note 31. Income Taxes The provision for income taxes is calculated based on the expected tax treatment of transactions recorded in our Consolidated Statements of Income or Changes in Equity. In determining the provision for income taxes, we interpret tax legislation in a variety of jurisdictions and make assumptions about the expected timing of the reversal of deferred tax assets and liabilities. If our interpretations differ from those of tax authorities or if the timing of reversals is not as expected, our provision for income taxes could increase or decrease in future periods. The amount of any such increase or decrease cannot be reasonably estimated. Deferred tax assets are recognized only when it is probable that sufficient taxable profit will be available in future periods against which deductible temporary differences may be utilized. We are required to assess whether it is probable that our deferred income tax asset will be realized prior to its expiration and, based on all the available evidence, determine if any portion of our deferred income tax asset should not be recognized. The factors used to assess the probability of realization are our past experience of income and capital gains, forecast of future net income before taxes, available tax planning strategies that could be implemented to realize the deferred income tax asset, and the remaining expiration period of tax loss carryforwards. Additional information regarding the allowance for credit losses is Additional information regarding our accounting for income taxes is included in Note 4. included in Note 25. 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, we would recognize this difference in other comprehensive income. Goodwill For the purpose of impairment testing, goodwill is allocated to our groups of cash generating units (“CGUs”), which represent the lowest level within the bank at which goodwill is monitored for internal management purposes. Impairment testing is performed at least annually, and whenever there is an indication that a CGU may be impaired, by comparing the carrying value and the recoverable amount N o t e s BMO Financial Group 197th Annual Report 2014 129 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS of the CGU to which goodwill has been allocated to determine whether the recoverable amount of the group is greater than its carrying value. If the carrying value were to exceed the recoverable amount of the group, an impairment calculation would be performed. Fair value less costs to sell was used to perform the impairment test. In determining fair value less costs to sell, we employ a discounted cash flow model consistent with those used when we acquire businesses. This model is dependent on assumptions related to revenue growth, discount rates, synergies achieved on acquisition and the availability of comparable acquisition data. Changes in any of these assumptions would affect the determination of fair value for each of the CGUs in a different manner. Management must exercise its judgment and make assumptions in determining fair value less costs to sell, and differences in judgments and assumptions could affect the determination of fair value and any resulting impairment write-down. Additional information regarding goodwill is included in Note 13. Purchased Loans Significant judgments and assumptions were made in determining the fair value of the Marshall & Ilsley Corporation (“M&I”) loan portfolio. Loans were identified as either purchased performing loans or purchased credit impaired loans (“PCI loans”), both of which were recorded at fair value at the time of acquisition. Determining the fair value involved estimating the expected cash flows to be received and determining the discount rate to be applied to the cash flows from the loan portfolio. In determining the possible discount rates, we considered various factors, including our cost to raise funds in the current market, the risk premium associated with the loans and the cost to service the portfolios. PCI loans are those where the timely collection of interest and principal was no longer reasonably assured as at the date of acquisition. Subsequent to the acquisition date, we regularly re-evaluate what we expect to collect on PCI loans. Changes in expected cash flows could result in the recognition of impairment or a recovery in our provision for credit losses. Assessing the timing and amount of cash flows requires significant management judgment regarding key assumptions, including the probability of default, severity of loss and timing of payment receipts, as well as the valuation of collateral. All of these factors are inherently subjective and can result in significant changes in cash flow estimates over the life of a loan. Subsequent to the determination of the initial fair value, the purchased performing loans are subject to the credit review processes applied to loans we originate. Additional information regarding the accounting for purchased loans is included in Note 4. Acquired Deposits M&I deposit liabilities were recorded at fair value at acquisition. The determination of fair value involved estimating the expected cash flows to be paid and determining the discount rate applied to the cash flows. Assessing the timing and amount of cash flows requires significant management judgment regarding the likelihood of early redemption by us and the timing of withdrawal by the client. Discount rates were based on the prevailing rates we were paying on similar deposits at the date of acquisition. Insurance-Related Liabilities Insurance claims and policy benefit liabilities represent current claims and estimates of future insurance policy benefits. Liabilities for life insurance contracts are determined using the Canadian Asset Liability Method, which incorporates best-estimate assumptions for mortality, morbidity, policy lapses, surrenders, future investment yields, policy dividends, administration costs and margins for adverse deviation. These assumptions are reviewed at least annually and updated to reflect actual experience and market conditions. The most significant impact on the valuation of a liability would result from a change in the assumption for future investment yields. 130 BMO Financial Group 197th Annual Report 2014 s e t o N Additional information regarding insurance-related liabilities is included in Note 16. Provisions The bank and its subsidiaries are involved in various legal actions in the ordinary course of business. Provisions are recorded at the best estimate of the amounts required to settle any obligations related to these legal actions as at the balance sheet date, taking into account the risks and uncertainties associated with the obligation. Management and internal and external experts are involved in estimating any provisions. The actual costs of resolving these claims may be substantially higher or lower than the amounts of the provisions. Additional information regarding provisions is provided in Note 30. Significant Judgments Applied in Assessing Control For most of our subsidiaries, control is determined based on holding the majority of the voting rights. For certain investments in limited partnerships, we exercise judgment in determining if we control an entity. Based on an assessment of our interests and rights, we have determined that we do not control certain entities, even though we may have an ownership interest greater than 50%. This may be the case when we are not the general partner in an arrangement and the general partner’s rights most significantly affect the returns of the entity. Additionally, we have determined that we control certain entities despite having an ownership interest less than 50%. This may be the case when we are the general partner in an arrangement and the general partner’s rights most significantly affect the returns of the entity. We also exercise judgment in determining if we control structured entities. Structured entities are discussed in greater detail in Note 9. Changes In Accounting Policies Effective November 1, 2013, we adopted the following new and amended accounting pronouncements issued by the IASB. Employee Benefits On November 1, 2013, we adopted revisions to IAS 19 Employee Benefits (“IAS 19”) that amend the measurement, presentation and disclosure requirements for employee benefit plans. The standard has been applied retroactively and the comparative periods in our Consolidated Balance Sheet, Statement of Income and Statement of Comprehensive Income have been restated. The amendments to IAS 19 require the full funded status of our pension and other employee future benefit plans to be reflected as the net defined benefit liability or asset in the Consolidated Balance Sheet. Actuarial gains and losses are recognized immediately in Other Comprehensive Income (“OCI”) and are no longer deferred and amortized into income. Past service costs resulting from plan amendments are immediately recognized in income when a plan is amended, without regard to vesting. Interest costs and expected return on plan assets under the previous version of IAS 19 have been replaced with a net interest cost or revenue calculated by applying the discount rate to the net defined benefit liability or asset. Further, these amendments also require enhanced disclosures about the characteristics of those plans and the risks to which the bank is exposed through participation in those plans. Additional disclosures are included in Note 24 to comply with these requirements. Presentation of Financial Statements Amendments to IAS 1 Presentation of Financial Statements require items within OCI to be presented separately based on whether or not the item will subsequently be reclassified into net income. The new presentation was adopted on a retroactive basis together with the amendments to IAS 19. Actuarial gains and losses that are recognized directly in OCI under IAS 19 remain in OCI and will never be reclassified to net income. Consolidated Financial Statements and Accounting for Joint Ventures IFRS 10 Consolidated Financial Statements (“IFRS 10”) provides a single consolidation model that defines control and establishes control as the basis for consolidation for all types of interests. Under IFRS 10, we control an entity when we have power over the entity, exposure or rights to variable returns from our involvement, and the ability to exercise power to affect the amount of our returns. The adoption of IFRS 10 resulted in the deconsolidation of BMO Subordinated Notes Trust, BMO Capital Trust II and certain of our Canadian customer securitization vehicles as disclosed in Note 9. The standard has been applied retroactively and comparative periods have been restated. IFRS 11 Joint Arrangements (“IFRS 11”) requires joint ventures to be accounted for using the equity method. With the adoption of IFRS 11, we changed the accounting for a joint venture from proportionate consolidation to the equity method of accounting. The impact of retroactive adoption was to record a net investment in joint venture in securities, other and record our portion of the earnings from the joint venture in interest, dividend and fee income, securities in our Consolidated Statement of Income. The following table summarizes the impact of adoption of IAS 19, IFRS 10 and IFRS 11 on our prior period consolidated financial statements: As at October 31, 2013 (Canadian $ in millions) Increase (decrease) in IFRS 10 and 11 IAS 19 Cash Securities Loans, business and governments Premises and equipment Goodwill Intangible assets Deferred tax asset Other assets Deposits, business and governments Capital trust securities Other liabilities 6 819 199 (23) (74) (19) – (948) 1,548 (463) (1,123) – – – – – – 116 (331) – – 85 Accumulated other comprehensive income Retained earnings – (2) (165) (135) Net income attributable to bank shareholders for the year ended October 31, 2013 decreased by $55 million after tax, as a result of the retroactive adoption of amended IAS 19, IFRS 10 and IFRS 11. Basic and diluted earnings per share for the year ended October 31, 2013 was $6.19 and $6.17, respectively. An opening balance sheet has not been presented as the impact of transition is not material to the financial statements. Interests in Other Entities We also adopted IFRS 12 Disclosure of Interests in Other Entities (“IFRS 12”). IFRS 12 sets out the disclosure requirements for all forms of interests in other entities, including subsidiaries, joint arrangements, associates and unconsolidated structured entities. This new standard requires disclosure of the nature of our interests in other entities, and for unconsolidated structured entities, disclosure of risks associated with and the effects of these interests on our financial position, financial performance and cash flows. The additional disclosures required are included in Note 9 and Note 28. Fair Value Measurement We adopted IFRS 13 Fair Value Measurement (“IFRS 13”), which provides a common definition of fair value and establishes a framework for measuring fair value. The new standard also requires additional disclosures about fair value measurements. The new standard did not have a significant impact on our consolidated financial statements. The additional disclosures required by the standard are included in Note 31. Offsetting Financial Assets and Financial Liabilities We adopted the amendments to IFRS 7 Financial Instruments: Disclosures – Offsetting Financial Assets and Financial Liabilities (“IFRS 7 amendment”), which contain new disclosure requirements for financial assets and financial liabilities that are offset in the balance sheet or subject to master netting agreements or other similar arrangements. The additional disclosures required by the IFRS 7 amendment are included in Note 21. Future Changes in IFRS Impairment of Assets In May 2013, the IASB issued narrow-scope amendments to IAS 36 Impairment of Assets. These amendments address the disclosure of information about the recoverable amount of impaired assets if that amount is based on fair value less costs of disposal. The amendments are effective for our fiscal year beginning November 1, 2014. We do not expect the amendments to have a significant disclosure impact on our consolidated financial statements. Offsetting Financial Assets and Financial Liabilities In December 2011, the IASB issued amendments to IAS 32 Offsetting Financial Assets and Financial Liabilities (“IAS 32”). The amendments clarify that an entity has a current legally enforceable right to offset if that right is not contingent on a future event, and that right is enforceable both in the normal course of business and in the event of default, insolvency or bankruptcy of the entity and all counterparties. The amendments are effective for our fiscal year beginning November 1, 2014. We do not expect these amendments to have a significant impact on our consolidated financial statement. Financial Instruments In July 2014, the IASB issued IFRS 9 Financial Instruments (“IFRS 9”), which addresses classification and measurement, impairment and hedge accounting. The new standard requires assets to be classified based on our business model for managing the financial assets and the contractual cash flow characteristics of the financial assets. Financial assets will be measured at fair value through profit or loss unless certain conditions are met which permit measurement at amortized cost or fair value through other comprehensive income. The classification and measurement of liabilities remain generally unchanged, with the exception of liabilities recorded at fair value through profit and loss. For financial liabilities designated at fair value through profit and loss, IFRS 9 requires the presentation of the effects of changes in our own credit risk in OCI instead of net income. IFRS 9 introduces a new single impairment model for financial assets. The new model is based on expected credit losses and will result in credit losses being recognized regardless of whether a loss event has occurred. The expected credit loss model will apply to most financial instruments not measured at fair value, with the most significant impact being to loans. The expected credit loss model requires the recognition of credit losses based on a 12-month time horizon for performing loans and requires the recognition of lifetime expected credit losses for loans that experience a significant deterioration in credit risk since inception. IFRS 9 also introduces a new hedge accounting model that expands the scope of eligible hedged items and risks eligible for hedge accounting and aligns hedge accounting more closely with risk management. The new model no longer specifies quantitative measures for effectiveness testing and does not permit hedge de-designation. IFRS 9 is effective for our fiscal year beginning on November 1, 2018; early adoption is permitted. Additionally, the own credit risk presentation requirements can be early adopted prior to adopting the other requirements of IFRS 9. We are currently assessing the impact of this new standard on our future financial results. BMO Financial Group 197th Annual Report 2014 131 N o t e s NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Investment Entities In October 2012, the IASB issued amendments to IFRS 10, IFRS 12 and IAS 27 Separate Financial Statements, which introduce an exception to the principle that all subsidiaries are to be consolidated. The amendments require a parent that is an investment entity to measure its investments in particular subsidiaries at fair value through profit or loss instead of consolidating all subsidiaries in its consolidated financial statements. The amendments are effective for our fiscal year beginning November 1, 2014. We do not expect these amendments to have a significant impact on our consolidated financial statements as we are not considered to be an investment entity. Levies In May 2013, the IFRS Interpretations Committee (“IFRIC”) issued IFRIC 21 Levies, which provides guidance on when to recognize a liability to pay a levy imposed by a government on an entity in accordance with legislation. IFRIC 21 is effective for our fiscal year beginning November 1, 2014. We do not expect this interpretation to have a significant impact on our consolidated financial statements. Revenue In May 2014, the IASB issued IFRS 15 Revenue from Contracts with Customers (“IFRS 15”), which replaces the existing standards for revenue recognition. The new standard establishes a framework for the recognition and measurement of revenues generated from contracts with customers, except for items such as financial instruments, insurance contracts and leases. The new standard also requires additional disclosures about the nature, amount, timing and uncertainty of revenues and cash flows arising from transactions with our customers. IFRS 15 is effective for our fiscal year beginning November 1, 2017. We are currently assessing the impact of the standard on our future financial results. Note 2: Cash Resources and Interest Bearing Deposits with Banks (Canadian $ in millions) Cash and deposits with banks (1) Cheques and other items in transit, net Total cash and cash equivalents 2014 2013 27,056 1,330 24,679 1,410 28,386 26,089 (1) Deposits with banks include deposits with the Bank of Canada, the U.S. Federal Reserve and other banks. Cheques and Other Items in Transit, Net Cheques and other items in transit are recorded at cost and represent the net position of the uncleared cheques and other items in transit between us and other banks. Cash Restrictions Some of our foreign operations are required to maintain reserves or minimum balances with central banks in their respective countries of operation amounting to $1,638 million as at October 31, 2014 ($1,211 million in 2013). Interest Bearing Deposits with Banks Deposits with banks are recorded at amortized cost and include acceptances we have purchased that were issued by other banks. Interest income earned on these deposits is recorded on an accrual basis. Note 3: Securities Securities are divided into four types, each with a different purpose and accounting treatment. The types of securities we hold are as follows: Trading securities are securities that we purchase for resale over a short period of time. We report these securities at their fair value and record the fair value changes and transaction costs in our Consolidated Statement of Income in trading revenues. Securities Designated at Fair Value Securities designated at fair value through profit or loss are financial instruments that are accounted for at fair value, with changes in fair value recorded in income provided they meet certain criteria. Securities designated at fair value through profit or loss must have reliably measurable fair values and satisfy one of the following criteria: (1) accounting for them at fair value eliminates or significantly reduces an inconsistency in measurement or recognition that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on a different basis; (2) the securities are part of a group of financial assets, financial liabilities or both that is managed and has its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and is reported to key management personnel on a fair value basis; or (3) the securities are hybrid financial instruments with one or more embedded derivatives that would otherwise have to be bifurcated and accounted for separately from the host contract. Financial instruments must be designated on initial recognition, and the designation is irrevocable. If these securities were not designated at fair value, they would be accounted for as available-for-sale securities with unrealized gains and losses recorded in other comprehensive income. We designate certain securities held by our insurance subsidiaries that support our insurance liabilities at fair value through profit or loss 132 BMO Financial Group 197th Annual Report 2014 s e t o N since the actuarial calculation of insurance liabilities is based on the fair value of the investments supporting them. This designation aligns the accounting result with the way the portfolio is managed on a fair value basis. The fair value of these investments as at October 31, 2014 of $6,599 million ($5,766 million in 2013) is recorded in securities, trading in our Consolidated Balance Sheet. The impact of recording these investments at fair value through profit or loss was an increase of $379 million in non-interest revenue, insurance income for the year ended October 31, 2014 (decrease of $178 million in 2013). Changes in the insurance liability balances are also recorded in non-interest revenue, insurance income. As at October 31, 2014, our credit protection vehicle held only cash and cash equivalents. During 2013, this vehicle held investments that were designated at fair value through profit or loss, which aligned the accounting result with the way the portfolio was managed on a fair value basis. The impact of recording these investments at fair value through profit or loss in 2013 was a decrease in non-interest revenue, trading revenue of $40 million. We recognized offsetting amounts for derivative contracts that were held to hedge changes in fair value of those instruments. Additional information relating to our credit protection vehicle is included in Note 9. We designate certain investments held in our merchant banking business at fair value through profit or loss, which aligns the accounting result with the way the portfolio is managed. The fair value of these investments as at October 31, 2014 of $467 million ($488 million in 2013) is recorded in securities, other in our Consolidated Balance Sheet. The impact of recording these investments at fair value through profit or loss was an increase in non-interest revenue, securities gains, other than trading of $28 million in our Consolidated Statement of Income for the year ended October 31, 2014 (decrease of $18 million in 2013). Available-for-sale securities consist of debt and equity securities that may be sold in response to or in anticipation of changes in interest rates and resulting prepayment risk, changes in foreign currency risk, changes in funding sources or terms, or to meet liquidity needs. Available-for-sale securities are initially recorded at fair value plus transaction costs. They are subsequently re-measured at fair value with unrealized gains and losses recorded in unrealized gains (losses) on available-for-sale securities in our Consolidated Statement of Comprehensive Income until the security is sold. Gains and losses on disposal and impairment losses are recorded in our Consolidated Statement of Income in non-interest revenue, securities gains, other than trading. Interest income earned and dividends received on available-for-sale securities are recorded in our Consolidated Statement of Income in interest, dividend and fee income, securities. Investments held by our insurance operations are classified as available-for-sale securities, except for those investments that support the policy benefit liabilities on our insurance contracts, which are designated at fair value through profit or loss as discussed above. Interest and other fee income on the insurance available-for-sale securities is recognized when earned in our Consolidated Statement of Income in non-interest revenue, insurance income. Held-to-maturity securities are debt securities that we have the intention and ability to hold to maturity. These securities are initially recorded at fair value plus transaction costs and subsequently re- measured at amortized cost using the effective interest method. Gains and losses on disposal and impairment losses are recorded in our Consolidated Statement of Income in securities gains (losses), other than trading. Interest income earned and amortization of premiums or discounts on the debt securities are recorded in our Consolidated Statement of Income in interest, dividend and fee income, securities. Other securities are investments in companies where we exert significant influence over operating, investing and financing decisions (generally companies in which we own between 20% and 50% of the voting shares) and certain securities held by our merchant banking business. We account for all of our securities transactions using settlement date accounting in our Consolidated Balance Sheet. Changes in fair value between the trade date and settlement date are recorded in net income. For available-for-sale securities, changes in fair value between the trade date and settlement date are recorded in other comprehensive income. Impairment Review For available-for-sale, held-to-maturity and other securities, impairment losses are recognized if there is objective evidence of impairment as a result of an event that reduces the estimated future cash flows from the security and the impact can be reliably estimated. For equity securities, a significant or prolonged decline in the fair value of a security below its cost is considered to be objective evidence of impairment. The impairment loss on available-for-sale securities is the difference between the cost/amortized cost and current fair value, less any previously recognized impairment losses. The impairment loss on held-to-maturity securities is the difference between a security’s carrying amount and the present value of estimated future cash flows discounted at the asset’s original effective interest rate. If there is objective evidence of impairment, a write-down is recorded in our Consolidated Statement of Income in securities gains, other than trading. For debt securities, a previous impairment loss is reversed through net income if an event occurs after the impairment was recognized that can be objectively attributed to an increase in fair value, to a maximum of the original impairment charge. Reversals of impairment losses on held-to-maturity securities are recorded to a maximum of the amortized cost of the investment before the original impairment charge. For equity securities, previous impairment losses are not reversed through net income and any subsequent increases in fair value are recorded in other comprehensive income. As at October 31, 2014, we had 565 available-for-sale securities (979 in 2013) with unrealized losses totalling $35 million (unrealized losses of $96 million in 2013). Of these available-for-sale securities, 203 have been in an unrealized loss position continuously for more than one year (44 in 2013), amounting to an unrealized loss position of $20 million (unrealized loss position of $5 million in 2013). Unrealized losses on these instruments, excluding corporate equities, resulted from changes in interest rates and not from deterioration in the creditworthiness of the issuers. We expect full recovery of these available-for-sale instruments and have determined that there is no significant impairment. We did not own any securities issued by a single non-government entity where the book value, as at October 31, 2014 or 2013, was greater than 10% of our shareholders’ equity. Fair Value Measurement For traded securities, quoted market value is considered to be fair value. Quoted market value is based on bid prices. For securities where market quotes are not available, we use estimation techniques to determine fair value. Discussion of fair value measurement is included in Note 31. N o t e s BMO Financial Group 197th Annual Report 2014 133 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Canadian $ in millions, except as noted) Trading Securities Issued or guaranteed by: Canadian federal government Canadian provincial and municipal governments U.S. federal government U.S. states, municipalities and agencies Other governments Mortgage-backed securities and collateralized mortgage obligations Corporate debt Corporate equity Total trading securities Available-for-Sale Securities Issued or guaranteed by: Canadian federal government Amortized cost Fair value Yield (%) Canadian provincial and municipal governments Amortized cost Fair value Yield (%) U.S. federal government Amortized cost Fair value Yield (%) U.S. states, municipalities and agencies Amortized cost Fair value Yield (%) Other governments Amortized cost Fair value Yield (%) Mortgage-backed securities and collateralized mortgage obligations – Canada (1) Amortized cost Fair value Yield (%) Mortgage-backed securities and collateralized mortgage obligations – U.S. Amortized cost Fair value Yield (%) Corporate debt Amortized cost Fair value Yield (%) Corporate equity Amortized cost Fair value Yield (%) Total cost or amortized cost Total fair value Yield (%) Held-to-Maturity Securities Issued or guaranteed by: Canadian federal government Amortized cost Fair value Canadian provincial and municipal governments Amortized cost Fair value Mortgage-backed securities and collateralized mortgage obligations – Canada (1) Amortized cost Fair value Total cost or amortized cost Total fair value Other Securities Carrying value Fair value Total carrying value or amortized cost of securities Total securities value Total by Currency (in Canadian $ equivalent) Canadian dollar U.S. dollar Other currencies Total securities s e t o N (1) These amounts are supported by insured mortgages. Term to maturity 2014 2013 Within 1 year 1 to 3 years 3 to 5 years 5 to 10 years Over 10 years Total Total 2,306 1,925 1,029 109 3 35 1,362 – 1,522 2,899 665 219 – 40 5,296 47,732 10,462 7,196 6,165 711 223 702 11,831 47,732 6,769 58,373 85,022 10,824 5,711 5,903 759 136 652 11,087 40,087 75,159 1,518 586 871 84 97 170 1,577 – 4,903 156 156 0.95 67 67 1.05 233 233 0.41 492 493 0.82 1,701 1,703 1.32 104 104 1.70 2 2 1.74 4,146 1,013 1,986 273 91 399 1,982 – 9,890 4,669 4,693 1.17 765 771 1.40 – – – 2,299 2,307 0.49 2,493 2,497 1.23 791 795 1.78 5 5 2.16 1,002 1,006 0.86 3,977 4,033 1.75 – – – – – – 970 773 1,614 26 32 58 1,614 – 5,087 5,105 5,159 1.82 1,800 1,812 1.72 861 860 1.43 1,097 1,107 0.84 1,876 1,886 1.42 2,124 2,142 1.93 17 18 1.36 1,703 1,712 1.95 – – – 490 493 2.00 1,431 1,454 2.59 – – – 923 948 2.35 46 46 1.88 12 13 5.15 221 223 1.92 895 915 3.02 – – – 3,757 14,999 14,583 3,764 15,101 14,696 1.07 1.27 1.69 4,018 4,092 2.52 100 100 – – 405 405 505 505 15 15 477 477 966 971 578 593 1,855 1,865 966 971 686 733 2,021 2,041 3,507 3,569 – – 45 45 – – 600 616 – – 600 616 19 19 – – – – – – – – – 950 960 1.47 – – – – – – 6,627 6,647 0.88 – – – 1,582 1,706 2.25 9,159 9,313 1.18 – – – – 3,711 3,759 3,711 3,759 908 2,227 10,420 10,501 1.52 12,989 13,115 1.53 4,063 4,104 1.96 1,094 1,093 1.21 5,761 5,815 1.04 6,116 6,132 1.32 3,031 3,054 1.90 6,872 6,895 0.92 7,577 7,666 1.83 1,582 1,706 2.25 46,516 46,966 1.48 2,432 2,442 2,532 2,558 5,380 5,490 10,344 10,490 987 2,306 3,707 3,698 2.00 4,650 4,660 0.39 5,363 5,392 0.90 6,165 6,163 1.39 2,271 2,277 1.83 6,535 6,528 1.16 10,210 10,317 1.40 1,413 1,560 1.90 53,303 53,710 1.33 2,432 2,435 2,284 2,290 1,316 1,316 6,032 6,041 899 2,410 9,180 26,910 23,222 11,406 72,151 142,869 135,393 9,187 27,012 23,335 11,480 72,305 143,319 135,800 5,046 3,324 817 15,621 10,330 1,061 15,178 7,714 443 8,384 3,096 – 49,897 22,116 292 94,126 46,580 2,613 90,100 42,690 3,010 9,187 27,012 23,335 11,480 72,305 143,319 135,800 Yields in the table above are calculated using the cost of the security and the contractual interest or stated dividend rates associated with each security adjusted for any amortization of premiums and discounts. Tax effects are not taken into consideration. The term to maturity included in the table above is based on the contractual maturity date of the security. The term to maturity of mortgage- backed securities and collateralized mortgage obligations is based on average expected maturities. Actual maturities could differ as issuers may have the right to call or prepay obligations. Securities with no maturity date are included in the over 10 years category. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. 134 BMO Financial Group 197th Annual Report 2014 Unrealized Gains and Losses (Canadian $ in millions) Issued or guaranteed by: Canadian federal government Canadian provincial and municipal governments U.S. federal government U.S. states, municipalities and agencies Other governments Mortgage-backed securities and collateralized mortgage obligations – Canada (1) Mortgage-backed securities and collateralized mortgage obligations – U.S. Corporate debt Corporate equity Total 2014 Amortized cost Gross unrealized gains Gross unrealized losses Fair value Amortized cost Gross unrealized gains Gross unrealized losses 2013 Fair value 10,420 4,063 1,094 5,761 6,116 3,031 6,872 7,577 1,582 46,516 82 44 2 57 17 24 35 95 129 485 1 10,501 4,104 3 1,093 3 5,815 3 6,132 1 3,054 1 6,895 12 7,666 6 1,706 5 12,989 3,707 4,650 5,363 6,165 2,271 6,535 10,210 1,413 35 46,966 53,303 129 23 10 41 7 6 24 115 148 503 32 – 12 9 – 31 3 13,115 3,698 4,660 5,392 6,163 2,277 6,528 8 10,317 1,560 1 96 53,710 (1) These amounts are supported by insured mortgages. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Unrealized Losses (Canadian $ in millions) Available-for-sale securities in an unrealized loss position for Less than 12 months 12 months or longer Gross unrealized losses Gross unrealized losses Fair value Gross unrealized losses Fair value Available-for-sale securities in an unrealized loss position for Less than 12 months 12 months or longer Gross unrealized losses Gross unrealized losses Fair value Gross unrealized losses Fair value 2014 Total Fair value 2013 Total Fair value Issued or guaranteed by: Canadian federal government Canadian provincial and municipal governments U.S. federal government U.S. states, municipalities and agencies Other governments Mortgage-backed securities and collateralized mortgage obligations – Canada (1) Mortgage-backed securities and collateralized mortgage obligations – U.S. Corporate debt Corporate equity 666 1 280 – 579 3 916 – 158 – 1 657 5 1,969 822 1 40 4 – – 487 3 – – 3 732 1 1,003 – – 7 1,630 773 5 27 1 666 1 767 3 3 579 3 1,648 1 1,161 657 1 12 3,599 6 1,595 67 5 – 3 721 30 1,662 – 11 1,385 8 1,142 74 – 30 4,005 8 2,753 96 1 Total 15 6,087 20 4,652 35 10,739 91 11,838 (1) These amounts are supported by insured mortgages. Income from securities has been included in our consolidated financial statements as follows: – – 26 2 – – 1 317 1 1,316 – – 143 1 37 – 2 – 5 1,841 – 3 721 32 1,688 – 12 1,702 9 2,458 74 – 31 4,148 8 2,790 98 1 96 13,679 (Canadian $ in millions) Reported in Consolidated Statement of Income: Interest, Dividend and Fee Income (1) Trading securities (2) Available-for-sale securities Held-to-maturity securities Other securities Non-Interest Revenue Available-for-sale securities Gross realized gains Gross realized losses Unrealized gain on investment reclassified from equity to available-for-sale Available-for-sale and other securities, net realized and unrealized gains (losses) Impairment write-downs Securities gains (losses), other than trading (1) Trading securities, net realized and unrealized gains (losses) (1) (2) Total income from securities 2014 2013 2012 1,086 570 152 186 1,994 1,409 610 47 210 1,621 561 1 213 2,276 2,396 304 (167) – 33 (8) 162 340 90 (3) 191 24 (17) 285 (1,273) 153 (24) – 28 (5) 152 374 2,496 1,288 2,922 (1) The following amounts of income related to our insurance operations were included in non-interest revenue, insurance income in our Consolidated Statement of Income: Interest, dividend and fee income of $263 million for the year ended October 31, 2014 ($263 million in 2013 and $253 million in 2012). Securities gains (losses), other than trading of $5 million for the year ended October 31, 2014 ($1 million in 2013 and $nil in 2012). (2) Excluded from the table above are trading securities, net realized and unrealized gains (losses) related to our insurance operations of $379 million for the year ended October 31, 2014 ($(190) million in 2013 and $286 million in 2012). Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. N o t e s BMO Financial Group 197th Annual Report 2014 135 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 4: Loans, Customers’ Liability under Acceptances and Allowance for Credit Losses Loans Loans are initially measured at fair value plus directly attributable costs, and are subsequently measured at amortized cost using the effective interest method. The effective interest method allocates interest income over the expected term of the loan by applying the effective interest rate to the carrying amount of the loan. The effective interest rate is defined as the rate that exactly discounts estimated future cash receipts through the expected term of the loan to the net carrying amount of the loan. Under the effective interest method, the amount recognized in interest, dividend and fee income, loans, varies over the term of the loan based on the principal outstanding. The treatment of interest income for impaired loans is described below. Securities Borrowed or Purchased Under Resale Agreements Securities borrowed or purchased under resale agreements represent the amounts we will receive as a result of our commitment to resell securities that we have purchased, back to the original seller, on a specified date at a specified price. We account for these instruments as if they were loans. Lending Fees The accounting treatment for lending fees varies depending on the transaction. Some loan origination, restructuring and renegotiation fees are recorded as interest income over the term of the loan, while other lending fees, to a certain threshold, are taken into income at the time of loan origination. Commitment fees are recorded as interest income over the term of the loan, unless we believe the loan commitment will not be used. In the latter case, commitment fees are recorded as lending fees over the commitment period. Loan syndication fees are included in lending fees as the syndication is completed, unless the yield on any loans we retain is less than that of other comparable lenders involved in the financing. In the latter case, an appropriate portion of the syndication fee is recorded as interest income over the term of the loan. Customers’ Liability under Acceptances Acceptances represent a form of negotiable short-term debt that is issued by our customers, which we guarantee for a fee. We have offsetting claims, equal to the amount of the acceptances, against our customers in the event of a call on these commitments. The amount due under acceptances is recorded in other liabilities and our corresponding claim is recorded as a loan in our Consolidated Balance Sheet. Fees earned are recorded in lending fees in our Consolidated Statement of Income over the term of the acceptance. Impaired Loans Generally consumer loans in both Canada and the U.S. are classified as impaired when payment is contractually 90 days past due, or one year past due for residential mortgages if guaranteed by the Government of Canada. Credit card loans are immediately written off when principal or interest payments are 180 days past due, and are not reported as impaired. In Canada, consumer instalment loans, other personal loans and some small business loans are normally written off when they are one year past due. In the U.S., all consumer loans are written off when they are 180 days past due, except for non-real estate term loans, which are written off at 120 days. For the purpose of measuring the amount to be written off, the determination of the recoverable amount includes an estimate of future recoveries. Corporate and commercial loans are classified as impaired when we determine there is no longer reasonable assurance that principal or interest will be collected in its entirety on a timely basis. Generally, corporate and commercial loans are considered impaired when payments are 90 days past due, or for fully secured loans, when 136 BMO Financial Group 197th Annual Report 2014 payments are 180 days past due. Corporate and commercial loans are written off following a review on an individual loan basis that confirms all recovery attempts have been exhausted. Our average gross impaired loans and acceptances were $2,261 million for the year ended October 31, 2014 ($2,800 million in 2013). Our average impaired loans, net of the specific allowance, were $1,783 million for the year ended October 31, 2014 ($2,354 million in 2013). During the year ended October 31, 2014, we recorded a net gain of $12 million (net gain of $46 million in 2013) on the sale of impaired loans. Once a loan is identified as impaired, we continue to recognize interest income based on the original effective interest rate of the loan. Interest income on impaired loans of $111 million was recognized for the year ended October 31, 2014 ($133 million in 2013). A loan will be reclassified back to performing status when we determine that there is reasonable assurance of full and timely repayment of interest and principal in accordance with the terms and conditions of the loan, and that none of the criteria for classification of the loan as impaired continue to apply. Allowance for Credit Losses (“ACL”) The allowance for credit losses recorded in our Consolidated Balance Sheet is maintained at a level that we consider adequate to absorb credit-related losses on our loans, customers’ liability under acceptances and other credit instruments. The portion related to other credit instruments is recorded in other liabilities in our Consolidated Balance Sheet and amounted to $232 million as at October 31, 2014 ($305 million in 2013). The allowance is comprised of a specific allowance and a collective allowance. Specific Allowance These allowances are recorded for individually identified impaired loans to reduce their carrying value to the expected recoverable amount. We review our loans and acceptances on an ongoing basis to assess whether any loans should be classified as impaired and whether an allowance or write-off should be recorded (other than credit card loans, which are classified as impaired and written off when principal or interest payments are 180 days past due, as discussed under impaired loans). The review of individually significant problem loans is conducted at least quarterly by the account managers, each of whom assesses the ultimate collectability and estimated recoveries for a specific loan based on all events and conditions that are relevant to the loan. This assessment is then approved by an independent credit officer. Individually Significant Impaired Loans To determine the amount we expect to recover from an individually significant impaired loan, we use the value of the estimated future cash flows discounted at the loan’s original effective interest rate. The determination of estimated future cash flows of a collateralized loan reflects the expected realization of the underlying security net of expected costs and any amounts legally required to be paid to the borrower. Security can vary by type of loan and may include cash, securities, real properties, accounts receivable, guarantees, inventory or other capital assets. Individually Insignificant Impaired Loans Residential mortgages, consumer instalment and other personal loans are individually insignificant and thus are collectively assessed for impairment, taking into account historical loss experience. In the periods following the recognition of impairment, adjustments to the allowance for these loans reflecting the time value of money are recognized and presented as interest income. s e t o N Collective Allowance We maintain a collective allowance in order to cover any impairment in the existing portfolio for loans that have not yet been individually identified as impaired. Our approach to establishing and maintaining the collective allowance is based on the requirements of IFRS, considering guidelines issued by our regulator, OSFI. The collective allowance methodology incorporates both quantitative and qualitative factors to determine an appropriate level for the collective allowance. For the purpose of calculating the collective allowance, we group loans on the basis of similarities in credit risk characteristics. The loss factors for groups of loans are determined based on a minimum of five years of historical data and a one-year loss emergence period, except for credit cards, where a seven-month loss emergence period is used. The loss factors are back-tested and calibrated on a regular basis to ensure that they continue to reflect our best estimate of losses that have been incurred but not yet identified, on an individual basis, within the pools of loans. Historical loss experience is also reviewed to determine loss factors. Qualitative factors are based on current observable data such as current macroeconomic and business conditions, portfolio-specific considerations, model risk factors, and the level of impaired loans for which a specific allowance has not yet been assessed. Provision for Credit Losses (“PCL”) Changes in the value of our loan portfolio due to credit-related losses or recoveries of amounts previously provided for or written off are included in the provision for credit losses in our Consolidated Statement of Income. Loans, including customers’ liability under acceptances and allowance for credit losses, by category are as follows: (Canadian $ in millions) Residential mortgages (1) Credit card, consumer instalment and other personal loans Business and government loans Customers’ liability under acceptances Total 2014 2013 2012 2014 2013 2012 2014 2013 2012 2014 2013 2012 2014 2013 2012 Gross loan balances at end of year (3) 101,013 96,392 84,211 72,115 71,510 69,250 120,766 104,585 94,072 10,878 8,472 8,019 304,772 280,959 255,552 Impairment Allowances (Specific ACL), beginning of year Amounts written off Recoveries of amounts written off in previous years Charge to income statement (Specific PCL) Foreign exchange and other 99 (87) 76 (104) 74 (173) 71 (655) 62 (750) 59 (882) 315 (407) 338 (443) 426 (538) 40 77 24 60 161 152 156 423 596 630 129 132 519 618 742 (35) (150) (113) movements (16) (26) (17) (22) (11) (13) (59) (26) (67) 74 71 62 622 624 565 237 756 315 759 338 817 – – – – – – – – – – – – – – – – – – 485 (1,149) 476 (1,297) 559 (1,593) 624 561 (97) 424 772 597 (63) 485 846 761 (97) 476 19 30 34 1,485 1,460 1,452 Specific ACL, end of year Collective ACL, beginning of year Charge to income statement (Collective PCL) Foreign exchange and other movements Collective ACL, end of year Total ACL Comprised of: Loans Other credit 113 88 (8) 3 83 196 169 99 47 40 1 88 76 36 11 – 47 187 167 123 113 50 6 678 752 752 (4) 59 (50) (35) (63) 2 622 693 693 – 624 686 686 48 754 991 786 32 756 5 759 1,071 1,097 786 877 8 – 27 27 27 (11) (4) – 19 19 19 – 30 30 30 – 57 (10) 35 3 5 1,542 1,485 1,460 1,966 1,970 1,936 1,734 1,665 1,706 instruments (2) 27 20 10 – – – 205 285 220 – – – 232 305 230 Net loan balances at end of year 100,844 96,225 84,098 71,363 70,817 68,564 119,980 103,799 93,195 10,851 8,453 7,989 303,038 279,294 253,846 (1) Included in the residential mortgages balance are Canadian government and corporate- (3) Included in loans as at October 31, 2014 are $95,269 million ($81,069 million in 2013 and insured mortgages of $58 billion as at October 31, 2014 ($52 billion in 2013). (2) The total specific and collective allowances related to other credit instruments are included in other liabilities. $72,904 million in 2012) of loans denominated in U.S. dollars and $1,039 million ($947 million in 2013 and $622 million in 2012) of loans denominated in other foreign currencies. Certain comparative figures have been reclassified to conform with the current year’s presentation and changes in accounting policies – see Note 1. Loans, including customers’ liability under acceptances and allowance for credit losses, by geographic region are as follows: (Canadian $ in millions) By geographic region (1): Canada United States Other countries Total Gross amount Specific allowance (2) Collective allowance (3) Net amount 2014 2013 2014 2013 2014 2013 2014 2013 213,490 80,135 11,147 203,496 68,505 8,958 304,772 280,959 191 182 1 374 244 196 4 444 766 594 – 726 495 – 212,533 79,359 11,146 202,526 67,814 8,954 1,360 1,221 303,038 279,294 (1) Geographic region is based upon the country of ultimate risk. (2) Excludes specific allowance of $50 million for other credit instruments ($41 million in 2013), (3) Excludes collective allowance of $182 million for other credit instruments ($264 million in 2013), which is included in other liabilities. which is included in other liabilities. Certain comparative figures have been reclassified to conform with the current year’s presentation and changes in accounting policies – see Note 1. N o t e s BMO Financial Group 197th Annual Report 2014 137 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Impaired loans, including the related allowances, are as follows: (Canadian $ in millions) Gross impaired amount Specific allowance (3) Net of specific allowance Residential mortgages Consumer instalment and other personal loans Business and government loans Total (1) By geographic region (2): Canada United States Other countries Total 2014 532 544 972 2,048 742 1,301 5 2,048 2013 595 455 1,494 2,544 754 1,783 7 2,544 2014 86 74 214 374 191 182 1 374 2013 79 71 294 444 244 196 4 444 2014 446 470 758 1,674 551 1,119 4 1,674 2013 516 384 1,200 2,100 510 1,587 3 2,100 (1) Excludes purchased credit impaired loans. (2) Geographic region is based upon the country of ultimate risk. (3) Excludes specific allowance of $50 million for other credit instruments ($41 million in 2013), Fully secured loans with past due amounts between 90 and 180 days that we have not classified as impaired totalled $134 million and $256 million as at October 31, 2014 and 2013, respectively. which is included in other liabilities. Specific provisions for credit losses by geographic region are as follows: (Canadian $ in millions) For the year ended October 31 By geographic region (1): Canada United States Other countries Total Residential mortgages Credit card, consumer instalment and other personal loans Business and government loans (2) Total 2014 2013 2014 2013 2014 2013 2014 2013 12 65 – 77 4 125 – 129 410 109 – 519 431 187 – 618 107 (140) (2) (35) 133 (281) (2) (150) 529 34 (2) 561 568 31 (2) 597 (1) Geographic region is based upon the country of ultimate risk. (2) Includes provisions relating to customers’ liability under acceptances in the amount of $nil and $nil as at October 31, 2014 and 2013, respectively. Foreclosed Assets Property or other assets that we have received from borrowers to satisfy their loan commitments are classified as either held for use or held for sale according to management’s intention and are recorded at the lower of carrying amount or fair value less costs to sell. Fair value is determined based on market prices where available. Otherwise, fair value is determined using other methods, such as analysis of discounted cash flows or market prices for similar assets. During the year ended October 31, 2014, we foreclosed on impaired loans and received $225 million of real estate properties that we classified as held for sale ($301 million in 2013). As at October 31, 2014, real estate properties held for sale totalled $199 million ($278 million in 2013). These properties are disposed of when considered appropriate. During the year ended October 31, 2014, we recorded an impairment loss of $34 million on real estate properties classified as held for sale ($36 million in 2013). Renegotiated Loans From time to time we modify the contractual terms of loans due to the poor financial condition of the borrower. We assess renegotiated loans for impairment consistent with our existing policies for impairment. When renegotiation leads to significant concessionary modifications to the contractual terms of the loan and the concessions are for economic or legal reasons related to the borrower’s financial difficulty that we would not otherwise consider, the loan is classified as impaired. We consider one or a combination of the following to be significant concessions: (1) a reduction of the stated interest rate, (2) an extension of the maturity date or dates at a stated interest rate lower than the current market rate for a new loan with a similar term, or (3) forgiveness of principal or accrued interest. Renegotiated loans are permitted to remain in performing status if the modifications are not considered to be significant concessions or are returned to performing status when none of the criteria for classification as impaired continue to apply. The carrying value of our renegotiated loans was $728 million as at October 31, 2014 ($388 million in 2013). Renegotiated loans of 138 BMO Financial Group 197th Annual Report 2014 s e t o N $291 million were classified as performing during the year ended October 31, 2014 ($155 million in 2013). Renegotiated loans of $25 million and $59 million were written off in the years ended October 31, 2014 and 2013, respectively. Purchased Loans We record all loans that we purchase at fair value on the day that we acquire the loans. The fair value of the acquired loan portfolio includes an estimate of the interest rate premium or discount on the loans calculated as the difference between the contractual rate of interest on the loans and prevailing interest rates (the “interest rate mark”). Also included in fair value is an estimate of expected credit losses (the “credit mark”) as of the acquisition date. The credit mark consists of two components: an estimate of the amount of losses that exist in the acquired loan portfolio on the acquisition date but that haven’t been specifically identified on that date (the “incurred credit mark”) and an amount that represents future expected losses (the “future credit mark”). Because we record the loans at fair value, no allowance for credit losses is recorded in our Consolidated Balance Sheet on the day we acquire the loans. Fair value is determined by estimating the principal and interest cash flows expected to be collected on the loans and discounting those cash flows at a market rate of interest. We estimate cash flows expected to be collected based on specific loan reviews for commercial loans. For retail loans, we use models that incorporate management’s best estimate of current key assumptions such as default rates, loss severity and the timing of prepayments, as well as collateral. Acquired loans are classified into the following categories: those that on the acquisition date we expect to continue to make timely principal and interest payments (the “purchased performing loans”) and those for which on the acquisition date the timely collection of interest and principal was no longer reasonably assured (the “purchased credit impaired loans” or “PCI loans”). Because PCI loans are recorded at fair value at acquisition based on the amount expected to be collected, none of the PCI loans are considered to be impaired at acquisition. Subsequent to the acquisition date, we account for each type of loan as follows: Purchased Performing Loans For performing loans with fixed terms, the future credit mark is fully amortized to net interest income over the expected life of the loan using the effective interest method. The impact on net interest income for the year ended October 31, 2014 was $34 million ($48 million in 2013 and $97 million in 2012). The incurred credit losses are re- measured at each reporting period, with any increases recorded as an increase in the collective allowance and the provision for credit losses. Decreases in incurred credit losses are recorded as a decrease in the collective allowance and in the provision for credit losses until the accumulated collective allowance related to these loans is exhausted. Any additional decrease is recorded in net interest income. The impact of the re-measurement of incurred credit losses for performing loans with fixed terms for the year ended October 31, 2014 was $2 million in the provision for credit losses and $6 million in net interest income ($nil and $143 million, respectively, in 2013 and $nil and $104 million, respectively, in 2012). For performing loans with revolving terms, the incurred and future credit marks are amortized into net interest income on a straight-line basis over the contractual terms of the loans. The impact on net interest income of such amortization for the year ended October 31, 2014 was $35 million ($123 million in 2013 and $179 million in 2012). As performing loans are repaid, the related unamortized credit mark remaining is recorded as net interest income during the period in which the cash is received. The impact on net interest income of such repayments for the year ended October 31, 2014 was $151 million ($241 million in 2013 and $301 million in 2012). Actual specific provisions for credit losses related to these performing loans will be recorded as they arise in a manner that is consistent with our policy for loans we originate. The total specific provision for credit losses for purchased performing loans for the year ended October 31, 2014 was $82 million ($240 million in 2013 and $291 million in 2012). As at October 31, 2014, the amount of purchased performing loans remaining on the balance sheet was $11,703 million ($16,588 million in 2013). As at October 31, 2014, the credit mark remaining on performing term loans, revolving loans and other performing loans was $279 million, $94 million and $2 million, respectively ($425 million, $156 million and $6 million, respectively, in 2013). Of the total credit mark for performing loans of $375 million, $207 million represents the credit mark that will be amortized over the remaining life of the portfolio. The remaining $168 million represents the incurred credit mark and will be re-measured each reporting period. Note 5: Other Credit Instruments We use off-balance sheet credit instruments as a method of meeting the financial needs of our customers. Summarized below are the types of instruments that we use: ‰ Standby letters of credit and guarantees represent our obligation to make payments to third parties on behalf of another party if that party is unable to make the required payments or meet other contractual requirements. Standby letters of credit and guarantees include our guarantee of a subsidiary’s debt directly provided to a third party; ‰ Securities lending represents our credit exposure when we lend our securities, or our customers’ securities, to third parties should a securities borrower default on its redelivery obligation; ‰ Documentary and commercial letters of credit represent our agreement to honour drafts presented by a third party upon completion of specific activities; and Purchased Credit Impaired Loans Subsequent to the acquisition date, we regularly re-evaluate what we expect to collect on the PCI loans. Increases in expected cash flows will result in a recovery in the specific provision for credit losses and either a reduction in any previously recorded allowance for credit losses or, if no allowance exists, an increase in the current carrying value of the PCI loans. Decreases in expected cash flows will result in a charge to the specific provision for credit losses and an increase in the allowance for credit losses. The impact of these evaluations for the year ended October 31, 2014 was a $252 million recovery in the specific provision for credit losses ($410 million recovery in 2013 and $509 million recovery in 2012). As at October 31, 2014, the amount of PCI loans remaining on the balance sheet was $488 million ($654 million in 2013). As at October 31, 2014, we have no remaining credit mark related to purchased credit impaired loans ($128 million in 2013). Unfunded Commitments and Letters of Credit Acquired As part of our acquisition of M&I, we recorded a liability related to unfunded commitments and letters of credit. The total credit mark and interest rate mark associated with unfunded commitments and letters of credit are amortized into net interest income on a straight-line basis over the contractual term of the acquired liabilities. As the credit mark is amortized, an appropriate collective allowance is recorded, consistent with our methodology for the collective allowance. For unfunded commitments and letters of credit, the incurred and future credit marks are amortized into net interest income on a straight- line basis over the contractual terms of the commitments. The impact on net interest income of such amortization for unfunded commitments and letters of credit for the year ended October 31, 2014 was $12 million ($83 million in 2013). As at October 31, 2014, the credit mark remaining on unfunded commitments and letters of credit acquired was $4 million ($15 million in 2013). FDIC Covered Loans Certain acquired loans are subject to a loss share agreement with the Federal Deposit Insurance Corporation (“FDIC”). Under this agreement, the FDIC reimburses us for 80% of the net losses we incur on the covered loans. We recorded net recoveries of $8 million for the year ended October 31, 2014 ($15 million in 2013). These amounts are net of the amounts expected to be reimbursed by the FDIC. ‰ Commitments to extend credit represent our commitment to our customers to grant them credit in the form of loans or other financings for specific amounts and maturities, subject to their meeting certain conditions. The contractual amount of our other credit instruments represents the maximum undiscounted potential credit risk if the counterparty does not perform according to the terms of the contract, before possible recoveries under recourse and collateral provisions. Collateral requirements for these instruments are consistent with collateral requirements for loans. A large majority of these commitments expire without being drawn N o t e s upon. As a result, the total contractual amounts may not be representative of the funding likely to be required for these commitments. BMO Financial Group 197th Annual Report 2014 139 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS We strive to limit credit risk by dealing only with counterparties that Summarized information related to various commitments is as we believe are creditworthy, and we manage our credit risk for other credit instruments using the same credit risk process that is applied to loans and other credit assets. follows: (Canadian $ in millions) Credit Instruments Standby letters of credit and guarantees Securities lending Documentary and commercial letters of credit Commitments to extend credit (1) – Original maturity of one year and under – Original maturity of over one year Total 2014 2013 Contractual amount Contractual amount 13,949 4,872 1,111 16,752 68,507 13,470 3,772 1,205 13,616 58,244 105,191 90,307 Note 6: Risk Management We have an enterprise-wide approach to the identification, measurement, monitoring and management of risks faced across the organization. The key risks related to our financial instruments are classified as credit and counterparty, market, and liquidity and funding risk. 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 risk arises predominantly with respect to loans, over-the-counter derivatives and other credit instruments. This is the most significant measurable risk that we face. Our risk management practices and key measures are disclosed in the text and tables presented in a blue-tinted font in Management’s Discussion and Analysis on pages 84 to 86 of this report. Additional information on loans and derivative-related credit risk is disclosed in Notes 4 and 10, respectively. Concentrations of Credit and Counterparty Risk Concentrations of credit risk exist if a number of clients are engaged in similar activities, are located in the same geographic region or have similar economic characteristics such that their ability to meet contractual obligations could be similarly affected by changes in economic, political or other conditions. Concentrations of credit risk indicate a related sensitivity of our performance to developments affecting a particular counterparty, industry or geographic location. At year end, our credit assets consisted of a well-diversified portfolio representing millions of clients, the majority of them consumers and small to medium-sized businesses. From an industry viewpoint, our most significant exposure as at year end was to individual consumers, captured within the individual sector in the following table, comprising $169.0 billion ($181.6 billion in 2013). Additional information on the composition of our loans and derivatives exposure is disclosed in Notes 4 and 10, respectively. (1) Commitments to extend credit exclude personal lines of credit and credit card lines of credit that are unconditionally cancellable at our discretion. Basel III Framework We use the Basel III Framework as our capital management framework. We use the Advanced Internal Ratings Based (“AIRB”) approach to determine credit risk-weighted assets in our portfolio except for acquired loans in our M&I and other select portfolios, for which we use the Standardized Approach. The framework uses exposure at default to assess credit and counterparty risk. Exposures are classified as follows: ‰ Drawn loans include loans, acceptances, deposits with regulated financial institutions, and certain securities. 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. ‰ Undrawn commitments cover all unutilized authorizations, including those which are unconditionally cancellable. EAD for undrawn commitments is model generated based on internal empirical data. ‰ Over-the-counter (“OTC”) derivatives are those in our proprietary accounts that attract credit risk in addition to market risk. EAD for OTC derivatives is equal to the net gross replacement cost plus any potential credit exposure amount. ‰ Other off-balance sheet exposures include items such as guarantees, standby letters of credit and documentary credits. EAD for other off- balance sheet items is based on management’s best estimate. ‰ Repo-style transactions include repos, reverse repos and securities lending transactions, which represent both asset and liability exposures. EAD for repo-style transactions is the total amount drawn, adding back any write-offs. ‰ Adjusted EAD represents exposures that have been redistributed to a more favourable probability of default band or a different Basel asset class as a result of applying credit risk mitigation. s e t o N 140 BMO Financial Group 197th Annual Report 2014 Total non-trading exposure at default by industry sector, as at October 31, 2014 and 2013, based on the Basel III classifications is as follows: (Canadian $ in millions) Drawn Commitments (undrawn) OTC derivatives Other off-balance sheet items Repo-style transactions Total 2014 2013 2014 2013 2014 2013 2014 2013 2014 2013 2014 2013 Financial institutions Governments Manufacturing Real estate Retail trade Service industries Wholesale trade Oil and gas Individual Agriculture Others (1) Total exposure at 69,174 43,035 13,678 18,408 11,973 21,944 8,260 5,969 132,360 9,016 38,090 60,448 43,142 11,617 18,532 9,394 22,999 7,465 3,831 139,905 8,077 24,951 15,164 1,838 9,499 5,602 4,995 8,873 4,253 6,931 36,627 1,905 12,692 12,693 1,581 9,125 4,639 4,675 8,161 3,927 5,807 41,576 2,256 11,114 default 371,907 350,361 108,379 105,554 (1) Includes industries having a total exposure of less than 2%. 1 – 40 – – 6 – – 26 – 1 74 – – 14 – – 6 – – – – 3 2,825 1,010 1,189 1,072 537 2,748 461 612 18 36 4,303 2,978 1,333 1,061 1,122 532 3,547 365 401 67 32 3,238 40,362 10,266 – – – 2 – – 8 – 397 27,515 9,503 – – – – – – – – – 127,526 56,149 24,406 25,082 17,505 33,573 12,974 13,512 169,039 10,957 55,483 103,634 55,559 21,817 24,293 14,601 34,713 11,757 10,039 181,548 10,365 39,306 23 14,811 14,676 51,035 37,018 546,206 507,632 Additional information about our credit risk exposure by geographic region and product category for loans, including customers’ liability under acceptances, is provided in Note 4. Credit Quality We assign risk ratings based on probabilities as to whether counterparties will default on their financial obligations to us. Our process for assigning risk ratings is disclosed in the text presented in a blue-tinted font in the Enterprise-Wide Risk Management section of Management’s Discussion and Analysis on pages 85 to 86 of this report. Based on the Basel III classifications, the following tables present our retail and wholesale credit exposure by risk rating on an adjusted exposure at default basis as at October 31, 2014 and 2013. Wholesale includes all loans that are not classified as retail. Wholesale Credit Exposure by Risk Rating (Canadian $ in millions) Drawn Undrawn (1) Investment grade Non-investment grade Watchlist Default Total Bank Corporate Sovereign Bank Corporate Sovereign 19,982 3,465 9 1 23,457 86,291 40,996 2,058 938 101,128 183 1 3 130,283 101,315 2,764 252 – 1 3,017 47,071 16,449 451 89 64,060 2,218 3 – – 2,221 (1) Included in the undrawn amounts are uncommitted exposures of $24,051 million in 2014 ($23,662 million in 2013). 2014 Total exposure 259,454 61,348 2,519 1,032 324,353 2013 Total exposure 230,658 51,659 2,470 2,086 286,873 Retail Credit Drawn Exposure by Portfolio and Risk Rating (Canadian $ in millions) Risk profile (probability of default): 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%) Total Residential mortgages and home equity lines of credit Qualifying revolving retail (1) Other retail and retail small and medium-sized enterprises 2014 2013 2014 2013 2014 2013 1,108 45,424 9,649 11,011 3,521 822 71,535 983 47,622 11,216 8,925 3,503 829 73,078 88 559 2,913 2,504 288 43 6,395 320 1,711 2,578 2,073 293 36 7,011 85 4,447 6,680 6,147 322 117 71 7,521 7,995 7,255 294 86 17,798 23,222 (1) Qualifying revolving retail includes exposures to individuals that are revolving, unsecured and uncommitted up to a maximum amount of $125,000 to a single individual. Loans Past Due Not Impaired Loans that are past due but not classified as impaired are loans where our customers have failed to make payments when contractually due, but for which we expect the full amount of principal and interest payments to be collected. The following table presents the loans that are past due but not classified as impaired as at October 31, 2014 and 2013: Loans Past Due Not Impaired (Canadian $ in millions) 1 to 29 days 30 to 89 days 90 days or more Total Residential mortgages (1) Credit card, consumer instalment and other personal loans Business and government loans Customers’ liability under acceptances Total 2014 2013 647 1,915 414 20 2,996 641 1,747 805 – 3,193 2014 488 471 126 4 2013 2014 2013 2014 2013 524 434 294 59 37 104 169 – 310 65 95 183 – 343 1,172 2,490 709 24 4,395 1,230 2,276 1,282 59 4,847 1,089 1,311 N o t e s (1) The percentage of loans 90 days or more past due but not impaired that were guaranteed by the Government of Canada is 5% for 2014 and 5% for 2013. BMO Financial Group 197th Annual Report 2014 141 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loan Maturities and Rate Sensitivity The following table presents gross loans and acceptances by contractual maturity and by country of ultimate risk: (Canadian $ in millions) 1 year or less Over 1 year Over 5 years Total 2014 2013 2014 2013 2014 2013 2014 2013 Canada Consumer Commercial and corporate (excluding real estate) Commercial real estate United States Other countries Total 50,026 41,608 4,506 22,292 10,632 45,847 37,435 5,405 17,670 8,365 93,486 10,981 5,331 41,084 465 92,543 8,486 4,540 36,195 593 5,984 141 1,427 16,759 50 6,990 1,472 778 14,640 – 149,496 52,730 11,264 80,135 11,147 145,380 47,393 10,723 68,505 8,958 129,064 114,722 151,347 142,357 24,361 23,880 304,772 280,959 Certain comparative figures have been reclassified to conform with the current year’s presentation and for changes in accounting policies – see Note 1. The following table analyzes net loans and acceptances by interest rate sensitivity: (Canadian $ in millions) Fixed rate Floating rate Non-interest sensitive (1) Total 2014 2013 150,021 142,139 10,878 139,832 130,990 8,472 303,038 279,294 (1) Non-interest sensitive loans and acceptances include customers’ liability under acceptances. Certain comparative figures have been reclassified to conform with the current year’s presentation and changes in accounting policies – see Note 1. Market Risk Market risk is the potential for adverse changes in the value of our assets and liabilities resulting from changes in market variables such as interest rates, foreign exchange rates, equity and commodity prices and their implied volatilities, and credit spreads, as well as the risk of credit migration and default. We incur market risk in our trading and underwriting activities and in the management of structural market risk in our banking and insurance activities. Note 7: Guarantees In the normal course of business, we enter into a variety of guarantees. Guarantees include contracts where 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, due to changes in an underlying interest rate, foreign exchange rate or other variable. In addition, contracts under which we may be required to make payments to reimburse the counterparty for a loss if a third party does not perform according to the terms of a contract or does not make payments when due under the terms of a debt instrument, and contracts under which we provide indirect guarantees of the indebtedness of another party, are considered guarantees. Guarantees that qualify as derivatives are accounted for in accordance with the policy for derivative instruments (see Note 10). For guarantees that do not qualify as derivatives, the liability is initially recorded at fair value, which is generally the fee to be received. Subsequently, guarantees are recorded at the higher of the initial fair value, less amortization to recognize any fee income earned over the period, and the best estimate of the amount required to settle the obligation. Any increase in the liability is reported in our Consolidated Statement of Income. The most significant guarantees are as follows: Standby Letters of Credit and Guarantees Standby letters of credit and guarantees represent our obligation to make payments to third parties on behalf of another party if that party is unable to make the required payments or meet other contractual requirements. The maximum amount payable under standby letters of credit and guarantees totalled $13,949 million as at October 31, 2014 142 BMO Financial Group 197th Annual Report 2014 Our market risk management practices and key measures are disclosed in the text and tables presented in a blue-tinted font in the Enterprise-Wide Risk Management section of Management’s Discussion and Analysis on pages 91 to 95 of this report. Liquidity and Funding Risk Liquidity and funding risk is the potential for loss if we are unable to meet financial commitments in a timely manner at reasonable prices as they fall due. It is our policy to ensure that sufficient liquid assets and funding capacity are available to meet financial commitments, including liabilities to depositors and suppliers, and lending, investment and pledging commitments, even in times of stress. Managing liquidity and funding risk is essential to maintaining both depositor confidence and stability in earnings. Our liquidity and funding risk management practices and key measures are disclosed in the text presented in a blue-tinted font in the Enterprise-Wide Risk Management section of Management’s Discussion and Analysis on pages 95 to 99 of this report. ($13,470 million in 2013). The majority have a term of one year or less. Collateral requirements for standby letters of credit and guarantees are consistent with our collateral requirements for loans. A large majority of these commitments expire without being drawn upon. As a result, the total contractual amounts may not be representative of the funding likely to be required for these commitments. As at October 31, 2014, $50 million ($41 million in 2013) was included in other liabilities related to guaranteed parties that were unable to meet their obligations to a third party (see Note 4). No other amount was included in our Consolidated Balance Sheet as at October 31, 2014 and 2013 related to these standby letters of credit and guarantees. Backstop and Other Liquidity Facilities Backstop liquidity facilities are provided to asset-backed commercial paper (“ABCP”) programs administered by either us or third parties as an alternative source of financing in the event that such programs are unable to access ABCP markets or when predetermined performance measures of the financial assets held by these programs are not met. The terms of the backstop liquidity facilities do not require us to advance money to these programs in the event of bankruptcy of the borrower. The facilities’ terms are generally no longer than one year, but can be several years. The maximum amount payable under these backstop and other liquidity facilities totalled $5,501 million as at October 31, 2014 ($4,512 million in 2013). As at October 31, 2014, $53 million was outstanding from facilities drawn in accordance with the terms of the backstop liquidity facilities ($145 million in 2013). s e t o N Credit Enhancement Facilities Where warranted, we provide partial credit enhancement facilities for transactions within ABCP programs administered by either us or third parties. Credit enhancement facilities are included in backstop liquidity facilities. Derivatives Certain of our derivative instruments meet the accounting definition of a guarantee when they require the issuer to make payments to reimburse the holder for a loss incurred because a debtor fails to make payment when due under the terms of a debt instrument. In order to reduce our exposure to these derivatives, we enter into contracts that hedge the related risks. Written credit default swaps require us to compensate a counterparty following the occurrence of a credit event in relation to a specified reference obligation, such as a bond or a loan. The maximum amount payable under credit default swaps is equal to their notional amount of $11,983 million as at October 31, 2014 ($13,288 million in 2013). The terms of these contracts range from less than one year to 10 years. The fair value of the related derivative liabilities included in derivative instruments in our Consolidated Balance Sheet was $124 million as at October 31, 2014 ($102 million in 2013). Exchange and Clearinghouse Guarantees We are a member of several securities and futures exchanges and clearinghouses. Membership in certain of these organizations may require us to pay a pro rata share of the losses incurred by the organization in the event of default of another member. Such obligations vary with different organizations. These obligations may be limited to members who dealt with the defaulting member, an amount related to our contribution to a member’s guarantee fund, or an amount specified in the membership agreement. It is difficult to estimate our maximum exposure under these membership agreements, since this would require an assessment of future claims that may be made against us that have not yet occurred. Based on historical experience, we expect the risk of loss to be remote. Indemnification Agreements In the normal course of operations, we enter into various agreements that provide general indemnifications. These indemnifications typically occur in connection with sales of assets, securities offerings, service contracts, membership agreements, clearing arrangements, derivative contracts and leasing transactions. We also have a securities lending business that lends securities owned by clients to borrowers who have been evaluated for credit risk using the same credit risk process that is applied to loans and other credit assets. In connection with these activities, we provide an indemnification to lenders against losses resulting from the failure of the borrower to return loaned securities when due. All borrowings are fully collateralized with cash or marketable securities. As securities are loaned, we require borrowers to maintain collateral which is equal to or in excess of 100% of the fair value of the securities borrowed. The collateral is revalued on a daily basis. The amount of securities loaned subject to indemnification was $5,269 million as at October 31, 2014 ($4,778 million in 2013). No amount was included in our Consolidated Balance Sheet as at October 31, 2014 and 2013 related to these indemnifications. Note 8: Asset Securitization Periodically, we securitize loans to obtain alternate sources of funding. Securitization involves selling loans to trusts (“securitization vehicles”), which buy the loans and then issue either interest bearing or discounted investor certificates. We use a bank securitization vehicle to securitize our Canadian credit card loans. We are required to consolidate this vehicle. See Note 9 for further information. We also sell Canadian mortgage loans to third- party Canadian securitization programs, including the Canadian Mortgage Bond program, and directly to third-party investors under the National Housing Act Mortgage-Backed Securities program. We assess whether the loans qualify for off-balance sheet treatment based on the transfer of the risks and rewards. Under these programs, we are entitled to the payment over time of the excess of the sum of interest and fees collected from customers, in connection with the loans that were sold, over the yield paid to investors in the securitization vehicle or third-party securitization program, less credit losses and other costs. The loans sold to third-party securitization programs or directly to third parties do not qualify for off-balance sheet recognition as we have determined that the transfer of these loans has not resulted in the transfer of substantially all the risks and rewards, since we continue to be exposed to substantially all of the prepayment, interest rate and/or credit risk associated with the securitized loans. We continue to recognize the loans in our Consolidated Balance Sheet, and we recognize the instruments issued as a liability representing a secured financing. The carrying amount of assets in the table below reflects the value of the securitized mortgages, as well as payments received on securitized mortgages that are held in the vehicle or designated accounts. The interest and fees collected, net of the yield paid to investors, is recorded in net interest income using the effective interest method over the term of the securitization. Credit losses associated with the loans are recorded in the provision for credit losses. During the year ended October 31, 2014, we sold $5,564 million of loans to third-party securitization programs ($6,704 million in 2013), which does not include amounts that were transferred and repurchased during the year. The following table shows the carrying amounts related to securitization activities with third parties that are recorded in our Consolidated Balance Sheet, together with the associated liabilities, for each category of asset on the balance sheet: (Canadian $ in millions) Residential mortgages Other related assets (2) Total 2014 (1) 2013 Associated liabilities Carrying amount of assets 9,569 8,382 Associated liabilities Carrying amount of assets 9,956 8,660 17,951 17,546 18,616 18,235 N o t e s (1) The fair value of the securitized assets is $18,078 million and the fair value of the associated liabilities is $17,858 million, for a net position of $220 million. Securitized assets are those which we have transferred to third parties, including other related assets. (2) Other related assets represent payments received on account of loans pledged under securitization that have not been applied against the associated liabilities. The payments received are held on behalf of the investors in the securitization vehicles until principal payments are required to be made on the associated liabilities. In order to compare all assets supporting the associated liabilities, this amount is added to the carrying value of the securitized assets in the table above. BMO Financial Group 197th Annual Report 2014 143 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 9: Structured Entities We enter into certain transactions in the ordinary course of business which involve the establishment of structured entities (“SEs”) to facilitate or secure customer transactions and to obtain alternative sources of funding. We are required to consolidate an SE if we control the entity. We control an SE when we have power over the SE, exposure to variable returns as a result of our involvement, and the ability to exercise power to affect the amount of our returns. In assessing whether we control an SE, we consider the entire arrangement to determine the purpose and design of the SE, the nature of any rights held through contractual arrangements and whether we are acting as a principal or agent. We perform a re-assessment of consolidation if facts and circumstances indicate that there have been changes to one or more of the elements of control over the SE. Consolidated Structured Entities Total assets and liabilities included in our Consolidated Balance Sheet related to our consolidated SEs and our exposure to losses are summarized in the following table: (Canadian $ in millions) 2014 2013 Cash and cash equivalents Loans Other Deposits Other Exposure to loss Securities held Drawn facilities Undrawn facilities (1) Derivative assets Bank securitization vehicles U.S. customer securitization vehicle Credit protection vehicle Capital and funding vehicles (2) Bank securitization vehicles U.S. customer securitization vehicle Credit protection vehicle (1) Capital and funding vehicles (2) 34 7,266 – 7,300 – 4,998 4,998 2,012 – – – 2,012 68 3,036 3 3,107 2,926 3 2,929 – 149 5,236 – 5,385 394 – – 394 – 163 163 253 – – 13 266 649 16,435 – 17,084 – 18 18 840 14,793 10,361 58 26,052 25 7,190 – 7,215 – 4,328 4,328 1,499 – – – 1,499 370 3,537 3 3,910 3,578 2 3,580 – 264 4,417 – 4,681 1,430 – – 1,430 – 530 530 922 – – 20 942 351 20,717 – 21,068 – 18 18 840 18,595 8,455 84 27,974 (1) During the year ended October 31, 2013, the senior funding facility provided to our credit protection vehicle was terminated. (2) The loans balance primarily consists of mortgages transferred to our covered bonds programs. Mortgages in excess of the amount of covered bonds outstanding plus the minimum required over-collateralization amounts under these programs are readily available to us. The undrawn facilities also primarily relate to our covered bond programs; we retain the authority to determine whether the facilities are utilized. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Bank Securitization Vehicles We use securitization vehicles to securitize our Canadian credit card loans in order to obtain alternate sources of funding. The structure of these vehicles limits the activities they can undertake and the types of assets they can hold, and the vehicles have limited decision-making authority. The vehicles issue term asset-backed securities to fund their activities. We control and consolidate these vehicles, as we have the key decision-making powers necessary to obtain the majority of the benefits of their activities. U.S. Customer Securitization Vehicle We sponsor a customer securitization vehicle (also referred to as a bank- sponsored multi-seller conduit) that provides our customers with alternate sources of funding through the securitization of their assets. This vehicle provides clients with access to financing in the asset-backed commercial paper (“ABCP”) markets by allowing them to sell their assets into the vehicle, which then issues ABCP to investors to fund the purchases. We do not sell assets to the customer securitization vehicle. We earn fees for providing services related to the securitizations, including liquidity, distribution and financial arrangement fees for supporting the ongoing operations of the vehicle. We have determined that we control and therefore consolidate this vehicle, as we are exposed to the variable returns of the entity and we have the key decision-making powers necessary to affect the amount of those returns in our capacity as liquidity provider and servicing agent. Credit Protection Vehicle We sponsor a credit protection vehicle which provides credit protection to investors on investments in corporate debt portfolios through credit default swaps. In May 2008, upon the restructuring of the vehicle, we entered into credit default swaps with swap counterparties and offsetting swaps with the vehicle. In 2014, the vehicle redeemed $1,049 million of its outstanding medium-term notes ($742 million in 2013), of which $678 million ($480 million in 2013) were held by us. We continue to hold $256 million of outstanding medium-term notes. As at October 31, 2014 and 2013, we have hedged our exposure to our holdings of notes issued by the vehicle. A third party holds its exposure to the vehicle through a total return swap with us on $109 million of notes. We control and therefore consolidate this vehicle. Capital and Funding Vehicles Capital and funding vehicles are created to issue notes or capital trust securities or to guarantee payments due to bondholders on bonds issued by us. These vehicles purchase notes from us, or we may sell assets to the vehicles in exchange for promissory notes. For those trusts that purchase assets from us, we have determined that, based on the rights of the arrangements, we have significant exposure to the variable returns of the entities as we are exposed to the variability of their underlying assets; therefore we have determined that we are operating as the principal in the entities, and that we control and therefore consolidate these vehicles. See Note 1 and Note 18 for further information related to capital trusts. s e t o N 144 BMO Financial Group 197th Annual Report 2014 Unconsolidated Structured Entities The table below presents amounts related to our interests in unconsolidated SEs: (Canadian $ in millions) Interests recorded on the balance sheet Cash and cash equivalents Trading securities Available-for-sale securities Other Deposits Derivatives Other Exposure to loss Securities held Drawn facilities Undrawn facilities Capital and funding vehicles Canadian customer securitization vehicles (1) (2) 11 2 – – 13 1,265 – 21 1,286 2 12 43 57 39 10 652 – 701 39 – – 39 662 – 4,565 5,227 2014 Structured finance vehicles – 10,414 – 42 10,456 5,853 1,115 3,447 10,415 10,414 – na 10,414 Capital and funding vehicles Canadian customer securitization vehicles (1) (2) 8 2 – – 10 1,254 – 20 1,274 2 12 43 57 52 13 721 – 786 52 – – 52 734 – 3,866 4,600 2013 Structured finance vehicles – 12,120 – 119 12,239 6,584 985 4,582 12,151 12,120 – na 12,120 Total assets of the entities 1,286 3,783 10,456 (1) These undrawn facilities represent backstop liquidity facilities. The majority of these facilities (2) Securities held that are issued by our Canadian customer securitization vehicles are are not related to credit support as at October 31, 2014 and 2013. na - not applicable Certain comparative figures have been reclassified to conform with the current year’s presentation and restated as a result of the adoption of new accounting principles – see Note 1. Capital and Funding Vehicles Certain of our capital and funding vehicles purchase notes issued by us as their underlying assets. In these situations, we are not exposed to significant default or credit risk. Our remaining exposure to variable returns is less than that of the note holders, who are exposed to our default and credit risk. We have determined that we are operating in the capacity of an agent in these situations, and therefore we do not consolidate these vehicles. See Note 1 and Note 18 for further information related to capital trusts. Canadian Customer Securitization Vehicles For our Canadian customer securitization vehicles, we have determined that we do not have control of these entities as the key relevant activity, the servicing of program assets, does not reside with us. Structured Finance Vehicles We facilitate development of investment products by third parties, including mutual funds, unit investment trusts and other investment funds that are sold to retail investors. We enter into derivative contracts with these funds to provide the investors their desired exposure, and we hedge our exposure related to these derivative contracts by investing in other funds through SEs. We are not required to consolidate these vehicles. Compensation Trusts We have established trusts in order to administer our employee share ownership plan. Under this plan, employees can direct a portion of their gross salary towards the purchase of our common shares and we match 50% of employees’ contributions up to 6% of their individual gross salary. Our matching contributions are paid into trusts, which purchase our common shares on the open market for distribution to employees once employees are entitled to the shares under the terms of the plan. Total assets held by our compensation trusts amounted to $1,413 million as at October 31, 2014 ($1,343 million in 2013). We are not required to consolidate these compensation trusts. These trusts are not included in the table above as we have no interest in the trusts. comprised of asset-backed commercial paper and are classified as trading securities and available-for-sale securities. All assets held by these vehicles relate to assets in Canada. BMO Managed Funds We have established a number of funds that we also manage. We assess whether or not we control these funds based on the economic interest we have in the funds, including investments in the funds and management fees, and any investors’ rights to remove us as investment manager. Based on our assessment, we have determined that we do not control these funds. Our total exposure to unconsolidated BMO managed funds was $513 million at October 31, 2014. Non-BMO Managed Funds We purchase and hold units of non-BMO managed funds for investment and other purposes. We are considered to have an interest in these funds through our holding of units, and because we may act as counterparty in certain derivative contracts or other interests. These activities do not constitute control, and as a result our interests in these funds are not consolidated. Our total exposure to non-BMO managed funds was $11,647 million at October 31, 2014. Other SEs We are involved with other entities that may potentially be SEs. This involvement can include, for example, acting as a derivatives counterparty, liquidity provider, investor, fund manager or trustee. These activities do not cause us to control the SEs. As a result, we are not required to consolidate these SEs. Transactions with these SEs are conducted at market rates, and individual creditor investment decisions are based upon an analysis of the specific SE, taking into consideration the quality of the underlying assets. We record and report these transactions in the same manner as other transactions. For example, derivative contracts are recorded in accordance with our derivatives accounting policy as outlined in Note 10. Liquidity facilities and indemnification agreements are described in Note 7. We are deemed to be the sponsor of an SE if we are involved in the design, legal set-up or marketing of the SE. We are also deemed to be the sponsor of an SE if market participants would reasonably associate the entity with us. We do not have an interest in certain SEs that we have sponsored. The amounts of revenue earned from and assets transferred to such entities are not significant. BMO Financial Group 197th Annual Report 2014 145 N o t e s NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 10: Derivative Instruments Derivative instruments are financial contracts that derive their value from underlying changes in interest rates, foreign exchange rates or other financial or commodity prices or indices. Derivative instruments are either regulated exchange-traded contracts or negotiated over-the-counter contracts. We use these instruments for trading purposes, as well as to manage our exposures, mainly to currency and interest rate fluctuations, as part of our asset/ liability management program. Types of Derivatives Swaps Swaps are contractual agreements between two parties to exchange a series of cash flows. The various swap agreements that we enter into are as follows: Interest rate swaps – counterparties generally exchange fixed and floating rate interest payments based on a notional value in a single currency. Cross-currency swaps – fixed rate interest payments and principal amounts are exchanged in different currencies. Cross-currency interest rate swaps – fixed and/or floating rate interest payments and principal amounts are exchanged in different currencies. Commodity swaps – counterparties generally exchange fixed and floating rate payments based on a notional value of a single commodity. Equity swaps – counterparties exchange the return on an equity security or a group of equity securities for the return based on a fixed or floating interest rate or the return on another equity security or group of equity securities. Credit default swaps – one counterparty pays the other a fee in exchange for that other counterparty agreeing to make a payment if a credit event occurs, such as bankruptcy or failure to pay. Total return swaps – one counterparty agrees to pay or receive from the other cash amounts based on changes in the value of a reference asset or group of assets, including any returns such as interest earned on these assets, in exchange for amounts that are based on prevailing market funding rates. The main risks associated with these instruments are related to exposure to movements in interest rates, foreign exchange rates, credit quality, securities values or commodities prices, as applicable, and the possible inability of counterparties to meet the terms of the contracts. Forwards and Futures Forwards and futures are contractual agreements to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a specified price and date in the future. Forwards are customized contracts transacted in the over-the- counter market. Futures are transacted in standardized amounts on regulated exchanges and are subject to daily cash margining. The main risks associated with these instruments arise from the possible inability of over-the-counter counterparties to meet the terms of the contracts and from movements in commodities prices, securities values, interest rates and foreign exchange rates, as applicable. Options Options are contractual agreements that convey to the purchaser the right but not the obligation to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a fixed future date or at any time within a fixed future period. For options written by us, we receive a premium from the purchaser for accepting market risk. For options purchased by us, we pay a premium for the right to exercise the option. Since we have no obligation to exercise the option, 146 BMO Financial Group 197th Annual Report 2014 s e t o N our primary exposure to risk is the potential credit risk if the writer of an over-the-counter contract fails to meet the terms of the contract. Caps, collars and floors are specialized types of written and purchased options. They are contractual agreements in which the writer agrees to pay the purchaser, based on a specified notional amount, the difference between the market rate and the prescribed rate of the cap, collar or floor. The writer receives a premium for selling this instrument. A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. A future option is an option contract in which the underlying instrument is a single futures contract. Use of Derivatives Trading Derivatives Trading derivatives include derivatives entered into with customers to accommodate their risk management needs, market-making to facilitate customer-driven demand for derivatives, derivatives transacted on a limited basis to generate trading income from our principal trading positions and certain derivatives that are executed as part of our risk management strategy that do not qualify as hedges for accounting purposes (“economic hedges”). We structure and market derivative products to enable customers to transfer, modify or reduce current or expected risks. Principal trading activities include market-making and positioning activities. Market-making involves quoting bid and offer prices to other market participants with the intention of generating revenues based on spread and volume. Positioning activities involve managing market risk positions with the expectation of profiting from favourable movements in prices, rates or indices. We may also occasionally take principal trading positions in capital market instruments and derivatives that, taken together, are designed to profit from anticipated changes in market conditions. Trading derivatives are marked to fair value. Realized and unrealized gains and losses are recorded in trading revenues (losses) in our Consolidated Statement of Income. Unrealized gains on trading derivatives are recorded as derivative instrument assets and unrealized losses are recorded as derivative instrument liabilities in our Consolidated Balance Sheet. Hedging Derivatives In accordance with our risk management strategy, we enter into various derivative contracts to hedge our interest rate and foreign currency exposures. Risks Hedged Interest Rate Risk We manage interest rate risk through bonds, interest rate futures, interest rate swaps and options, which are linked to and adjust the interest rate sensitivity of a specific asset, liability, forecasted transaction or firm commitment, or a specific pool of transactions with similar risk characteristics. Foreign Currency Risk We manage foreign currency risk through currency futures, foreign currency options, cross-currency swaps and forward contracts. These derivatives are marked to market, with realized and unrealized gains and losses recorded in non-interest revenue, consistent with the accounting treatment for gains and losses on the economically hedged item. Changes in fair value on forward contracts that qualify as accounting hedges are recorded in other comprehensive income, with the spot/forward differential (the difference between the foreign currency exchange rate at inception of the contract and the rate at the end of the contract) being recorded in interest expense over the term of the hedge. We also sometimes economically hedge U.S. dollar earnings through forward foreign exchange contracts to minimize fluctuations in our Canadian dollar earnings due to the translation of our U.S. dollar earnings. These contracts are marked to fair value, with gains and losses recorded as non-interest revenue in foreign exchange, other than trading. Fair Value Hedges Fair value hedges modify exposure to changes in a fixed rate instrument’s fair value caused by changes in interest rates. These hedges convert fixed rate assets and liabilities to floating rate. Our fair value hedges include hedges of fixed rate securities, deposits and subordinated debt. Accounting Hedges In order for a derivative to qualify as an accounting hedge, the hedging relationship must be designated and formally documented at its inception, detailing the particular risk management objective and strategy for the hedge and the specific asset, liability or cash flow being hedged, as well as how its effectiveness is being assessed. Changes in the fair value of the derivative must be highly effective in offsetting either changes in the fair value of on-balance sheet items resulting from the risk being hedged or changes in the amount of future cash flows. Hedge effectiveness is evaluated at the inception of the hedging relationship and on an ongoing basis, retrospectively and prospectively, primarily using quantitative statistical measures of correlation. Any ineffectiveness in the hedging relationship is recognized in non-interest revenue, other, in our Consolidated Statement of Income as it arises. Cash Flow Hedges Cash flow hedges modify exposure to variability in cash flows for variable rate interest bearing instruments and assets and liabilities denominated in foreign currencies. Our cash flow hedges, which have a maximum remaining term to maturity of ten years, are hedges of floating rate loans and deposits as well as assets and liabilities denominated in foreign currencies. We record interest that we pay or receive on these derivatives as an adjustment to net interest income in our Consolidated Statement of Income over the life of the hedge. To the extent that changes in the fair value of the derivative offset changes in the fair value of the hedged item, they are recorded in other comprehensive income. The excess of the change in fair value of the derivative that does not offset changes in the fair value of the hedged item (the “ineffectiveness of the hedge”) is recorded directly in non- interest revenue, other, in our Consolidated Statement of Income. For cash flow hedges that are discontinued before the end of the original hedge term, the unrealized gain or loss recorded in other comprehensive income is amortized to net interest income in our Consolidated Statement of Income as the hedged item affects earnings. If the hedged item is sold or settled, the entire unrealized gain or loss is recognized in net interest income in our Consolidated Statement of Income. The amount of unrealized gain that we expect to reclassify to our Consolidated Statement of Income over the next 12 months is $96 million ($71 million after tax). This will adjust the interest recorded on assets and liabilities that were hedged. We record interest receivable or payable on these derivatives as an adjustment to net interest income in our Consolidated Statement of Income over the life of the hedge. For fair value hedges, not only is the hedging derivative recorded at fair value but fixed rate assets and liabilities that are part of a hedging relationship are adjusted for the changes in value of the risk being hedged (“quasi fair value”). To the extent that the change in the fair value of the derivative does not offset changes in the quasi fair value of the hedged item (the “ineffectiveness of the hedge”), the net amount is recorded directly in non-interest revenue, other, in our Consolidated Statement of Income. For fair value hedges that are discontinued, we cease adjusting the hedged item to quasi fair value. The quasi fair value adjustment of the hedged item is then amortized as an adjustment to the net interest income on the hedged item over its remaining term to maturity. If the hedged item is sold or settled, any remaining quasi fair value adjustment is included in the determination of the gain or loss on sale or settlement. We did not hedge any commitments during the years ended October 31, 2014 and 2013. Net Investment Hedges Net investment hedges mitigate our exposure to foreign currency exchange rate fluctuations related to our net investment in foreign operations. Deposit liabilities denominated in foreign currencies are designated as hedges of this exposure. The foreign currency translation of our net investment in foreign operations and the corresponding hedging instrument is recorded in net gain (loss) on translation of net foreign operations in other comprehensive income. To the extent that the hedging instrument is not effective, amounts are included in the Consolidated Statement of Income in foreign exchange, other than trading. There was no hedge ineffectiveness associated with net investment hedges for the years ended October 31, 2014 and 2013. We use foreign currency deposits with a term to maturity of zero to three months as hedging instruments in net investment hedges, and the fair value of such deposits was $2,365 million as at October 31, 2014 ($7,547 million in 2013). Fair Value Hedging Relationships The following table presents the impact of fair value hedges on our financial results. (Canadian $ in millions) Contract type Interest rate contracts – 2014 2013 2012 Amount of gain/(loss) on hedging derivatives (1) Quasi fair value adjustment (2) Hedge ineffectiveness recorded in non-interest revenue – other Pre-tax gains/(losses) recorded in income 46 (371) 42 (39) 360 (44) 7 (11) (2) (1) Unrealized gains (losses) on hedging derivatives are recorded in Other Assets – Derivative instruments or Other Liabilities – Derivative instruments in the Consolidated Balance Sheet. (2) Unrealized gains (losses) on hedged items are recorded in Securities – Available for sale, Subordinated Debt and Deposits. N o t e s BMO Financial Group 197th Annual Report 2014 147 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Cash Flow Hedging Relationships The following table presents the impact of cash flow hedges on our financial results. (Canadian $ in millions) Contract type 2014 Interest rate Foreign exchange Total 2013 Interest rate Foreign exchange Total 2012 Interest rate Foreign exchange Total Fair value change recorded in other comprehensive income Fair value change recorded in non-interest revenue – other Pre-tax gains/(losses) recorded in income Reclassification of gains on designated hedges from other comprehensive income to net interest income Amortization of spot/forward differential on foreign exchange contracts to interest expense 224 102 326 (86) 49 (37) (45) (27) (72) 3 – 3 – – – 3 – 3 130 – 130 195 – 195 177 – 177 – (4) (4) – (25) (25) – (32) (32) Embedded Derivatives From time to time, we purchase or issue financial instruments containing embedded derivatives. The embedded derivative is separated from the host contract and carried at fair value if the economic characteristics of the derivative are not closely related to those of the host contract, the terms of the embedded derivative are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value. To the extent that we cannot reliably identify and measure the embedded derivative, the entire contract is carried at fair value, with changes in fair value reflected in income. Embedded derivatives in certain of our equity linked notes are accounted for separately from the host instrument. Contingent Features Certain over-the-counter derivative instruments contain provisions that link the amount of collateral we are required to post or payment requirements to our credit ratings (as determined by the major credit rating agencies). If our credit ratings were to be downgraded, certain counterparties to these derivative instruments could demand immediate and ongoing collateralization overnight on derivative liability positions or request immediate payment. The aggregate fair value of all derivative instruments with collateral posting requirements that were in a liability position on October 31, 2014 was $6.0 billion, for which we have posted collateral of $4.4 billion. If our credit rating had been downgraded to A and A- on October 31, 2014 (per Standard & Poor’s Ratings Services), we would have been required to post collateral or meet payment demands of an additional $1.1 billion and $1.4 billion, respectively. Fair Value Fair value represents point-in-time estimates that may change in subsequent reporting periods due to market conditions or other factors. Discussion of the fair value measurement of derivatives is included in Note 31. s e t o N 148 BMO Financial Group 197th Annual Report 2014 Fair values of our derivative instruments are as follows: (Canadian $ in millions) Trading Interest Rate Contracts Swaps Forward rate agreements Futures Purchased options Written options Foreign Exchange Contracts Cross-currency swaps Cross-currency interest rate swaps Forward foreign exchange contracts Purchased options Written options Commodity Contracts Swaps Purchased options Written options Equity Contracts Credit Default Swaps Purchased Written Total fair value – trading derivatives Average fair value (1) Hedging Interest Rate Contracts Cash flow hedges – swaps Fair value hedges – swaps Total swaps Foreign Exchange Contracts Cash flow hedges – forward foreign exchange contracts Total foreign exchange contracts Total fair value – hedging derivatives (2) Average fair value (1) Total fair value – trading and hedging derivatives Less: impact of master netting agreements Total Gross assets Gross liabilities 17,020 4 17 697 – (15,986) (6) (21) – (616) 2,153 5,705 3,874 447 – 376 307 – 947 80 – (1,182) (6,682) (2,856) – (465) (922) – (412) (3,040) (546) 307 (412) (2,093) – (124) 80 (124) 2014 Net 1,034 (2) (4) 697 (616) 971 (977) 1,018 447 (465) 2013 Net 924 – (2) 595 (672) 259 (182) 3 100 (88) (42) 238 (290) (2,531) Gross assets Gross liabilities (20,327) (5) (3) – (672) (897) (3,641) (1,549) – (88) (543) – (290) (3,067) 21,251 5 1 595 – 1,156 3,459 1,552 100 – 501 238 – 536 90 – – (102) 90 (102) 31,627 (32,312) (685) 29,484 (31,184) (1,700) 30,304 (31,092) (788) 38,016 (39,565) (1,549) 196 330 526 502 502 (115) (272) (387) 81 58 139 (958) (456) (958) (456) 1,028 (1,345) (317) 110 260 370 405 405 775 916 (1,089) (173) 1,100 (169) (348) (59) (88) (517) (147) (273) (273) (790) (674) 132 132 (15) 426 32,655 (33,657) (1,002) 30,259 (31,974) (1,715) (28,885) 28,885 – (27,493) 27,493 – 3,770 (4,772) (1,002) 2,766 (4,481) (1,715) (1) Average fair value amounts are calculated using a five-quarter rolling average. (2) The fair values of hedging derivatives wholly or partially offset the changes in fair values of Assets are shown net of liabilities to customers where we have a legally enforceable right to offset amounts and we intend to settle contracts on a net basis. the related on-balance sheet financial instruments or future cash flows. Derivative instruments recorded in our Consolidated Balance Sheet are as follows: (Canadian $ in millions) Fair value of trading derivatives Fair value of hedging derivatives Total Assets Liabilities 2014 2013 2014 2013 31,627 1,028 32,655 29,484 775 30,259 32,312 1,345 33,657 31,184 790 31,974 N o t e s BMO Financial Group 197th Annual Report 2014 149 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Notional Amounts The notional amounts of our derivatives represent the amount to which a rate or price is applied in order to calculate the amount of cash that must be exchanged under the contract. Notional amounts do not represent assets or liabilities and therefore are not recorded in our Consolidated Balance Sheet. (Canadian $ in millions) Interest Rate Contracts Over-the-counter Swaps Forward rate agreements Purchased options Written options Exchange-traded Futures Purchased options Written options Total interest rate contracts Foreign Exchange Contracts Over-the-counter Cross-currency swaps Cross-currency interest rate swaps Forward foreign exchange contracts Purchased options Written options Exchange-traded Futures Purchased options Written options Total foreign exchange contracts Commodity Contracts Over-the-counter Swaps Purchased options Written options Exchange-traded Futures Purchased options Written options Total commodity contracts Equity Contracts Over-the-counter Exchange-traded Total equity contracts Credit Default Swaps Over-the-counter purchased Over-the-counter written Total credit default swaps Total s e t o N Hedging Cash flow Fair value Trading 2014 Total Trading Hedging Cash flow Fair value 2013 Total 2,580,940 361,484 19,267 22,955 45,753 – – – 48,984 – – – 2,675,677 361,484 19,267 22,955 2,139,706 399,751 18,283 23,020 41,138 – – – 43,942 – – – 2,224,786 399,751 18,283 23,020 2,984,646 45,753 48,984 3,079,383 2,580,760 41,138 43,942 2,665,840 125,272 21,680 21,342 168,294 – – – – – – – – 125,272 21,680 21,342 111,913 16,534 15,429 168,294 143,876 – – – – – – – – 111,913 16,534 15,429 143,876 3,152,940 45,753 48,984 3,247,677 2,724,636 41,138 43,942 2,809,716 51,374 279,119 283,196 31,148 36,344 242 – 16,284 – – 681,181 16,526 813 343 319 1,475 – – – – 682,656 16,526 13,559 8,526 4,166 26,251 22,586 6,733 8,499 37,818 64,069 48,702 7,314 56,016 8,801 11,983 20,784 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – 51,616 279,119 299,480 31,148 36,344 44,607 255,337 249,412 10,923 13,530 227 – 14,195 – – 697,707 573,809 14,422 813 343 319 1,475 621 2,608 616 3,845 – – – – 699,182 577,654 14,422 13,559 8,526 4,166 26,251 22,586 6,733 8,499 37,818 64,069 48,702 7,314 56,016 8,801 11,983 20,784 15,122 8,081 4,285 27,488 24,037 8,044 9,894 41,975 69,463 39,360 5,851 45,211 8,835 13,288 22,123 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – 44,834 255,337 263,607 10,923 13,530 588,231 621 2,608 616 3,845 592,076 15,122 8,081 4,285 27,488 24,037 8,044 9,894 41,975 69,463 39,360 5,851 45,211 8,835 13,288 22,123 3,976,465 62,279 48,984 4,087,728 3,439,087 55,560 43,942 3,538,589 Derivative-Related Market Risk Derivative instruments are subject to market risk. Market risk arises from the potential for a negative impact on the balance sheet and/or income statement resulting from adverse changes in the value of derivative instruments as a result of changes in certain market variables. These variables include interest rates, foreign exchange rates, equity and commodity prices and their implied volatilities, as well as credit spreads, credit migration and default. We strive to limit market risk by employing comprehensive governance and management processes for all market risk-taking activities. 150 BMO Financial Group 197th Annual Report 2014 Derivative-Related Credit Risk Over-the-counter derivative instruments are subject to credit risk arising from the possibility that counterparties may default on their obligations. The credit risk associated with derivatives is normally a small fraction of the notional amount of the derivative instrument. Derivative contracts generally expose us to potential credit loss if changes in market rates affect a counterparty’s position unfavourably and the counterparty defaults on payment. The credit risk is represented by the positive fair value of the derivative instrument. We strive to limit credit risk by dealing with counterparties that we believe are creditworthy, and we manage our credit risk for derivatives using the same credit risk process that is applied to loans and other credit assets. We also pursue opportunities to reduce our exposure to credit losses on derivative instruments, including through collateral and by entering into master netting agreements with counterparties. The credit risk associated with favourable contracts is eliminated by master netting agreements to the extent that unfavourable contracts with the same counterparty cannot be settled before favourable contracts. (Canadian $ in millions) Interest Rate Contracts Swaps Forward rate agreements Purchased options Total interest rate contracts Foreign Exchange Contracts Cross-currency swaps Cross-currency interest rate swaps Forward foreign exchange contracts Purchased options Total foreign exchange contracts Commodity Contracts Swaps Purchased options Total commodity contracts Equity Contracts Credit Default Swaps Total derivatives Exchange-traded derivatives have limited potential for credit exposure as they are settled net daily with each exchange. Terms used in the credit risk table below are as follows: Replacement cost represents the cost of replacing all contracts that have a positive fair value, using current market rates. It represents in effect the unrealized gains on our derivative instruments. Replacement costs disclosed below represent the net of the asset and liability to a specific counterparty where we have a legally enforceable right to offset the amount owed to us with the amount owed by us and we intend either to settle on a net basis or to realize the asset and settle the liability simultaneously. Credit risk equivalent represents the total replacement cost plus an amount representing the potential future credit exposure, as outlined in OSFI’s Capital Adequacy Guideline. Risk-weighted assets represent the credit risk equivalent, weighted based on the creditworthiness of the counterparty, as prescribed by OSFI. Replacement cost Credit risk equivalent 2014 Risk- weighted assets Replacement cost Credit risk equivalent 2013 Risk- weighted assets 17,546 4 691 21,371 45 705 – – – 21,621 5 589 26,813 40 657 – – – 18,241 22,121 1,393 22,215 27,510 1,758 2,153 5,705 4,376 415 5,039 11,219 6,477 837 – – – – 12,649 23,572 1,656 376 30 406 896 80 1,902 1,109 3,011 3,547 271 – – 472 208 42 1,156 3,459 1,957 90 6,662 501 66 567 520 90 4,091 15,671 3,854 227 – – – – 23,843 2,448 2,289 1,045 3,334 3,054 448 – – 621 113 310 32,272 52,522 3,771 30,054 58,189 5,250 Less: impact of master netting agreements (28,885) (35,585) – (27,493) (38,607) – Total 3,387 16,937 3,771 2,561 19,582 5,250 The total derivatives and the impact of master netting agreements for replacement cost do not include exchange-traded derivatives with a fair value of $383 million as at October 31, 2014 ($205 million in 2013). Transactions are conducted with counterparties in various geographic locations and industry sectors. Set out below is the replacement cost of contracts before and after the impact of master netting agreements with customers located in the following countries, based on country of ultimate risk. (Canadian $ in millions, except as noted) Before master netting agreements After master netting agreements Canada United States United Kingdom Other countries (1) Total (1) No other country represented 15% or more of our replacement cost in 2014 or 2013. 2014 14,395 7,579 3,623 6,675 32,272 2013 12,425 7,193 4,761 5,675 45 23 11 21 2014 1,769 875 232 511 41 24 16 19 2013 1,389 728 148 296 52 26 7 15 54 28 6 12 100% 30,054 100% 3,387 100% 2,561 100% N o t e s BMO Financial Group 197th Annual Report 2014 151 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Transactions are conducted with various counterparties. Set out below is the replacement cost of contracts (before the impact of master netting agreements) with customers in the following industries: As at October 31, 2014 (Canadian $ in millions) Interest rate contracts Foreign exchange contracts Commodity contracts Equity contracts Credit default swaps Total Financial institutions Governments Natural resources Energy Other Total 13,997 2,262 33 171 1,778 18,241 8,903 2,330 27 255 1,134 12,649 157 11 37 36 165 406 660 – – – 236 896 66 – – – 14 80 23,783 4,603 97 462 3,327 32,272 As at October 31, 2013 (Canadian $ in millions) Interest rate contracts Foreign exchange contracts Commodity contracts Equity contracts Credit default swaps Total Financial institutions Governments Natural resources Energy Other Total 18,212 2,094 44 126 1,739 22,215 4,045 1,633 38 85 861 6,662 201 20 84 85 177 567 293 – – – 227 520 58 – – – 32 90 22,809 3,747 166 296 3,036 30,054 Credit Derivatives Credit derivatives – protection sold by ratings/maturity profile: As at October 31, 2014 (Canadian $ in millions) Within 1 year 1 to 5 years Over 5 years Total Liability Maximum payout/Notional Fair value Credit default swaps Investment grade (1) Non-investment grade (1) Non-rated Total (2) 480 100 – 580 9,445 472 1,148 11,065 – 34 304 338 9,925 606 1,452 11,983 Maximum payout/Notional As at October 31, 2013 (Canadian $ in millions) Within 1 year 1 to 5 years Over 5 years Total Credit default swaps Investment grade (1) Non-investment grade (1) Non-rated Total (2) 2,714 267 7 2,988 9,751 163 241 10,155 – – 145 145 12,465 430 393 13,288 41 18 65 124 Fair value Liability 80 16 6 102 (1) Credit ratings of AAA, AA, A and BBB represent investment grade ratings and ratings of BB or lower represent non-investment grade ratings. These credit ratings largely reflect those assigned by external rating agencies and represent the payment or performance risk of the underlying security or referenced asset. (2) As at October 31, 2014, the notional value and net carrying value of credit protection sold in which we held purchased protection with identical underlying assets was $4.5 billion and $47 million ($4.3 billion and $41 million in 2013). Term to Maturity Our derivative contracts have varying maturity dates. The remaining contractual terms to maturity for the notional amounts of our derivative contracts are set out below: (Canadian $ in millions) Term to maturity Within 1 year 1 to 3 years 3 to 5 years 5 to 10 years Over 10 years 2014 2013 Total notional amounts Total notional amounts Interest Rate Contracts Swaps Forward rate agreements, futures and options 936,985 457,542 723,847 105,482 675,787 4,594 287,458 4,113 51,600 269 2,675,677 572,000 2,224,786 584,930 Total interest rate contracts 1,394,527 829,329 680,381 291,571 51,869 3,247,677 2,809,716 Foreign Exchange Contracts Cross-currency swaps Cross-currency interest rate swaps Forward foreign exchange contracts, futures and options 11,576 64,208 361,285 20,275 90,727 6,298 9,157 60,197 795 6,729 51,834 55 3,879 12,153 14 51,616 279,119 368,447 44,834 255,337 291,905 Total foreign exchange contracts 437,069 117,300 70,149 58,618 16,046 699,182 592,076 Commodity Contracts Swaps Futures and options Total commodity contracts Equity Contracts Credit Contracts Total notional amount 152 BMO Financial Group 197th Annual Report 2014 8,725 22,109 4,203 26,258 30,834 30,461 47,116 6,134 1,553 13,267 383 1,932 2,315 1,579 3,922 247 194 441 1 17 18 7 1,180 1,895 147 13,559 50,510 64,069 56,016 20,784 15,122 54,341 69,463 45,211 22,123 1,911,099 996,491 758,346 352,532 69,260 4,087,728 3,538,589 s e t o N Note 11: Premises and Equipment We record all premises and equipment at cost less accumulated amortization, except land, which is recorded at cost. Buildings, computer equipment and operating system software, other equipment and leasehold improvements are amortized on a straight-line basis over their estimated useful lives. The maximum estimated useful lives we use to amortize our assets are as follows: Buildings Computer equipment and operating system software Other equipment Leasehold improvements 10 to 40 years 15 years 10 years Lease term to a maximum of 10 years Gains and losses on disposal are included in non-interest expense, premises and equipment in our Consolidated Statement of Income. Amortization methods, useful lives and the residual values of premises and equipment are reviewed annually for any change in circumstances and are adjusted if appropriate. At least annually, we review whether there are any indications that premises and equipment need to be tested for impairment. If there is an indication that an asset may be impaired, we test for impairment by comparing the asset’s carrying value to its recoverable amount. The recoverable amount is calculated as the higher of the value in use and the fair value less costs to sell. Value in use is the present value of the future cash flows expected to be derived from the asset. An impairment charge is recorded when the recoverable amount is less than the carrying value. There were no significant write-downs of premises and equipment due to impairment during the years ended October 31, 2014 and 2013. When major components of buildings have different useful lives, they are accounted for separately and amortized over each component’s useful life. Amortization expense for the years ended October 31, 2014, 2013 and 2012 amounted to $365 million, $348 million and $351 million, respectively. Lease Commitments We have entered into a number of non-cancellable leases for premises and equipment. Our computer and software leases are typically fixed for one term and our premises leases have various renewal options and rights. Our total contractual rental commitments as at October 31, 2014 were $1,857 million. The commitments for each of the next five years and thereafter are $308 million for 2015, $281 million for 2016, $247 million for 2017, $208 million for 2018, $175 million for 2019 and $638 million thereafter. Included in these amounts are the commitments related to 834 leased branch locations as at October 31, 2014. Net rent expense for premises and equipment reported in our Consolidated Statement of Income for the years ended October 31, 2014, 2013 and 2012 was $431 million, $434 million and $418 million, respectively. (Canadian $ in millions) 2014 Land Buildings Computer equipment Other equipment Leasehold improvements Total Land Buildings Computer equipment Other equipment Leasehold improvements 2013 Total Cost Balance at beginning of year Additions Disposals (1) Additions from acquisitions (2) Foreign exchange and other 297 (1) (16) – 20 1,680 106 (44) – 60 1,531 189 (188) 3 36 Balance at end of year 300 1,802 1,571 Accumulated Depreciation and Impairment Balance at beginning of year Disposals (1) Amortization Foreign exchange and other Balance at end of year – – – – – Net carrying value 300 900 (28) 34 73 979 823 1,104 (175) 149 30 1,108 463 770 29 (22) 2 26 805 508 (19) 60 5 554 251 1,045 5,323 291 8 (4) – 2 429 (277) 9 176 106 (7) 4 34 1,554 118 (34) – 42 1,374 219 (71) – 9 1,182 5,660 297 1,680 1,531 643 3,155 (227) 365 91 (5) 122 (17) 743 3,384 – – – – – 439 2,276 297 815 (5) 33 57 900 780 1,007 (48) 135 10 1,104 427 764 50 (63) – 19 770 470 (23) 58 3 508 262 961 80 (7) – 11 4,944 475 (179) – 83 1,045 5,323 558 (4) 122 (33) 2,850 (80) 348 37 643 3,155 402 2,168 (1) Includes fully depreciated assets written off. (2) Premises and equipment are recorded at their fair values at the date of acquisition. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Note 12: Acquisitions The cost of an acquisition is measured at the fair value of the consideration transferred, including contingent consideration. Acquisition-related costs are recognized as an expense in the period in which they are incurred. The identifiable assets acquired and liabilities assumed and contingent consideration are measured at their fair values at the date of acquisition. Goodwill is measured as the excess of the aggregate of the consideration transferred over the net of the amounts of identifiable assets acquired and liabilities assumed. The results of operations of acquired businesses are included in our consolidated financial statements beginning on the date of acquisition. F&C Asset Management plc (“F&C”) On May 7, 2014, we completed the acquisition of all the issued and outstanding share capital of F&C Asset Management plc, an investment manager based in the United Kingdom, for cash consideration of £712 million. The acquisition was accounted for as a business combination. The results of the acquired business are included in our Wealth Management reporting segment. As part of the acquisition, we acquired intangible assets comprised primarily of fund management contracts and customer relationships, including $178 million of intangible assets that have an indefinite life and $313 million that are being amortized over 2 to 10 years, primarily on a straight-line basis. This acquisition strengthens our position as a globally significant money manager, enhances our asset management platform capabilities and provides opportunities to service wealth markets in the United Kingdom and the rest of Europe. Goodwill of $1,268 million related to this acquisition was recorded and is not deductible for tax purposes. As part of the acquisition of F&C, we acquired a subsidiary of F&C, F&C REIT LLP, that is 30% owned by three other partners. We have N o t e s BMO Financial Group 197th Annual Report 2014 153 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS recorded the ownership interests of the partners in F&C REIT LLP as non- controlling interest in our Consolidated Balance Sheet based on the non- controlling partners’ proportionate share of the net assets of F&C REIT LLP. F&C contributed approximately 5% to Wealth Management’s revenues and expenses for the year. Included in non-interest expense in our Consolidated Statement of Income are acquisition costs of $16 million for the year ended October 31, 2014. Aver Media LP (“Aver”) On April 1, 2013, we completed the acquisition of the assets of Aver Media LP, a private Canadian-based film and TV media lending company, for cash consideration of $260 million, subject to a post-closing adjustment based on net assets, plus contingent consideration of approximately $10 million to be paid over eighteen months after the acquisition date. During the year ended October 31, 2014, we paid $9 million of the contingent consideration plus accrued interest. Acquisition-related costs of $1 million were expensed in non-interest expense, other in our Consolidated Statement of Income for the year ended October 31, 2013. This acquisition is predominantly of the Aver loan portfolio which provides us with additional opportunities to grow our commercial loan business by expanding our presence in the film and television production industry. Goodwill related to this acquisition is deductible for tax purposes. As part of this acquisition, we acquired a customer relationship intangible asset which is being amortized on an accelerated basis over 10 years. Aver is part of our Canadian P&C reporting segment. The acquisition was accounted for as a business combination. Asian Wealth Management Business (“AWMB”) On January 25, 2013, we completed the acquisition of an Asian-based wealth management business for cash consideration of $33 million. During the year ended October 31, 2013, the purchase price increased to $34 million due to a post-closing adjustment based upon working capital. Acquisition costs of $4 million were expensed in non-interest expense, other in our Consolidated Statement of Income. The business provides private banking services to high net worth individuals in the Asia-Pacific region and provides an important opportunity for us to expand our offering to high net worth individuals in this region. Goodwill related to this acquisition is deductible for tax purposes. As part of this acquisition, we acquired a customer relationship intangible asset which is being amortized on a straight-line basis over 15 years, and software intangible assets which are being amortized over their remaining useful lives. AWMB is part of our Wealth Management reporting segment. The estimated fair values of the assets acquired and the liabilities assumed at the date of acquisition are as follows: (Canadian $ in millions) Cash resources Loans Premises and equipment Goodwill Intangible assets Other assets Total assets Deposits Other liabilities Total liabilities Non-controlling interests Purchase price The allocation of the purchase price for F&C is subject to refinement as we complete the valuation of the assets acquired and liabilities assumed. 2014 F&C 338 – 9 1,268 491 293 2,399 – 1,083 1,083 22 Aver – 232 – 20 16 3 271 – 1 1 – 1,294 270 2013 AWMB 434 310 1 17 17 2 781 746 1 747 – 34 Note 13: Goodwill and Intangible Assets Goodwill When we complete an acquisition, we allocate the purchase price paid to the assets acquired, including identifiable intangible assets and the liabilities assumed. Any excess of the consideration transferred over the fair value of those net assets is considered to be goodwill. Goodwill is not amortized and is instead tested for impairment annually. Fair value less costs to sell was the measurement we used to perform the impairment test for goodwill in 2014 and 2013. We determined the fair value less costs to sell for each group of cash generating units (“CGU”) by discounting cash flow projections. Cash flows were projected for the first 10 years based on actual operating results, expected future business performance and past experience. Beyond the first 10 years, cash flows were assumed to grow at perpetual annual rates of up to 3%, a rate that is consistent with long- s e t o N 154 BMO Financial Group 197th Annual Report 2014 term nominal GDP growth. The discount rates we applied in determining the recoverable amounts ranged from 6.9% to 12.8% (7.8% to 18.1% in 2013), and were based on our estimate of the cost of capital for each CGU. The cost of capital for each CGU was estimated using the Capital Asset Pricing Model, based on the historical betas of publicly traded peer companies that are comparable to the CGU. There were no write-downs of goodwill due to impairment during the years ended October 31, 2014 and 2013. The key assumptions described above may change as market and economic conditions change. However, we estimate that reasonably possible changes in these assumptions are not expected to cause recoverable amounts to decline below carrying amounts. A continuity of our goodwill by group of CGUs for the years ended October 31, 2014 and 2013 is as follows: (Canadian $ in millions) Balance – October 31, 2012 Acquisitions during the year Other (1) Balance – October 31, 2013 Acquisitions during the year Other (1) Balance – October 31, 2014 Personal and Commercial Banking Total 2,642 20 109 2,771 – 219 Wealth Management BMO Capital Markets Traditional Wealth Management (7) Insurance 806 17 24 847 (4) 1,268 35 2 – – 2 – – Total 808 17 24 849 1,268 35 194 – 5 199 – 12 Canadian P&C 48 20 1 69 – (1) U.S. P&C 2,594 – 108 2,702 – 220 68 (2) 2,922 (3) 2,990 2,150 (4) 2 (5) 2,152 211 (6) Corporate Services Technology and Operations – – – – – – – Total 3,644 37 138 3,819 1,268 266 5,353 (1) Other changes in goodwill included the effects of translating goodwill denominated in foreign currencies into Canadian dollars and purchase accounting adjustments related to prior-year purchases. (2) Relates primarily to bcpbank Canada, Diners Club and Aver Media LP. On November 1, 2013, we adopted IFRS 11. Goodwill of $73 million related to our joint venture is now included in the equity investment balance in other equity securities. (4) Relates to BMO Nesbitt Burns Inc., Guardian Group of Funds Ltd., Pyrford International plc, Integra GRS, Lloyd George Management, M&I, Harris myCFO, Inc., Stoker Ostler Wealth Advisors, Inc., CTC Consulting LLC, AWMB and F&C Asset Management plc. (5) Relates to AIG. (6) Relates to Gerard Klauer Mattison & Co., Inc., BMO Nesbitt Burns Inc., Griffin, Kubik, Stephens & Thompson, Inc., Paloma Securities L.L.C. and M&I. (3) Relates primarily to New Lenox State Bank, First National Bank of Joliet, Household Bank (7) During the current year, the grouping of cash generating units disclosed within our Wealth branches, Mercantile Bancorp, Inc., Villa Park Trust Savings Bank, First National Bank & Trust, Ozaukee Bank, Merchants and Manufacturers Bancorporation, Inc., AMCORE and M&I. Management operating group was aligned with how we manage our business. Prior periods have been restated to reflect this change. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Intangible Assets Intangible assets related to our acquisitions are recorded at their fair value at the acquisition date. Software is recorded at cost less accumulated amortization. The following table presents the change in the balance of the intangible assets: (Canadian $ in millions) Cost as at October 31, 2012 Additions/disposals/other Acquisitions Foreign exchange Cost as at October 31, 2013 Additions/disposals/other Acquisitions Foreign exchange Cost as at October 31, 2014 Customer relationships Core deposits Branch distribution networks Purchased software – amortizing Developed software – amortizing Software under development Other Total 348 10 23 8 389 – 171 66 626 723 – – 31 754 – – 61 815 150 (3) – 7 154 – – 13 167 538 2 – 4 544 24 – (28) 1,485 104 – 17 1,606 286 17 24 156 85 – 2 243 69 – 4 29 – – – 29 – 303 (1) 3,429 198 23 69 3,719 379 491 139 540 1,933 316 331 4,728 Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. The following table presents the accumulated amortization of the intangible assets: (Canadian $ in millions) Accumulated amortization at October 31, 2012 Disposals/other Amortization Foreign exchange Accumulated amortization at October 31, 2013 Disposals/other Amortization Foreign exchange Accumulated amortization at October 31, 2014 Carrying value at October 31, 2014 Carrying value at October 31, 2013 Customer relationships Core deposits Branch distribution networks Purchased software – amortizing Developed software – amortizing Software under development Other Total 77 1 42 4 124 – 61 44 229 397 265 305 – 76 16 397 – 69 40 506 309 357 148 (5) 3 6 152 – 2 12 166 1 2 484 (27) 29 3 489 – 20 (29) 849 (40) 194 15 1,018 – 221 11 480 1,250 – – – – – – – – – 28 (2) 2 – 28 – 9 8 45 1,891 (73) 346 44 2,208 – 382 86 2,676 60 55 683 588 316 243 286 2,052 1 1,511 Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Intangible assets are amortized to income over the period during which we believe the assets will benefit us on either a straight-line or an accelerated basis, over a period not to exceed 15 years. We have $178 million in intangible assets with indefinite lives that were acquired as part of the F&C acquisition. carrying value may not be recoverable. Indefinite life intangible assets are tested annually for impairment. If any intangible assets are determined to be impaired, we write them down to their recoverable amount, the higher of value in use and fair value less costs to sell, when this is less than the carrying value. The useful lives of intangible assets are reviewed annually for any There were write-downs of intangible assets of $1 million in the changes in circumstances. We test finite life intangible assets for impairment when events or changes in circumstances indicate that their year ended October 31, 2014 ($nil in 2013). N o t e s BMO Financial Group 197th Annual Report 2014 155 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 14: Other Assets (Canadian $ in millions) 2014 2013 Accounts receivable, prepaid expenses and other items Accrued interest receivable Due from clients, dealers and brokers Insurance-related assets (1) Pension asset (Note 24) Total 6,104 879 542 445 261 8,231 5,681 753 503 566 192 7,695 (1) Includes reinsurance assets related to our life insurance business in the amount of $215 million as at October 31, 2014 ($383 million in 2013). Certain comparative figures have been reclassified to conform with the current year’s presentation and for changes in accounting policies – see Note 1. Note 15: Deposits (Canadian $ in millions) Interest bearing Non-interest bearing Payable on demand Payable after notice Payable on a fixed date Total 2014 2013 2014 2013 2014 2013 2014 2013 2014 2013 Deposits by: Banks Businesses and governments Individuals Total (1) (2) Booked in: Canada United States Other countries Total 997 14,958 2,524 679 13,947 2,579 993 28,001 12,900 928 23,535 11,448 2,412 57,165 75,529 4,076 54,178 69,853 13,841 139,015 44,753 14,908 130,686 41,552 18,243 239,139 135,706 20,591 222,346 125,432 18,479 17,205 41,894 35,911 135,106 128,107 197,609 187,146 393,088 368,369 16,753 1,191 535 15,440 1,153 612 28,832 12,972 90 25,601 10,211 99 77,232 57,314 560 76,414 51,262 431 111,193 66,664 19,752 109,574 59,800 17,772 234,010 138,141 20,937 227,029 122,426 18,914 18,479 17,205 41,894 35,911 135,106 128,107 197,609 187,146 393,088 368,369 (1) Includes structured notes designated at fair value through profit or loss. (2) As at October 31, 2014 and 2013, total deposits payable on a fixed date included $18,183 million and $19,496 million, respectively, of federal funds purchased, commercial paper issued and other deposit liabilities. Included in deposits as at October 31, 2014 and 2013 are $191,155 million and $176,235 million, respectively, of deposits denominated in U.S. dollars, and $8,204 million and $4,822 million, respectively, of deposits denominated in other foreign currencies. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. The following table presents the maturity schedule for our deposits payable on a fixed date: Payable on a fixed date (1) (Canadian $ in millions) Within 1 year 1 to 2 years 2 to 3 years 3 to 4 years 4 to 5 years Over 5 years Total 2014 2013 124,782 22,733 23,491 8,379 8,498 9,726 114,079 21,211 21,471 11,468 9,179 9,738 197,609 187,146 (1) Includes $174,612 million of deposits, each greater than one hundred thousand dollars, of which $92,668 million were booked in Canada, $62,193 million were booked in the United States and $19,751 million were booked in other countries ($161,942 million, $89,378 million, $54,791 million and $17,773 million, respectively, in 2013). Of the $92,668 million of deposits booked in Canada, $27,304 million mature in less than three months, $7,465 million mature in three to six months, $11,565 million mature in six to 12 months and $46,334 million mature after 12 months ($89,378 million, $31,304 million, $4,079 million, $6,861 million and $47,134 million, respectively, in 2013). We have unencumbered liquid assets of $170,981 million to support these and other deposit liabilities ($160,635 million in 2013). Deposits Deposits payable on demand are comprised primarily of our customers’ chequing accounts, some of which we pay interest on. Our customers need not notify us prior to withdrawing money from their chequing accounts. Deposits payable after notice are comprised primarily of our customers’ savings accounts, on which we pay interest. Deposits payable on a fixed date are comprised of: ‰ Various investment instruments purchased by our customers to earn interest over a fixed period, such as term deposits and guaranteed investment certificates. The terms of these deposits can vary from one day to 10 years. ‰ Federal funds purchased, which are overnight borrowings of other banks’ excess reserve funds at a United States Federal Reserve Bank. As at October 31, 2014, we had borrowed $651 million of federal funds ($181 million in 2013). ‰ Commercial paper, which totalled $4,294 million as at October 31, 2014 ($4,753 million in 2013). ‰ Covered bonds, which totalled $7,683 million as at October 31, 2014 ($7,964 million in 2013). s e t o N On May 7, 2014 we issued €1.0 billion of 1.0% Covered Bonds under our Global Registered Covered Bond Program. The issue, Series CBL1, is due May 7, 2019. During the years ended October 31, 2014 and 2013, Covered Bond Series 4, US$2.0 billion 1.3% and Covered Bond Series 1 €1.0 billion 4.25% matured, respectively. 156 BMO Financial Group 197th Annual Report 2014 The following table presents the average deposit balances and average rates of interest paid during 2014 and 2013: (Canadian $ in millions) Deposits Booked in Canada Demand deposits – interest bearing Demand deposits – non-interest bearing Payable after notice Payable on a fixed date Total deposits booked in Canada Deposits Booked in the United States and Other Countries Banks located in the United States and other countries Governments and institutions in the United States and other countries Other demand deposits Other deposits payable after notice or on a fixed date Total deposits booked in the United States and other countries Total average deposits Average balances Average rate paid (%) 2014 2013 2014 2013 16,469 26,702 76,903 118,094 16,050 24,400 71,820 100,118 238,168 212,388 8,195 12,095 12,744 127,389 9,308 9,283 9,305 117,446 160,423 145,342 398,591 357,730 0.45 – 0.70 1.44 0.97 0.28 0.36 0.02 0.38 0.35 0.72 0.47 – 0.67 1.63 1.03 0.35 0.42 0.03 0.39 0.36 0.76 As at October 31, 2014 and 2013, deposits by foreign depositors in our Canadian bank offices amounted to $30,622 million and $19,248 million, respectively. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. A portion of our structured note liabilities have been designated at fair value through profit or loss and are accounted for at fair value, which better aligns the accounting result with the way the portfolio is managed. The change in fair value of these structured notes was recorded as a decrease in non-interest revenue, trading revenues of $6 million for the year ended October 31, 2014 (increase of $5 million in 2013). This includes a decrease of $41 million attributable to changes in our credit spread (decrease of $53 million in 2013). We hold derivatives and other financial instrument contracts to partially hedge changes in the fair value of these structured notes. The change in fair value related to changes in our credit spread that has been recognized since the notes were designated at fair value through profit or loss to October 31, 2014 was an unrealized loss of approximately $76 million. We may enter into positions to manage the exposure to changes in our credit spread. The fair value and notional amount due at contractual maturity of these notes as at October 31, 2014 were $7,639 million and $7,733 million, respectively ($5,928 million and $6,028 million, respectively, in 2013). Note 16: Other Liabilities (Canadian $ in millions) Acceptances Securities sold but not yet purchased Securities lent or sold under repurchase agreements 2014 2013 10,878 27,348 39,695 8,472 22,446 28,884 77,921 59,802 Acceptances Acceptances represent a form of negotiable short-term debt that is issued by our customers and which we guarantee for a fee. We have an offsetting claim, equal to the amount of the acceptances, against our customers. The amount due under acceptances is recorded as a liability and our corresponding claim is recorded as a loan in our Consolidated Balance Sheet. Securities Lending and Borrowing Securities lending and borrowing transactions are generally collateralized by securities or cash. Cash advanced or received as collateral is recorded in other assets or other liabilities, respectively. The transfer of the securities to counterparties is only reflected in our Consolidated Balance Sheet if the risks and rewards of ownership have also been transferred. Securities borrowed are not recognized in our Consolidated Balance Sheet unless they are then sold to third parties, in which case the obligation to return the securities is recorded in Securities sold but not yet purchased. Securities Sold but not yet Purchased Securities sold but not yet purchased represent our obligations to deliver securities that we did not own at the time of sale. These obligations are recorded at their market value. Adjustments to the market value as at the balance sheet date and gains and losses on the settlement of these obligations are recorded in trading revenues in our Consolidated Statement of Income. Securities Lent or Sold Under Repurchase Agreements Securities lent or sold under repurchase agreements represent short- term funding transactions in which we sell securities that we own and simultaneously commit to repurchase the same securities at a specified price on a specified date in the future. The obligation to repurchase these securities is recorded at the amount owing. The interest expense related to these liabilities is recorded on an accrual basis. Other Liabilities The components of the other liabilities balance were as follows: (Canadian $ in millions) Securitization and SE liabilities Accounts payable, accrued expenses and other items Accrued interest payable Liabilities of subsidiaries, other than deposits Insurance-related liabilities Pension liability (Note 24) Other employee future benefits liability (Note 24) Total 2014 2013 22,465 22,361 7,713 1,050 3,775 6,827 229 1,204 7,587 877 3,054 6,115 106 1,079 43,263 41,179 Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Liabilities related to the notes issued by our credit protection vehicle have been designated at fair value through profit or loss and are accounted for at fair value. This eliminates a measurement inconsistency that would otherwise arise from measuring these note liabilities and offsetting changes in the fair value of the related investments and derivatives on a different basis. The fair value of these note liabilities as at October 31, 2014 of $139 million ($505 million in 2013) is recorded in other liabilities in our Consolidated Balance Sheet. The change in fair value of these note liabilities resulted in an increase of $0.4 million in non-interest revenue, trading revenues for the year ended October 31, 2014 (decrease of $24 million in 2013). BMO Financial Group 197th Annual Report 2014 157 N o t e s NOTES TO CONSOLIDATED FINANCIAL STATEMENTS We designate the obligations related to certain annuity contracts at fair value through profit or loss, which eliminates a measurement inconsistency that would otherwise arise from measuring the annuity liabilities and offsetting changes in the fair value of the investments supporting them on a different basis. The fair value of these annuity liabilities as at October 31, 2014 of $407 million ($329 million in 2013) is recorded in other liabilities in our Consolidated Balance Sheet. The change in fair value of these annuity liabilities resulted in a decrease of $37 million in non-interest revenue, insurance income for the year ended October 31, 2014 (increase of $7 million in 2013). Changes in the fair value of investments supporting these annuity liabilities are also recorded in non-interest revenue, insurance income. Insurance-Related Liabilities We are engaged in insurance businesses related to life and health insurance, annuities and reinsurance. Insurance claims and policy benefit liabilities represent current claims and estimates of future insurance policy benefits. Liabilities for life insurance contracts are determined using the Canadian Asset Liability Method, which incorporates best-estimate assumptions for mortality, morbidity, policy lapses, surrenders, investment yields, policy dividends, administration costs and margins for adverse deviation. These assumptions are reviewed at least annually and updated to reflect actual experience and market conditions. The Actuarial Standards Board (“ASB”) made changes to the Canadian actuarial standards of practice with respect to economic reinvestment assumptions used in the valuation of insurance contract liabilities. The changes, which took effect on October 15, 2014, resulted in an ultimate reinvestment rate of 3.3%, introduced credit spreads based on underlying investment mix and provided limits on the benefit of non-fixed income investments. The impact resulted in a decrease in our insurance-related liabilities with little to no increase in our reported sensitivity to changes in interest rates. Insurance claims and policy benefit liabilities are included in Other liabilities – Insurance-related liabilities. Note 17: Subordinated Debt Subordinated debt represents our direct unsecured obligations, in the form of notes and debentures, to our debt holders and forms part of our Basel III regulatory capital. Subordinated debt is recorded at amortized cost using the effective interest rate method. The rights of the holders of our notes and debentures are subordinate to the claims of depositors and certain other creditors. We require approval from OSFI before we can redeem any part of our subordinated debt. Where appropriate, we enter into fair value hedges to hedge the risks caused by changes in interest rates (see Note 10). On September 19, 2014, we issued $1.0 billion of 3.12% subordinated debt under our Canadian Medium-Term Note Program. The issue, Series H Medium-Term Notes, Tranche 1, is due September 19, A reconciliation of the change in insurance-related liabilities is as follows: (Canadian $ in millions) Insurance-related liabilities, beginning of year Increase (decrease) in life insurance policy benefit liabilities from: New business In-force policies Changes in actuarial assumptions and methodology Foreign currency Net increase in life insurance policy benefit liabilities Change in other insurance-related liabilities Insurance-related liabilities, end of year 2014 2013 6,115 6,040 476 346 324 (55) (291) 2 (201) 1 533 179 69 6 6,827 6,115 Reinsurance In the ordinary course of business, our insurance subsidiaries reinsure risks to other insurance and reinsurance companies in order to provide greater diversification, limit loss exposure to large risks and provide additional capacity for future growth. These ceding reinsurance arrangements do not relieve our insurance subsidiaries from their direct obligation to the insureds. We evaluate the financial condition of the reinsurers and monitor their credit ratings to minimize our exposure to losses from reinsurer insolvency. Reinsurance assets related to our life insurance business are included in other assets, insurance-related assets. Reinsurance amounts included in non-interest revenue, insurance income in our Consolidated Statement of Income for the years ended October 31, 2014, 2013 and 2012 are shown in the table below. (Canadian $ in millions) Direct premium income Ceded premiums 2014 1,850 (450) 1,400 2013 1,567 (434) 1,133 2012 1,357 (410) 947 2024. The notes reset to a floating rate on September 19, 2019. The notes include a non-viability contingent capital provision, which is necessary for the notes to qualify as regulatory capital under Basel III. As such, the notes are convertible into a variable number of our common shares if OSFI publicly announces that the bank is or is about to become non-viable or a federal or provincial government in Canada publicly announces that the bank has accepted or agreed to accept a capital injection to avoid non-viability. During the year ended October 31, 2013, we did not issue any subordinated debt. During the years ended October 31, 2014 and 2013, we did not redeem any of our subordinated debt. s e t o N 158 BMO Financial Group 197th Annual Report 2014 The term to maturity and repayments of our subordinated debt required over the next two years and thereafter are as follows: (Canadian $ in millions, except as noted) Face value Maturity date Interest rate (%) Redeemable at our option beginning in 2014 Total (8) Debentures Series 16 Debentures Series 20 Series C Medium-Term Notes Tranche 2 Series D Medium-Term Notes Tranche 1 Series F Medium-Term Notes Tranche 1 Series G Medium-Term Notes Tranche 1 Series H Medium-Term Notes Tranche 1 Total (7) (1) Redeemable at the greater of par and the Canada Yield Price after their redemption date of February 20, 2012 until their maturity date of February 20, 2017. (2) Redeemable at the greater of par and the Canada Yield Price prior to April 22, 2015, and redeemable at par commencing April 22, 2015. (3) Redeemable at the greater of par and the Canada Yield Price prior to April 21, 2016, and redeemable at par commencing April 21, 2016. (4) Redeemable at the greater of par and the Canada Yield Price prior to March 28, 2018, and redeemable at par commencing March 28, 2018. (5) Interest on this issue is payable semi-annually at a fixed rate of 3.979% until July 8, 2016, and at a floating rate equal to the three-month Canadian Dealer Offered Rate (“CDOR”) plus 1.09%, paid quarterly, thereafter to maturity. This issue is redeemable at par commencing July 8, 2016. Note 18: Capital Trust Securities We issue BMO Capital Trust Securities (“BMO BOaTS”) through our subsidiary BMO Capital Trust (the “Trust”). The proceeds of BMO BOaTS are used for general corporate purposes. We consolidate the Trust, and the BMO BOaTS are reported in our Consolidated Balance Sheet as non-controlling interest in subsidiaries. During the years ended October 31, 2014 and 2013 we did not issue any BMO BOaTS. 100 150 February 2017 December 2025 to 2040 10.00 8.25 February 2012 (1) Not redeemable 500 April 2020 4.87 April 2015 (2) 700 April 2021 5.10 April 2016 (3) 900 March 2023 6.17 March 2018 (4) 100 150 500 700 900 1,500 July 2021 3.98 July 2016 (5) 1,500 1,500 1,000 September 2024 3.12 September 2019 (6) 1,000 – 2013 Total 100 150 500 700 900 4,850 3,850 (6) Interest on this issue is payable semi-annually at a fixed rate of 3.12% until September 19, 2019, and at a floating rate equal to the three-month CDOR plus 1.08%, paid quarterly, thereafter to maturity. This issue is redeemable at par commencing September 19, 2019. (7) Certain subordinated debt amounts include fair value hedge adjustments that increased their carrying value as at October 31, 2014 by $63 million ($146 million in 2013); see Note 10 for further details. Subordinated debt that we repurchase is excluded from the carrying value. (8) All of our subordinated debt has a remaining term to maturity of two years or more. Please refer to the offering circular related to each of the above issues for further details on Canada Yield Price calculations and the definition of CDOR. Holders of the BMO BOaTS are entitled to receive semi-annual non- cumulative fixed cash distributions as long as we declare dividends on our preferred shares or, if no preferred shares are outstanding, on our common shares in accordance with our ordinary dividend practice. (Canadian $ in millions, except Distribution) Distribution dates Distribution per BOaTS (1) Redemption date Principal amount At the option of the Trust 2014 2013 BMO BOaTS Series D Series E June 30, December 31 June 30, December 31 27.37 (2) 23.17 (3) December 31, 2009 December 31, 2010 600 450 600 450 1,050 1,050 (1) Distribution paid on each trust security that has a par value of $1,000. (2) After December 31, 2014, the distribution will be at the Bankers’ Acceptance Rate plus 1.5%. (3) After December 31, 2015, the distribution will be at the Bankers’ Acceptance Rate plus 1.5%. Redemption by the Trust On or after the redemption dates indicated above, and subject to the prior approval of OSFI, the Trust may redeem the securities in whole without the consent of the holders. On November 28, 2014, we announced our intention to redeem all of our BMO BOaTS Series D on December 31, 2014. During the years ended October 31, 2014 and 2013, we did not redeem any of our BMO BOaTS. Conversion by the Holders BMO BOaTS Series D and E cannot be converted at the option of the holders. Automatic Exchange The BMO BOaTS Series D and E will each be automatically exchanged for 40 Class B non-cumulative preferred shares of the bank, Series 11 and 12, respectively, without the consent of the holders on the occurrence of specific events, such as a wind-up of the bank, a regulatory requirement to increase capital or violations of regulatory capital requirements. N o t e s BMO Financial Group 197th Annual Report 2014 159 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 19: Interest Rate Risk We earn interest on interest bearing assets and we pay interest on interest bearing liabilities. We also hold derivative instruments, such as interest rate swaps and interest rate options, with values that are sensitive to changes in interest rates. To the extent that we hold assets, liabilities and derivative instruments maturing or repricing at different points in time, we are exposed to interest rate risk. Interest Rate Gap Position The determination of the interest rate sensitivity or gap position by necessity entails numerous assumptions. It is based on the earlier of the repricing date or maturity date of assets, liabilities and derivatives used to manage interest rate risk. The gap position presented is as at October 31, 2014 and 2013. It represents the position outstanding at the close of the business day and may change significantly in subsequent periods based on customer behaviour and the application of our asset and liability management strategies. The assumptions for the years ended October 31, 2014 and 2013 were as follows: Assets Fixed rate, fixed term assets, such as residential mortgage loans and consumer loans, are reported based upon the scheduled repayments and estimated prepayments that reflect expected borrower behaviour. Trading and underwriting (mark-to-market) assets and interest bearing assets on which the customer interest rate changes with the prime rate or other short-term market rates are reported in the zero to three months category. Goodwill and intangible and fixed assets are reported as non- interest sensitive. Other fixed rate and non-interest bearing assets with no defined maturity are reported based upon an assumed maturity profile that considers historical and forecasted trends in balances. Liabilities Fixed rate, fixed term liabilities, such as investment certificates, are reported at scheduled maturity with estimated redemptions that reflect expected depositor behaviour. Interest bearing deposits on which the customer interest rate changes with the prime rate or other short-term market rates are reported in the zero to three months category. Fixed rate and non-interest bearing liabilities with no defined maturity are reported based upon an assumed maturity profile that considers historical and forecasted trends in balances. Capital Common shareholders’ equity is reported as non-interest sensitive. Yields Yields are based upon the effective interest rates for the assets or liabilities on October 31, 2014 and 2013. Interest Rate Gap Position (Canadian $ in millions, except as noted) As at October 31 Assets Cash and cash equivalents Interest bearing deposits with banks Securities Securities borrowed or purchased under resale agreements Loans Other assets Total assets Liabilities and Equity Deposits Securities sold but not yet purchased Securities lent or sold under repurchase agreements Other liabilities Subordinated debt, capital trust securities and preferred share liability Total equity 0 to 3 months 4 to 6 months 7 to 12 months Total within 1 year Effective interest rate (%) Effective interest rate (%) 1 to 5 years Over 5 years Effective interest rate (%) Non- interest sensitive Total 27,328 6,110 104,642 532 – 1,033 134 – 27,994 6,110 2,636 108,311 2,272 49,530 53,421 166,542 13,033 21,899 201,474 35,385 33,896 1,021 1,619 468 1.21 0.78 1.45 1.72 3.31 na 1,377 – 23,217 134 85,621 8,511 1.02 – (27) – 2.23 10,726 – 4.06 na – 5,065 351 – – 3.94 – 4.56 na (958) – 28,386 6,110 1,065 143,319 – 53,555 10,878 303,038 54,251 10,004 388,048 17,338 27,309 432,695 118,860 16,115 – 20,989 588,659 215,909 21,861 20,729 258,499 27,348 27,348 – – 0.73 119,737 – 1.48 1.10 14,852 – – 2.23 – – 393,088 27,348 – 39,695 46,873 – 1,899 – 2,175 39,695 50,947 0.68 na – 15,615 63 767 500 400 – – 563 1,167 – – 4,200 2,647 Total liabilities and shareholders’ equity 330,655 24,660 22,904 378,219 Asset/liability gap position 57,393 (7,322) 4,405 54,476 Notional amounts of derivatives (51,285) (2,183) 1,687 (51,781) 142,199 (23,339) 44,786 – na – – – 9,603 150 300 24,905 (8,790) 6,995 2,082 (3,877) – na – – – 12,046 39,695 88,211 – 31,290 4,913 35,404 43,336 588,659 (22,347) – (23,303) 956 – – – – – – – – 3,934 2,174 (5,433) (4,072) 6,672 (580) 5,173 (2,478) 16,048 5,399 6,108 (9,505) 6,092 2,695 – 21,447 – (1,795) – (22,347) 3,165 (2,189) (3,706) 940 4,876 507 4,335 (742) 15,636 15 1,442 (325) (21,413) 1,052 976 (2,766) 5,383 3,593 – 15,651 – 1,117 – (20,361) s e t o N Total interest rate gap position - 2014 Canadian dollar Foreign currency Total Gap Total interest rate gap position - 2013 Canadian dollar Foreign currency Total Gap na - not applicable 160 BMO Financial Group 197th Annual Report 2014 Note 20: Equity Share Capital (Canadian $ in millions, except as noted) Preferred Shares – Classified as Equity Class B – Series 5 (1) Class B – Series 13 Class B – Series 14 Class B – Series 15 Class B – Series 16 Class B – Series 17 Class B – Series 18 (2) Class B – Series 21 (3) Class B – Series 23 Class B – Series 25 Class B – Series 27 Class B – Series 29 Class B – Series 31 Common Shares Balance at beginning of year Issued under the Shareholder Dividend Reinvestment and Share Purchase Plan Issued/cancelled under the Stock Option Plan and other stock-based compensation plans (Note 23) Issued on the exchange of shares of a subsidiary corporation Repurchased for cancellation Number of shares Amount 2014 Dividends declared per share Number of shares Amount 2013 Dividends declared per share Number of shares Amount 2012 Dividends declared per share – 14,000,000 10,000,000 10,000,000 6,267,391 5,732,609 – – 16,000,000 11,600,000 20,000,000 16,000,000 12,000,000 – 350 250 250 157 143 – – 400 290 500 400 300 – 1.13 1.31 1.45 0.85 0.64 0.41 0.81 1.35 0.98 0.59 0.46 0.31 – 14,000,000 10,000,000 10,000,000 6,267,391 5,732,609 6,000,000 11,000,000 16,000,000 11,600,000 – – – – 350 250 250 157 143 150 275 400 290 – – – 0.33 1.13 1.31 1.45 1.19 0.17 1.63 1.63 1.35 0.98 – – – 8,000,000 14,000,000 10,000,000 10,000,000 12,000,000 – 6,000,000 11,000,000 16,000,000 11,600,000 – – – 200 350 250 250 300 – 150 275 400 290 – – – 3,040 2,265 2,465 1.33 1.13 1.31 1.45 1.30 – 1.63 1.63 1.35 0.98 – – – 644,129,945 12,003 650,729,644 11,957 638,999,563 11,332 2,786,997 223 2,069,269 130 9,738,842 543 2,133,107 131 2,068,132 116 1,763,389 – – – – – (10,737,100) – (200) 227,850 – 80 2 – Balance at End of Year 649,050,049 12,357 3.08 644,129,945 12,003 2.94 650,729,644 11,957 2.82 Share Capital 15,397 14,268 14,422 (1) During the year ended October 31, 2013, we redeemed all of our Class B – Series 5 Preferred shares. Dividends declared for the year ended October 31, 2013 were $0.33 per share and 8,000,000 shares were outstanding at the time of dividend declaration. (2) During the year ended October 31, 2014, we redeemed all of our Class B – Series 18 Preferred shares. Dividends declared for the year ended October 31, 2014 were $0.41 per share and 6,000,000 shares were outstanding at the time of the dividend declaration. (3) During the year ended October 31, 2014, we redeemed all of our Class B – Series 21 Preferred shares. Dividends declared for the year ended October 31, 2014 were $0.81 per share and 11,000,000 shares were outstanding at the time of the dividend declaration. Preferred Shares We are authorized by our shareholders to issue an unlimited number of Class A Preferred shares and Class B Preferred shares without par value, in series, for unlimited consideration. Class B Preferred shares may be issued in a foreign currency. On April 23, 2014, we issued 20 million Non-Cumulative, 5-Year Rate Reset Class B Preferred Shares Series 27, at a price of $25.00 cash per share, for gross proceeds of $500 million. On June 6, 2014, we issued 16 million Non-Cumulative, 5-Year Rate Reset Class B Preferred Shares Series 29, at a price of $25.00 cash per share, for gross proceeds of $400 million. On July 30, 2014, we issued 12 million Non-Cumulative, 5-Year Rate Reset Class B Preferred Shares Series 31, at a price of $25.00 cash per share, for gross proceeds of $300 million. During the year ended October 31, 2014 we redeemed all of our Non-cumulative Class B Preferred shares, Series 18, and our Non- cumulative Class B Preferred shares, Series 21, at a redemption price of $25.00 per share plus declared and unpaid dividends up to but excluding the dates fixed for redemption. During the year ended October 31, 2013 we redeemed all of our Non-Cumulative Class B Preferred Shares Series 5 at a redemption price of $25.00 per share plus declared and unpaid dividends up to but excluding the date fixed for redemption. During the year ended October 31, 2012, we redeemed all of our U.S. dollar-denominated Non-cumulative Class B Preferred shares, Series 10, at a price of US$25.00 per share plus all declared and unpaid dividends up to but excluding the date fixed for redemption. We recognized a gain of $96 million in contributed surplus related to foreign exchange upon redemption of these preferred shares. N o t e s BMO Financial Group 197th Annual Report 2014 161 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Preferred Share Rights and Privileges (Canadian $, except as noted) Class B – Series 13 Class B – Series 14 Class B – Series 15 Class B – Series 16 Class B – Series 17 Class B – Series 23 Class B – Series 25 Class B – Series 27 Class B – Series 29 Class B – Series 31 Redemption amount Quarterly non- cumulative dividend (1) Reset premiums Date redeemable / convertible 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 $ 0.28125 $0.328125 $ 0.3625 $0.211875 (3) Floating (8) $ 0.3375 (3) $ 0.24375 (3) $ 0.2500 (3) $ 0.24375 (3) $ 0.2375 (3) Current (2) Current (2) Current (2) August 25, 2018 (4)(5)(6) August 25, 2018 (4)(5)(6) 1.65% 1.65% February 25, 2015 (5)(6) 2.41% August 25, 2016 (5)(6) 1.15% May 25, 2019 (5)(6) 2.33% August 25, 2019 (5)(6) 2.24% 2.22% November 25, 2019 (5)(6) Convertible to na na na Class B – Series 17 (7) Class B – Series 16 (7) Class B – Series 24 (7) Class B – Series 26 (7) Class B – Series 28 (7) Class B – Series 30 (7) Class B – Series 32 (7) (1) Non-cumulative dividends are payable quarterly as and when declared by the Board of Directors. (2) Subject to a redemption premium if redeemed prior to February 25, 2016 – Series 13; November 25, 2016 – Series 14; and May 25, 2017 – Series 15. (3) The dividend rate will reset on the date redeemable and every five years thereafter at a rate equal to the 5-year Government of Canada bond yield plus the reset premium noted. If converted to a floating rate series, the rate will be set as and when declared to the 3-month Government of Canada treasury bill yield plus the reset premium noted. (4) On July 22, 2013, we announced that we did not intend to exercise our right to redeem the Non-cumulative 5-Year Rate Reset Class B Preferred shares, Series 16 on the initial redemption date. As a result, subject to certain conditions, the holders of Series 16 Preferred shares had the right, at their option, to elect to convert all or part of their Series 16 Preferred shares on a one-for-one basis into Non-cumulative Floating Rate Class B Preferred Shares, Series 17, effective August 26, 2013. (5) Redeemable on the date noted and every five years thereafter. (6) Convertible on the date convertible noted above and every five years thereafter if not redeemed. Series 17, 24, 26, 28, 30 and 32 are floating rate preferred shares. (7) If converted, the holders have the option to convert back to the original preferred shares on subsequent redemption dates. (8) Floating rate set as and when declared at the 3-month Government of Canada treasury bill yield plus reset premium of 1.65%. na – not applicable Non-Viability Contingent Capital Class B – Series 27, Class B – Series 29 and Class B – Series 31 Preferred share issues include a non-viability contingent capital provision, which is necessary for the shares to qualify as regulatory capital under Basel III. As such, the shares are convertible into a variable number of our common shares if OSFI publicly announces that the bank is or is about to become non-viable or a federal or provincial government in Canada publicly announces that the bank has accepted or agreed to accept a capital injection to avoid non-viability. Common Shares We are authorized by our shareholders to issue an unlimited number of our common shares, without par value, for unlimited consideration. Our common shares are not redeemable or convertible. Dividends are declared by our Board of Directors on a quarterly basis and the amount can vary from quarter to quarter. During the year ended October 31, 2014, we issued 4,920,104 common shares primarily through our dividend reinvestment and share purchase plan and the exercise of stock options (4,137,401 in 2013). Normal Course Issuer Bid On February 1, 2014, we renewed our normal course issuer bid, effective for one year. Under this normal course issuer bid, we may repurchase for cancellation up to 15,000,000 of our common shares. The timing and amount of purchases under the program are subject to management discretion based on factors such as market conditions and capital adequacy. The bank will periodically consult with OSFI before making purchases under the bid. Our previous normal course issuer bid, which allowed us to repurchase for cancellation up to 15,000,000 of our common shares, expired on January 31, 2014. During the year ended October 31, 2014, we did not make any repurchases under the normal course issuer bid. During the year ended October 31, 2013, we repurchased 10,737,100 of our common shares at an average cost of $62.89 per share. Share Redemption and Dividend Restrictions OSFI must approve any plan to redeem any of our preferred share issues for cash. We are prohibited from declaring dividends on our preferred or common shares when we would be, as a result of paying such a dividend, in contravention of the capital adequacy, liquidity or any other regulatory directive issued under the Bank Act. In addition, common share dividends cannot be paid unless all dividends declared and 162 BMO Financial Group 197th Annual Report 2014 payable on our preferred shares have been paid or sufficient funds have been set aside to do so. In addition, we have agreed that if either BMO Capital Trust, our subsidiary, or BMO Capital Trust II, an unconsolidated structured entity, (collectively, the “Trusts”), fails to pay any required distribution on their capital trust securities, we will not declare dividends of any kind on any of our preferred or common shares for a period of time following such Trusts’ failure to pay the required distribution (as defined in the applicable prospectuses) unless such Trusts first pay such distribution to the holders of their capital trust securities (see Note 18). Shareholder Dividend Reinvestment and Share Purchase Plan We offer a dividend reinvestment and share purchase plan (“DRIP”) for our shareholders. Participation in the plan is optional. Under the terms of the DRIP, cash dividends on common shares are reinvested to purchase additional common shares. Shareholders also have the opportunity to make optional cash payments to acquire additional common shares. We may issue these common shares at an average of the closing price of our common shares on the Toronto Stock Exchange based on the five trading days prior to the last business day of the month or we may purchase them on the open market at market prices. Commencing with the dividend paid in the fourth quarter of 2013 and continuing through the dividend paid in the second quarter of 2014, common shares to supply the DRIP were purchased on the open market. For the dividend paid in the third quarter of 2014, common shares to supply the DRIP were issued from treasury without discount. For the dividend paid in the fourth quarter of 2014, common shares to supply the DRIP were issued from treasury with a 2% discount from the then-current market price. During the year ended October 31, 2014, we issued a total of 2,786,997 common shares from treasury (2,069,269 in 2013) and purchased 1,276,088 common shares in the open market (700,362 in 2013) under the DRIP. Potential Share Issuances As at October 31, 2014, we had reserved 6,533,403 common shares (9,320,400 in 2013) for potential issuance in respect of our Shareholder Dividend Reinvestment and Share Purchase Plan. We have also reserved 13,337,765 common shares (15,801,966 in 2013) for the potential exercise of stock options, as further described in Note 23. s e t o N Treasury Shares When we purchase our common shares as part of our trading business, we record the cost of those shares as a reduction in shareholders’ equity. If those shares are resold at a price higher than their cost, the premium is recorded as an increase in contributed surplus. If those shares are resold at a price below their cost, the discount is recorded as a reduction first to contributed surplus and then to retained earnings for any amounts in excess of total contributed surplus related to treasury shares. Non-Controlling Interest Included in non-controlling interest in subsidiaries as at October 31, 2014 were capital trust securities including accrued interest totalling $1,063 million ($1,068 million in 2013) related to non-controlling interest in subsidiaries and formed part of our Tier 1 regulatory capital, as further described in Note 18. During 2013, we redeemed the US$250 million, 7.375% preferred shares issued by Harris Preferred Capital Corporation, a U.S. subsidiary. Non-controlling interest in other subsidiaries was $22 million at October 31, 2014 resulting from our F&C acquisition. Note 21: Offsetting of Financial Assets and Financial Liabilities The following table presents the amounts that have been offset in our Consolidated Balance Sheet, as well as those amounts that are subject to enforceable master netting arrangements or similar agreements but do not qualify for netting. Amounts offset in the Consolidated Balance Sheet include securities purchased under resale agreements, securities sold under repurchase agreements and derivative instruments. Amounts not offset in the Consolidated Balance Sheet relate to transactions where a master netting arrangement or similar agreement is in place with a right of set off only in the event of default, insolvency or bankruptcy, or where the offset criteria are otherwise not met. (Canadian $ in millions) Amounts not offset in the balance sheet 2014 Financial Assets Securities borrowed or purchased under resale agreements Derivative instruments Financial Liabilities Derivative instruments Securities lent or sold under repurchase agreements (Canadian $ in millions) Financial Assets Securities borrowed or purchased under resale agreements Derivative instruments Financial Liabilities Derivative instruments Securities lent or sold under repurchase agreements Amounts offset in the balance sheet Net amounts presented in the balance sheet Impact of master netting agreements 3,564 5,683 9,247 5,683 3,564 9,247 53,555 32,655 86,210 33,657 39,695 73,352 10,004 24,398 34,402 24,398 10,004 34,402 Financial instruments received/ pledged as collateral 41,042 1,676 42,718 3,048 28,868 31,916 Cash collateral Net amount – 825 825 323 – 323 2,509 5,756 8,265 5,888 823 6,711 2013 Amounts not offset in the balance sheet Amounts offset in the balance sheet Net amounts presented in the balance sheet Impact of master netting agreements 1,788 3,486 5,274 3,486 1,788 5,274 39,799 30,259 70,058 31,974 28,884 60,858 12,170 24,459 36,629 24,459 12,170 36,629 Financial instruments received/ pledged as collateral 22,941 1,208 24,149 2,007 15,820 17,827 Cash collateral Net amount – 823 823 1,301 – 1,301 4,688 3,769 8,457 4,207 894 5,101 Gross amounts 57,119 38,338 95,457 39,340 43,259 82,599 Gross amounts 41,587 33,745 75,332 35,460 30,672 66,132 Note 22: Capital Management Our objective is to maintain a strong capital position in a cost-effective structure that: considers our target regulatory capital ratios and internal assessment of required economic capital; is consistent with our targeted credit ratings; underpins our operating groups’ business strategies; and builds depositor confidence and long-term shareholder value. Our approach includes establishing limits, targets and performance measures for the management of balance sheet positions, risk levels and minimum capital amounts, as well as issuing and redeeming capital instruments to obtain a cost-effective capital structure. Regulatory capital requirements and risk-weighted assets for the consolidated entity are determined on a Basel III basis. Adjusted common shareholders’ equity, known as Common Equity Tier 1 capital under Basel III, is the most permanent form of capital. It is comprised of common shareholders’ equity less deductions for goodwill, intangible assets and certain other items under Basel III. Tier 1 capital is primarily comprised of regulatory common equity, preferred shares and innovative hybrid instruments net of Tier 1 capital deductions. Total capital includes Tier 1 and Tier 2 capital, net of certain deductions. Tier 2 capital is primarily comprised of subordinated debentures and the eligible portion of the collective allowance for credit losses, net of certain Tier 2 capital deductions. Details of the components of our capital position are presented in Notes 13, 16, 17, 18 and 20. N o t e s BMO Financial Group 197th Annual Report 2014 163 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Our Common Equity Tier 1 Capital Ratio, Tier 1 Capital Ratio, Total Capital Ratio and Assets-to-Capital Multiple are the primary regulatory capital measures. ‰ The Common Equity Tier 1 Capital Ratio is defined as common shareholders’ equity, net of capital adjustments, divided by Common Equity Tier 1 capital risk-weighted assets. ‰ The Tier 1 Capital Ratio is defined as Tier 1 capital divided by Tier 1 capital risk-weighted assets. ‰ The Total Capital Ratio is defined as Total capital divided by Total capital risk-weighted assets. ‰ The Assets-to-Capital Multiple is calculated by dividing total assets and specified off-balance sheet items, net of other specified deductions, by Total capital calculated on a Basel III transitional basis. Regulatory Capital and Risk-Weighted Assets (Canadian $ in millions, except as noted) Common Equity Tier 1 Capital Tier 1 Capital Total Capital Common Equity Tier 1 Capital Risk-Weighted Assets Tier 1 Capital Risk-Weighted Assets Total Capital Risk-Weighted Assets Common Equity Tier 1 Capital Ratio Tier 1 Capital Ratio Total Capital Ratio Assets-to-Capital Multiple Basel III 2014 22,421 26,602 31,927 222,092 222,428 222,931 10.1% 12.0% 14.3% 16.1 Basel III 2013 21,227 24,599 29,500 215,094 215,094 215,094 9.9% 11.4% 13.7% 15.6 All 2014 and 2013 balances above are on a Basel III “all-in” basis. We have met OSFI’s stated minimum capital ratio requirements as at October 31, 2014. Note 23: Employee Compensation – Stock-Based Compensation Stock Option Plan We maintain a Stock Option Plan for designated officers and employees. Options are granted at an exercise price equal to the closing price of our common shares on the day before the grant date. Stock options granted on or after December 2013 vest in equal tranches of 50% on the third and fourth anniversaries of their grant date. Options granted prior to December 2013 vest in tranches over a four-year period starting from their grant date. Each tranche (i.e. the portion that vests each year) is treated as a separate award with a different vesting period. A portion of the options can only be exercised once certain performance targets are met. All options expire 10 years from their grant date. and record this amount as compensation expense over the period that the stock options vest, with a corresponding increase to contributed surplus. When these stock options are exercised, we issue shares and record the amount of proceeds, together with the amount recorded in contributed surplus, in share capital. Amounts related to stock options granted to employees eligible to retire are expensed at the date of grant. We determine the fair value of stock options on their grant date The following table summarizes information about our Stock Option Plan: (Canadian $, except as noted) Outstanding at beginning of year Granted Exercised Forfeited/cancelled Expired Outstanding at end of year Exercisable at end of year Available for grant Outstanding stock options as a percentage of outstanding shares 2014 Weighted- average exercise price 78.17 68.60 53.66 79.77 139.34 76.21 90.85 2013 Weighted- average exercise price 79.96 60.11 47.95 56.35 150.78 78.17 98.79 Number of stock options 15,801,966 2,003,446 2,069,588 5,558 761,555 14,968,711 7,283,321 5,201,062 2.32% Number of stock options 14,968,711 1,618,223 2,133,107 88,965 1,027,097 13,337,765 6,607,237 4,222,722 2.06% 2012 Weighted- average exercise price 84.28 56.00 40.17 40.77 126.62 79.96 103.87 Number of stock options 16,989,499 2,526,345 1,766,318 54,565 1,892,995 15,801,966 7,900,710 6,879,964 2.43% Employee compensation expense related to this plan for the years ended October 31, 2014, 2013 and 2012 was $11 million, $14 million and $17 million before tax, respectively ($11 million, $13 million and $16 million after tax, respectively). The intrinsic value of a stock option grant is the difference between the current market price of our common shares and the strike price of the option. The aggregate intrinsic value of stock options outstanding at October 31, 2014, 2013 and 2012 was $279 million, $215 million and $79 million, respectively. The aggregate intrinsic value of stock options exercisable at October 31, 2014, 2013 and 2012 was $145 million, $107 million and $47 million, respectively. Options outstanding and exercisable at October 31, 2014 and 2013 by range of exercise price were as follows: (Canadian $, except as noted) 2014 2013 Options outstanding Options exercisable Options outstanding Options exercisable s e t o N Range of exercise prices Weighted- average remaining contractual life (years) Weighted- average exercise price Number of stock options Weighted- average remaining contractual life (years) Weighted- average exercise price Weighted- average remaining contractual life (years) Weighted- average exercise price Number of stock options Weighted- average remaining contractual life (years) Weighted- average exercise price Number of stock options Number of stock options 718,299 $30.01 to $40.00 208,437 $40.01 to $50.00 5,087,750 $50.01 to $60.00 5,956,232 $60.01 to $70.00 $70.01 and over (1) 1,367,047 (1) Issued as part of the acquisition of M&I. 164 BMO Financial Group 197th Annual Report 2014 4.1 4.6 5.7 6.0 2.6 718,299 34.13 42.36 208,437 56.05 3,000,262 63.89 1,313,192 232.14 1,367,047 4.1 4.6 6.0 4.1 2.6 34.13 1,044,175 42.36 262,959 55.73 6,934,041 62.71 4,886,738 232.14 1,840,798 5.1 5.6 6.0 5.6 3.1 34.12 1,044,175 42.44 262,959 55.78 2,845,945 62.28 1,289,444 234.78 1,840,798 5.1 5.6 6.1 3.2 3.1 34.12 42.44 55.57 63.94 234.78 The following table summarizes non-vested stock option activity for the years ended October 31, 2014 and 2013: (Canadian $, except as noted) Non-vested at beginning of year Granted Vested Expired Forfeited/cancelled Non-vested at end of 2014 Weighted- average grant date fair value Number of stock options 7.18 6.36 7.56 8.83 6.49 7,901,256 2,003,446 1,974,580 240,824 3,908 2013 Weighted- average grant date fair value 7.77 5.29 7.64 7.22 5.99 Number of stock options 7,685,390 1,618,223 1,971,073 559,841 42,171 year 6,730,528 6.74 7,685,390 7.18 The following table summarizes further information about our Stock Option Plan: (Canadian $ in millions, except as noted) 2014 2013 2012 Unrecognized compensation cost for non- vested stock option awards Weighted-average period over which it will be recognized (in years) Total intrinsic value of stock options exercised Cash proceeds from stock options exercised Actual tax benefits realized on stock options exercised Weighted-average share price for stock 5 2.7 49 115 1 6 2.1 35 99 – 9 2.3 31 71 4 options exercised 76.6 64.8 57.8 The fair value of options granted was estimated using a binomial option pricing model. The weighted-average fair value of options granted during the years ended October 31, 2014, 2013 and 2012 was $6.36, $5.29 and $5.54, respectively. To determine the fair value of the stock option tranches on the grant date, the following ranges of values were used for each option pricing assumption: Expected dividend yield Expected share price volatility Risk-free rate of return Expected period until exercise (in years) 2014 2013 2012 5.0% 6.0% – 6.2% 6.8% – 7.2% 16.40% 18.1% – 18.6% 21.3% – 22.3% 1.5% – 1.8% 1.7% – 1.9% 2.5% – 2.6% 6.5 – 7.0 5.5 – 7.0 5.5 – 7.0 Changes to the input assumptions can result in different fair value estimates. Expected dividend yield is based on market expectations of future dividends on our common shares. Expected volatility is determined based on the market consensus implied volatility for traded options on our common shares. The risk-free rate is based on the yields of a Canadian swap curve with maturities similar to the expected period until exercise of the options. The weighted-average exercise price on the grant date for the years ended October 31, 2014, 2013 and 2012 was $68.60, $60.11 and $56.00, respectively. Stock-Based Compensation Share Purchase Plan We offer our employees the option of directing a portion of their gross salary toward the purchase of our common shares. We match 50% of employee contributions up to 6% of their individual gross salary. The shares held in the employee share purchase plan are purchased on the open market and are considered outstanding for purposes of computing earnings per share. The dividends earned on our common shares held by the plan are used to purchase additional common shares on the open market. We account for our contribution as employee compensation expense when it is contributed to the plan. Employee compensation expense related to this plan for the years ended October 31, 2014, 2013 and 2012 was $50 million, $50 million and $48 million, respectively. There were 18.7 million, 19.3 million and 19.3 million common shares held in this plan for the years ended October 31, 2014, 2013 and 2012, respectively. Mid-Term Incentive Plans We offer mid-term incentive plans for executives and certain senior employees. Depending on the plan, the recipient receives either a single cash payment at the end of the three-year period of the plan, or cash payments over the three years of the plan. The amount of the payment is adjusted to reflect reinvested dividends and changes in the market value of our common shares. Mid-term incentive plan units granted during the years ended October 31, 2014, 2013 and 2012 totalled 5.9 million, 5.8 million and 6.4 million, respectively. We entered into agreements with third parties to assume most of our obligations related to these plans in exchange for cash payments of $214 million, $292 million and $310 million in the years ended October 31, 2014, 2013 and 2012, respectively. Amounts paid under these agreements were recorded in our Consolidated Balance Sheet in other assets and are recorded as employee compensation expense evenly over the period prior to payment to employees. Amounts related to units granted to employees who are eligible to retire are expensed at the time of grant. We no longer have any liability for the obligations transferred to third parties because any future payments required will be the responsibility of the third parties. The amount deferred and recorded in other assets in our Consolidated Balance Sheet totalled $131 million and $172 million as at October 31, 2014 and 2013, respectively. The deferred amount as at October 31, 2014 is expected to be recognized over a weighted-average period of 1.7 years (1.8 years in 2013). Employee compensation expense related to these plans for the years ended October 31, 2014, 2013 and 2012 was $239 million, $279 million and $280 million before tax, respectively ($177 million, $206 million and $204 million after tax, respectively). For the remaining obligations related to plans for which we have not entered into agreements with third parties, the fair value of the amount of compensation expense is recognized as an expense and a liability over the period from the grant date to payment date to employees. This liability is re-measured to fair value each reporting period. Amounts related to employees who are eligible to retire are expensed at the time of grant. Of the total units granted, we had remaining obligations on 3.1 million, 1.0 million and 1.1 million units for the years ended October 31, 2014, 2013 and 2012, respectively. The weighted-average grant date fair value of the units granted during the years ended October 31, 2014, 2013 and 2012 was $228 million, $50 million and $65 million, respectively. Payments made under these plans for the years ended October 31, 2014, 2013 and 2012 were $57 million, $37 million and $44 million, respectively. The intrinsic value of the vested plan units recorded in other liabilities in our Consolidated Balance Sheet as at October 31, 2014, 2013 and 2012 was $288 million, $126 million and $85 million, respectively. Employee compensation expense related to plans for which we have not entered into agreements with third parties for the years ended October 31, 2014, 2013 and 2012 was $159 million, $63 million and $48 million before tax, respectively ($118 million, $47 million and $35 million after tax, respectively). We economically hedge the impact of the change in the market value of our common shares by entering into total return swaps. Hedging gains recognized for the years ended October 31, 2014, 2013 and 2012 were $55 million, $32 million and $3 million, respectively, resulting in net employee compensation expense of $104 million, $31 million and $45 million before tax, respectively ($77 million, $23 million and $33 million after tax, respectively). A total of 16.5 million, 15.3 million and 14.7 million mid-term incentive plan units were outstanding for the years ended October 31, 2014, 2013 and 2012, respectively. BMO Financial Group 197th Annual Report 2014 165 N o t e s NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deferred Incentive Plans We offer deferred incentive plans for members of our Board of Directors, executives and key employees in BMO Capital Markets and Wealth Management. Under these plans, fees, annual incentive payments and/or commissions can be deferred as stock units of our common shares. These stock units are either fully vested on the grant date or vest at the end of three years. The value of these stock units is adjusted to reflect reinvested dividends and changes in the market value of our common shares. Deferred incentive plan payments are paid upon the participant’s departure from the bank. As a result of changes to the deferred share unit plan terms effective September 30, 2013, the deferred incentive plan payments can now only be made in cash. Employee compensation expense for these plans is recorded in the year the fees, incentive payments and/or commissions are earned. Changes in the amount of the incentive payments as a result of dividends and share price movements are recorded as increases or decreases in employee compensation expense in the period of the change. Deferred incentive plan units granted during the years ended October 31, 2014, 2013 and 2012 totalled 0.4 million, 0.4 million and 0.4 million, respectively. The weighted-average grant date fair value of the units granted during the years ended October 31, 2014, 2013 and 2012 was $26 million, $22 million and $21 million, respectively. Liabilities related to these plans are recorded in other liabilities in our Consolidated Balance Sheet and totalled $404 million and $349 million as at October 31, 2014 and 2013, respectively. Payments made under these plans for the years ended October 31, 2014, 2013 and 2012 were $18 million, $16 million and $19 million, respectively. Employee compensation expense related to these plans for the years ended October 31, 2014, 2013 and 2012 was $76 million, $85 million and $22 million before tax, respectively ($56 million, $63 million and $16 million after tax, respectively). We have entered into derivative instruments to hedge our exposure related to these plans. Changes in the fair value of these derivatives are recorded as employee compensation expense in the period in which they arise. Hedging gains for the years ended October 31, 2014, 2013 and 2012 of $56 million, $75 million and $9 million before tax, respectively, were also recognized, resulting in net employee compensation expense of $20 million, $10 million and $13 million before tax, respectively ($15 million, $7 million and $9 million after tax, respectively). A total of 4.7 million, 4.3 million and 4.0 million deferred incentive plan units were outstanding for the years ended October 31, 2014, 2013 and 2012, respectively. Note 24: Employee Compensation – Pension and Other Employee Future Benefits Pension and Other Employee Future Benefit Plans We sponsor a number of arrangements in Canada and the United States that provide pension and other employee future benefits to our retired and current employees. The largest of these arrangements, by defined benefit obligation, are the primary defined benefit pension plans for employees in Canada and the United States and the primary other employee future benefit plan for employees in Canada. Pension arrangements include defined benefit pension plans, as well as supplementary arrangements that provide pension benefits in excess of statutory limits. Generally, under these plans we provide retirement benefits based on an employee’s years of service and average annual earnings over a period of time prior to retirement. Our pension and other employee future benefit expenses, recorded in employee compensation expense, mainly comprise the current service cost plus or minus the interest on plan net defined benefit assets or liabilities. In addition, we provide defined contribution pension plans to employees in some of our subsidiaries. The costs of these plans, recorded in employee compensation expense, are equal to our contributions to the plans. We also provide other employee future benefits, including health and dental care benefits and life insurance, for current and retired employees. Short-term employee benefits, such as salaries, paid absences, bonuses and other benefits, are accounted for on an accrual basis over the period in which the employees provide the related services. Investment Policy The assets of the defined benefit pension plans are managed in accordance with all applicable laws and regulations. The plans are administered with a well-defined governance structure with the oversight and decision-making resting with the Board of Directors. s e t o N The plans are managed under a risk management framework that considers both assets and liabilities in the development of an investment policy and in managing risk. The plans invest in asset classes that include equities, fixed income and alternative strategies, under established investment guidelines. Plan 166 BMO Financial Group 197th Annual Report 2014 assets are diversified across asset classes and by geographic exposure. They are managed by asset management firms that are responsible for the selection of investment securities. Derivative instruments are permitted under policy guidelines and are generally used to hedge foreign currency exposures, manage interest rate exposures or replicate the return of an asset. Risk Management The plans are exposed to various risks, including market risk (interest rate, equity and foreign currency risks), credit risk, operational risk, surplus risk and longevity risk. We follow a number of approaches to monitor and actively manage these risks, including monitoring surplus- at-risk, which measures a plan’s risk in an asset-liability framework; stress testing and scenario analyses to evaluate the volatility of the plans’ financial positions and any potential impact on the bank; hedging of currency exposures and interest rate risk within policy limits; controls related to asset mix allocations, geographic allocations, portfolio duration, credit quality, liquidity, sector guidelines, issuer/counterparty limits, and others; and ongoing monitoring of exposures, performance and risk levels. Pension and Other Employee Future Benefit Liabilities Our actuaries perform valuations of our defined benefit obligations for pension and other employee future benefits as at October 31 of each year using the projected unit credit method based on management’s assumptions about discount rates, rates of compensation increase, retirement age, mortality and health care cost trend rates. The discount rates for the primary Canadian and U.S. pension and other employee future benefit plans were selected using high-quality AA rated corporate bonds with terms matching the plans’ cash flows. The fair value of plan assets is deducted from the defined benefit obligation to determine the net defined benefit asset or liability. For defined benefit pension plans that are in a net defined benefit asset position, the recognized asset is limited to the present value of economic benefits available in the form of future refunds from the plan or reductions in future contributions to the plan (the “asset ceiling”). Changes in the asset ceiling are recognized in OCI. Components of the change in our net defined benefit assets or liabilities and our pension and other employee future benefit expense are as follows: Benefits earned by employees represent benefits earned in the current year. They are determined with reference to the current workforce and the amount of benefits to which employees will be entitled upon retirement, based on the provisions of our benefit plans. Interest on net defined benefit asset or liability represents the increase in the net defined benefit asset or liability that results from the passage of time and is determined by applying the discount rate to the net defined benefit asset or liability. Actuarial gains or losses may arise in two ways. First, each year our actuaries recalculate the defined benefit obligations and compare them to those estimated as at the previous year end. Any differences that result from changes in demographic and economic assumptions or from plan member experience being different from management’s expectations at the previous year end are considered actuarial gains or losses. Secondly, actuarial gains and losses arise when there are differences between the discount rate and actual returns on plan assets. Actuarial gains and losses are recognized immediately in OCI as they occur and are not subsequently reclassified to income in future periods. Plan amendments are changes in our defined benefit obligations that result from changes to provisions of the plans. The effects of plan amendments are recognized immediately in income when a plan is amended. Settlements occur when defined benefit obligations for plan participants are settled, usually through lump sum cash payments, and as a result we no longer have any obligation to provide such participants with benefit payments in the future. Summarized information for the past three years is as follows: Funding of Pension and Other Employee Future Benefit Plans Our defined benefit pension plans in Canada and the United States are funded by us in accordance with statutory requirements and the assets in these plans are used to pay benefits to retirees and other employees. Some groups of employees are also eligible to make voluntary contributions in order to receive enhanced benefits. Our supplementary pension plan in Canada is funded, while in the United States the supplementary pension plan is unfunded. Our other employee future benefit plans in Canada and the United States are either partially funded or unfunded. Benefit payments related to these plans are either paid through the respective plan or paid directly by us. We measure the fair value of plan assets for our plans in Canada and the United States as at October 31. In addition to actuarial valuations for accounting purposes, we are required to prepare valuations for determining our minimum funding requirements for our pension arrangements in accordance with the relevant statutory framework (our “funding valuation”). The most recent funding valuation for our primary Canadian plan was performed as at October 31, 2014. The next funding valuation for this plan will be performed as at October 31, 2015. An annual funding valuation is required for our plan in the United States. The most recent valuation was performed as at January 1, 2014. Benefit payments for fiscal 2015 are estimated to be $386 million. (Canadian $ in millions) Pension benefit plans Other employee future benefit plans Defined benefit obligation Fair value of plan assets Surplus (deficit) and net defined benefit asset (liability) Surplus (deficit) is comprised of: Funded or partially funded plans Unfunded plans Surplus (deficit) and net defined benefit asset (liability) Remeasurement of net defined benefit asset/liability recognized in OCI 2014 7,504 7,536 32 197 (165) 32 108 2013 6,181 6,267 86 192 (106) 86 (368) 2012 6,011 5,800 2014 1,317 113 2013 1,174 95 2012 1,175 81 (211) (1,204) (1,079) (1,094) (137) (74) (211) 465 (12) (1,192) (1,204) 80 (9) (1,070) (1,079) (21) (1,073) (1,094) (56) 152 Comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Asset Allocations The investment policy for plan assets is to have a diversified mix of quality investments. Plan assets are rebalanced within ranges around target allocations. The asset allocation ranges and weighted-average actual asset allocations of our primary pension plans, based on the fair market values at October 31, are as follows: Equities Fixed income investments Other Pension benefit plans Range 2014 25% – 50% 35% – 55% 10% – 25% Actual 2014 42% 45% 13% Actual 2013 43% 42% 15% N o t e s BMO Financial Group 197th Annual Report 2014 167 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Pension and Other Employee Future Benefit Expenses Pension and other employee future benefit expenses are determined as follows: (Canadian $ in millions) Annual benefits expense Benefits earned by employees Net interest (income) expense on net defined benefit (asset) liability Administrative expenses Remeasurement of other long-term benefits Benefits expense Canada and Quebec pension plan expense Defined contribution expense Total annual pension and other employee future benefit expenses recognized in the Consolidated Statement of Income Comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Weighted-average assumptions used to determine benefit expenses Discount rate at beginning of year Rate of compensation increase Assumed overall health care cost trend rate Pension benefit plans Other employee future benefit plans 2014 2013 2012 2014 2013 2012 241 (11) 5 – 235 68 8 311 234 4 5 – 243 69 8 320 195 (18) 5 – 182 67 7 256 25 50 – (5) 70 – – 70 27 48 – (1) 74 – – 74 19 50 – – 69 – – 69 Pension benefit plans Other employee future benefit plans 2014 4.6% 2.9% na 2013 4.2% 2.9% na 2012 5.1% 3.3% na 2014 2013 2012 4.7% 2.7% 5.4% (1) 4.4% 3.2% 5.4% (1) 5.6% 3.2% 5.4% (1) (1) Trending to 4.5% in 2030 and remaining at that level thereafter. na – not applicable Assumptions regarding future mortality are based on published statistics and mortality tables calibrated to plan experience, when applicable. The current life expectancies underlying the amounts of the defined benefit obligations for our primary plans are as follows: (Years) Life expectancy for those currently age 65 Males Females Life expectancy at age 65 for those currently age 45 Males Females Canada United States 2014 2013 2014 2013 23.4 23.8 24.4 24.8 23.1 23.5 24.0 24.3 21.3 23.4 23.3 25.2 19.8 21.6 19.8 21.6 s e t o N 168 BMO Financial Group 197th Annual Report 2014 Changes in the estimated financial positions of our pension benefit plans and other employee future benefit plans are as follows: (Canadian $ in millions, except as noted) Defined benefit obligation Defined benefit obligation at beginning of year Opening adjustment for acquisitions Benefits earned by employees Interest cost on accrued benefit obligation Benefits paid to pensioners and employees Voluntary employee contributions Actuarial gains (losses) due to: Demographic assumption changes Financial assumption changes Plan member experience Other, primarily foreign exchange Defined benefit obligation at end of year Wholly or partially funded defined benefit obligation Unfunded defined benefit obligation Total defined benefit obligation Weighted-average assumptions used to determine the defined benefit obligation Discount rate at end of year Rate of compensation increase Assumed overall health care cost trend rate Fair value of plan assets Fair value of plan assets at beginning of year Opening adjustment for acquisitions Interest income on plan assets Excess (shortfall) of actual returns over interest income Employer contributions Voluntary employee contributions Benefits paid to pensioners and employees Administrative expenses Other, primarily foreign exchange Fair value of plan assets at end of year Surplus (deficit) and net defined benefit asset (liability) at the end of the year Recorded in: Other assets Other liabilities Surplus (deficit) and net defined benefit asset (liability) at end of year Comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. (1) Trending to 4.5% in 2030 and remaining at that level thereafter. na – not applicable Pension benefit plans Other employee future benefit plans 2014 2013 2014 2013 6,181 455 241 289 (326) 12 48 532 (14) 86 7,504 7,339 165 7,504 4.1% 2.9% na 6,267 456 300 458 284 12 (326) (5) 90 7,536 32 261 (229) 32 6,011 – 234 249 (286) 11 161 (289) 38 52 6,181 6,075 106 6,181 4.6% 2.9% na 5,800 – 245 278 178 11 (286) (5) 46 6,267 86 192 (106) 86 1,174 – 25 55 (33) – (15) 98 (3) 16 1,317 125 1,192 1,317 1,175 – 27 51 (30) – 36 (97) 8 4 1,174 104 1,070 1,174 4.2% 2.6% 5.4% (1) 4.7% 2.7% 5.4% (1) 95 – 4 5 33 – (33) – 9 113 81 – 3 8 30 – (30) – 3 95 (1,204) (1,079) – (1,204) (1,204) – (1,079) (1,079) N o t e s BMO Financial Group 197th Annual Report 2014 169 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The bank’s pension and other employee future benefit plan assets are measured at fair value on a recurring basis. The fair value of plan assets as at October 31 are as follows: (Canadian $ in millions, except as noted) Canadian plans (1) U.S. plans (2) Cash and money market funds Securities issued or guaranteed by: Canadian federal government Canadian provincial and municipal governments U.S. federal government U.S. states, municipalities and agencies Other governments Pooled funds Derivative instruments Corporate debt Corporate equity 2014 55 179 785 4 2 5 2,780 (17) 737 834 2013 178 131 613 – 14 4 2,428 6 556 851 2014 2013 39 24 – – 87 18 – 85 – 401 535 – – 47 15 – 104 1 336 495 5,364 4,781 1,165 1,022 (1) All of the Canadian plans’ assets have quoted prices in active markets, except securities issued or guaranteed by other governments, certain of the assets invested in corporate debt ($27 million as at October 31, 2014 and $nil as at October 31, 2013) and certain of the assets invested in pooled funds ($1,452 million as at October 31, 2014 and $1,186 million as at October 31, 2013). (2) All of the U.S. plans’ assets have quoted prices in active markets, except corporate debt and pooled funds. No plan assets are directly invested in the bank’s or related parties’ securities as at October 31, 2014 and 2013. As at October 31, 2014, our primary Canadian plan indirectly held approximately $11 million ($8 million in 2013) of the bank’s common shares. The plans do not hold any property occupied or other assets used by the bank. The plans paid $4 million in the year ended October 31, 2014 ($3 million in 2013) to us and certain of our subsidiaries for investment management, record-keeping, custodial and administrative services rendered. Sensitivity of Assumptions Key weighted-average assumptions used in measuring the defined benefit obligations for our primary plans are outlined in the following table. The sensitivity analysis provided in the table should be used with caution as it is hypothetical and the impact of changes in each key assumption may not be linear. The sensitivities to changes in each key variable have been calculated independently of the impact of changes in other key variables. Actual experience may result in simultaneous changes in a number of key assumptions. Changes in one factor may result in changes in another, which would amplify or reduce certain sensitivities. (Canadian $ in millions, except as noted) Discount rate (%) Impact of: 1% increase ($) 1% decrease ($) Rate of compensation increase (%) Impact of: 0.25% increase ($) 0.25% decrease ($) Mortality Impact of: 1 year increase ($) 1 year decrease ($) Assumed overall health care cost trend rate (%) Impact of: 1% increase ($) 1% decrease ($) Defined benefit obligation Pension benefit plans Other employee future benefit plans 4.1 (790) 999 2.8 45 (43) (115) 112 na na na 4.3 (152) 196 2.6 2 (1) (28) 29 5.2 (1) 6 (81) (1) Trending to 4.5% in 2030 and remaining at that level thereafter. na – not applicable Disaggregation of Defined Benefit Obligation Disaggregation of the defined benefit obligation for our primary plans is as follows: Canadian pension plans Active members Inactive and retired members U.S. pension plans Active members Inactive and retired members Canadian other employee future benefit plans Active members Inactive and retired members Maturity Profile The duration of the defined benefit obligation for our primary plans is as follows: (In years) s e t o N Canadian pension plans U.S. pension plans Canadian other employee future benefit plans 170 BMO Financial Group 197th Annual Report 2014 2014 2013 46% 54% 100% 62% 38% 100% 45% 55% 100% 46% 54% 100% 62% 38% 100% 45% 55% 100% 2014 13.6 11.2 16.5 2013 12.8 10.5 14.3 Cash Flows Cash payments we made during the year in connection with our employee future benefit plans are as follows: (Canadian $ in millions) Pension benefit plans Other employee future benefit plans Contributions to defined benefit plans Contributions to defined contribution plans Benefits paid directly to pensioners 2014 254 8 30 292 2013 154 8 24 186 2012 198 7 25 230 2014 2013 2012 – – 33 33 – – 30 30 – – 29 29 Our best estimate of the amounts we expect to contribute for the year ending October 31, 2015 is approximately $182 million to our pension benefit plans and $40 million to our other employee future benefit plans. Note 25: Income Taxes We report our provision for income taxes in our Consolidated Statement of Income based upon transactions recorded in our consolidated financial statements regardless of when they are recognized for income tax purposes, with the exception of repatriation of retained earnings from our foreign subsidiaries, as noted below. In addition, we record an income tax expense or benefit directly in shareholders’ equity when the taxes relate to amounts recorded in shareholders’ equity. For example, income tax expense (recovery) on hedging gains (losses) related to our net investment in foreign operations is recorded in our Consolidated Statement of Comprehensive Income as part of net gain (loss) on translation of net foreign operations. Current tax is the amount of income tax recoverable (payable) in respect of the taxable loss (profit) for a period. Deferred income tax assets and liabilities are measured at the tax rates expected to apply when temporary differences reverse. Changes in deferred income tax assets and liabilities related to a change in tax rates are recorded in income in the period the tax rate is substantively enacted, except to the extent that the tax arises from a transaction or event which is recognized either in other comprehensive income or directly in equity. Included in deferred income tax assets is $77 million related to Canadian tax loss carryforwards that will expire in 2030 to 2034, $1,331 million related to U.S. tax loss carryforwards that will expire in various Components of Deferred Income Tax Balances amounts in U.S. taxation years from 2028 through 2033 and $10 million related to U.K. tax loss carryforwards that are available for use indefinitely against relevant profits generated in the U.K. On the evidence available, including management projections of income, we believe that there will be sufficient taxable income generated by our business operations to support these deferred tax assets. The amount of tax on temporary differences, unused tax losses and unused tax credits for which no deferred tax asset is recognized in our Consolidated Balance Sheet as at October 31, 2014 is $182 million. Deferred tax assets have not been recognized in respect of these items because it is not probable that realization of these assets will occur. Income that we earn in foreign countries through our branches or subsidiaries is generally subject to tax in those countries. We are also subject to Canadian taxation on the income earned in our foreign branches. Canada allows a credit for foreign taxes paid on this income. Upon repatriation of retained earnings from certain foreign subsidiaries, we would be required to pay tax on certain of these earnings. As repatriation of such earnings is not planned in the foreseeable future, we have not recorded the related deferred income tax liability. The amount of temporary differences associated with investments in subsidiaries, branches, associates and interests in joint ventures for which deferred tax liabilities have not been recognized is $23 billion as at October 31, 2014 ($20 billion in 2013). (Canadian $ in millions) Deferred Income Tax Assets (1) As at October 31, 2012 Benefit (expense) to income statement Benefit (expense) to equity Translation and other As at October 31, 2013 Acquisitions Benefit (expense) to income statement Benefit (expense) to equity Translation and other As at October 31, 2014 (Canadian $ in millions) Deferred Income Tax Liabilities (2) As at October 31, 2012 Acquisitions Benefit (expense) to income statement Expense to equity Translation and other As at October 31, 2013 Acquisitions Benefit (expense) to income statement Benefit to equity Translation and other As at October 31, 2014 Allowance for credit losses Employee future benefits Deferred compensation benefits Other comprehensive income Tax loss carry- forwards Other Total 1,097 (216) – 33 914 – (252) – 96 758 296 46 (13) – 329 8 31 3 3 374 310 30 – 4 344 15 42 – 18 419 (47) 1,477 474 3,607 – 16 2 (35) – 43 (14) – 1 (189) 3 83 (29) 1,485 461 3,504 – – (3) 25 (7) 10 (180) – 103 2 49 – 72 35 (310) – 317 1,418 584 3,546 Premises and equipment Pension Goodwill and benefits intangible assets Securities Other Total (320) – 6 – (6) (320) 5 (10) – (24) (349) 78 – 8 (113) (4) (31) – (35) 60 2 (4) (232) (148) (28) (2) (35) – (6) – 113 – – – 108 – (3) (275) (35) 77 (90) 28 – (30) – 32 – 2 – (62) – 1 (650) (2) 200 (113) (19) (584) (85) (47) 60 (49) (367) (1) 16 (705) N o t e s (1) Deferred tax assets of $3,019 million and $3,027 million as at October 31, 2014 and 2013, respectively, are presented on the balance sheet net by legal jurisdiction. (2) Deferred tax liabilities of $178 million and $107 million as at October 31, 2014 and 2013, respectively, are presented on the balance sheet net by legal jurisdiction. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. BMO Financial Group 197th Annual Report 2014 171 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Provision for Income Taxes (Canadian $ in millions) Consolidated Statement of Income Current Provision for income taxes for the current period Adjustments in respect of current tax for prior periods Deferred Origination and reversal of temporary differences Effect of changes in tax rates Shareholders’ Equity Income tax expense (recovery) related to: Remeasurement of pension and other employee future benefit plans Unrealized (losses) on available-for-sale securities, net of hedging activities Gains (losses) on cash flow hedges Hedging of unrealized (gains) on translation of net foreign operations Total Components of Total Provision for Income Taxes (Canadian $ in millions) Canada: Current income taxes Federal Provincial Canada: Deferred income taxes Federal Provincial Total Canadian Foreign: Current income taxes Deferred income taxes Total foreign Total 2014 2013 2012 547 (1) 361 (4) 903 (63) (15) 51 (144) 732 1,095 (29) (10) (1) 1,055 126 (31) (57) (146) 947 706 (112) 287 (7) 874 (177) (26) (48) (13) 610 2014 2013 2012 292 200 492 33 29 62 554 (58) 236 178 732 457 300 757 (109) (76) (185) 572 90 285 375 947 288 186 474 (56) (31) (87) 387 43 180 223 610 Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Set out below is a reconciliation of our statutory tax rates and income taxes that would be payable at these rates to the effective income tax rates and provision for income taxes that we have recorded in our Consolidated Statement of Income: (Canadian $ in millions, except as noted) 2014 2013 2012 Combined Canadian federal and provincial income taxes at the statutory tax rate Increase (decrease) resulting from: 1,382 26.4% (1) 1,386 26.4% (1) 1,338 26.6% (1) Tax-exempt income from securities Foreign operations subject to different tax rates Change in tax rate for deferred income taxes Run-off of structured credit activities Income attributable to non-controlling interests Adjustments in respect of current tax for prior periods Other (343) (69) (4) 1 (33) (1) (30) (6.5) (1.3) (0.1) – (0.7) – (0.6) (250) (10) (1) (6) (35) (29) – (4.7) (0.2) – (0.1) (0.7) (0.6) – Provision for income taxes and effective tax rate 903 17.2% 1,055 20.1% (1) The combined statutory tax rate changed during the year as a result of legislation that became substantively enacted with respect to the year. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. (188) (30) (7) (67) (35) (112) (25) 874 (3.7) (0.7) (0.1) (1.3) (0.7) (2.2) (0.5) 17.4% s e t o N 172 BMO Financial Group 197th Annual Report 2014 Note 26: Earnings Per Share Basic Earnings per Share Our basic earnings per share is calculated by dividing our net income attributable to bank shareholders, after deducting total preferred share dividends, by the daily average number of fully paid common shares outstanding throughout the year. Basic Earnings per Share (Canadian $ in millions, except as noted) Net income attributable to bank shareholders Dividends on preferred shares Net income available to common shareholders Average number of common shares 2014 2013 2012 4,277 (120) 4,130 (120) 4,082 (136) 4,157 4,010 3,946 outstanding (in thousands) 645,860 648,476 644,407 Basic earnings per share (Canadian $) 6.44 6.19 6.13 Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. Diluted Earnings per Share Diluted earnings per share represents what our earnings per share would have been if instruments convertible into common shares that would have had the impact of reducing our earnings per share had been converted, either at the beginning of the year for instruments that were outstanding at the beginning of the year or from the date of issue for instruments issued during the year. Diluted Earnings per Share (Canadian $ in millions, except as noted) Net income available to common shareholders Average number of common shares outstanding (in thousands) Convertible shares Stock options potentially exercisable (1) Common shares potentially repurchased Average diluted number of common shares outstanding (in thousands) Diluted earnings per share (Canadian $) Convertible Shares In determining diluted earnings per share, we increase net income available to common shareholders by the aggregate amount of dividends paid on convertible preferred shares and interest on capital trust securities, as these distributions would not have been paid if the instruments had been converted at the beginning of the year. Similarly, we increase the average number of common shares outstanding by the number of shares that would have been issued had the conversion taken place at the beginning of the year or on the date of issue, if later. Employee Stock Options In determining diluted earnings per share, we increase the average number of common shares outstanding by the number of shares that would have been issued if all stock options with a strike price below the average share price for the year had been exercised. When performance targets have not been met, affected options are excluded from the calculation. We also decrease the average number of common shares outstanding by the number of our common shares that we could have repurchased if we had used the proceeds from the exercise of stock options to repurchase them on the open market at the average share price for the year. We do not adjust for stock options with a strike price above the average share price for the year because including them would increase our earnings per share, not dilute it. 2014 2013 2012 4,157 4,010 3,946 645,860 648,476 644,407 – 10,832 (8,217) – 10,656 (9,326) 3,040 6,353 (5,185) 648,475 649,806 648,615 6.41 6.17 6.10 (1) In computing diluted earnings per share, we excluded average stock options outstanding of 1,734,932, 2,677,737 and 6,226,858 with weighted-average exercise prices of $235.07, $201.93 and $132.63 for the years ended October 31, 2014, 2013 and 2012, respectively, as the average share price for the period did not exceed the exercise price. Note 27: Operating and Geographic Segmentation Operating Groups We conduct our business through three operating groups, each of which has a distinct mandate. We determine our operating groups based on our management structure and therefore these groups, and results attributed to them, may not be comparable with those of other financial services companies. We evaluate the performance of our groups using reported and adjusted measures such as net income, revenue growth, return on equity, and non-interest expense-to-revenue (productivity) ratio, as well as operating leverage. Personal and Commercial Banking Personal and Commercial Banking (“P&C”) is comprised of two operating segments: Canadian Personal and Commercial Banking and U.S. Personal and Commercial Banking. Canadian Personal and Commercial Banking Canadian Personal and Commercial Banking (“Canadian P&C”) provides a full range of financial products and services to more than seven million customers as they do business with us through their channel of choice: in our branches, on their mobile devices, online, over the telephone and through our automated banking machines. Personal Banking provides financial solutions for everyday banking, financing, investing, credit card and creditor insurance needs. Commercial banking provides our small business and commercial banking customers with a broad suite of integrated commercial and capital market products, as well as financial advisory services. U.S. Personal and Commercial Banking U.S. Personal and Commercial Banking (“U.S. P&C”) offers a broad range of products and services. Our retail and small and mid-sized business banking customers are served through our branches, contact centres, online and mobile banking platforms and ABMs across eight states. Wealth Management BMO’s group of wealth management businesses serves a full range of client segments from mainstream to ultra high net worth and institutional, with a broad offering of wealth management products and services including insurance products. Wealth Management (“WM”) is a global business with an active presence in markets across Canada, the United States, Europe and Asia. BMO Capital Markets BMO Capital Markets (“BMO CM”) is a North American-based financial services provider offering a complete range of products and services to corporate, institutional and government clients. Through our Investment BMO Financial Group 197th Annual Report 2014 173 N o t e s NOTES TO CONSOLIDATED FINANCIAL STATEMENTS and Corporate Banking and Trading Products lines of business we operate in 29 locations around the world, including 16 offices in North America. Corporate Services Corporate Services consists of Corporate Units and Technology and Operations (“T&O”). Corporate Units provide enterprise-wide expertise and governance support in a variety of areas, including strategic planning, risk management, finance, legal and compliance, marketing, communications and human resources. T&O manages, maintains and provides governance over information technology, operations services, real estate and sourcing for BMO Financial Group. The costs of providing these Corporate Units and T&O services are largely transferred to the three client operating groups (P&C, WM and BMO CM), and only relatively minor amounts are retained in Corporate Services results. As such, Corporate Services adjusted operating results largely reflect the impact of certain asset-liability management activities, the elimination of taxable equivalent adjustments, the results from certain impaired real estate secured assets, purchased loan accounting impacts, certain acquisition integration costs, restructuring costs, run-off structured credit activities and adjustments to the collective allowance for credit losses. Basis of Presentation The results of these operating groups are based on our internal financial reporting systems. The accounting policies used in these segments are generally consistent with those followed in the preparation of our consolidated financial statements, as disclosed in Note 1 and throughout the consolidated financial statements. A notable accounting measurement difference is the taxable equivalent basis adjustment as described below. Periodically, certain business lines and units within the business lines are transferred between client and corporate support groups to more closely align the bank’s organizational structure with its strategic priorities. In addition, revenue and expense allocations are updated to more accurately align with current experience. Results for prior periods are restated to conform to the current year’s presentation. Taxable Equivalent Basis We analyze net interest income on a taxable equivalent basis (“teb”) at the operating group level. This basis includes an adjustment that increases reported revenues and the reported provision for income taxes by an amount that would raise revenues on certain tax-exempt items to a level that incurs tax at the statutory rate. The operating groups’ teb adjustments are eliminated in Corporate Services. Inter-Group Allocations Various estimates and allocation methodologies are used in the preparation of the operating groups’ financial information. We allocate expenses directly related to earning revenue to the groups that earned the related revenue. Expenses not directly related to earning revenue, such as overhead expenses, are allocated to operating groups using allocation formulas applied on a consistent basis. Operating group net interest income reflects internal funding charges and credits on the groups’ assets, liabilities and capital, at market rates, taking into account relevant terms and currency considerations. The offset of the net impact of these charges and credits is reflected in Corporate Services. Geographic Information We operate primarily in Canada and the United States but we also have operations in the United Kingdom, Europe, the Caribbean and Asia, which are grouped in Other countries. We allocate our results by geographic region based on the location of the unit responsible for managing the related assets, liabilities, revenues and expenses, except for the consolidated provision for credit losses, which is allocated based upon the country of ultimate risk. s e t o N 174 BMO Financial Group 197th Annual Report 2014 Our results and average assets, grouped by operating segment and geographic region, are as follows: (Canadian $ in millions) 2014 (2) Net interest income Non-interest revenue Total Revenue Provision for credit losses Amortization Non-interest expense Income before taxes and non-controlling interest in subsidiaries Provision for income taxes Reported net income Non-controlling interest in subsidiaries Net Income attributable to bank shareholders Canadian P&C U.S. P&C Wealth Management BMO CM Corporate Services (1) Total Canada United States Other countries 4,772 1,723 6,495 541 149 3,111 2,694 680 2,014 – 2,014 2,488 569 3,057 164 173 1,832 888 240 648 – 648 560 3,273 3,833 (3) 119 2,715 1,002 217 785 3 782 1,179 2,545 3,724 (18) 52 2,301 1,389 310 1,079 – (538) 147 (391) (123) 254 215 (737) (544) (193) 53 8,461 8,257 16,718 561 747 10,174 5,236 903 4,333 56 5,476 5,443 10,919 533 424 6,023 3,939 676 3,263 54 1,079 (246) 4,277 3,209 2,836 2,194 5,030 30 279 3,657 1,064 217 847 – 847 149 620 769 (2) 44 494 233 10 223 2 221 Average Assets 190,673 72,584 24,980 260,962 44,729 593,928 370,060 201,542 22,326 (Canadian $ in millions) 2013 (2) Net interest income Non-interest revenue Total Revenue Provision for credit losses Amortization Non-interest expense Income before taxes and non-controlling interest in subsidiaries Provision for income taxes Reported net income Non-controlling interest in subsidiaries Net Income attributable to bank shareholders Canadian P&C U.S. P&C Wealth Management BMO CM Corporate Services (1) Total Canada United States Other countries 4,526 1,580 6,106 572 144 2,982 2,408 596 1,812 – 1,812 2,327 579 2,906 223 172 1,697 814 233 581 – 581 558 2,890 3,448 3 81 2,266 1,098 268 830 – 830 1,202 2,190 3,392 (36) 45 2,039 1,344 300 1,044 – 64 147 211 (175) 251 549 (414) (342) (72) 65 8,677 7,386 16,063 587 693 9,533 5,250 1,055 4,195 65 5,383 4,901 10,284 654 406 5,709 3,515 626 2,889 54 3,223 2,093 5,316 (65) 274 3,547 1,560 434 1,126 11 1,044 (137) 4,130 2,835 1,115 71 392 463 (2) 13 277 175 (5) 180 – 180 Average Assets 177,623 64,277 22,143 247,609 43,779 555,431 345,340 189,839 20,252 (Canadian $ in millions) 2012 (2) Net interest income Non-interest revenue Total Revenue Provision for credit losses Amortization Non-interest expense Income before taxes and non-controlling interest in subsidiaries Provision for income taxes Reported net income Non-controlling interest in subsidiaries Net Income attributable to bank shareholders Canadian P&C U.S. P&C Wealth Management BMO CM Corporate Services (1) Total Canada United States Other countries 4,467 1,517 5,984 613 135 2,908 2,328 579 1,749 – 1,749 2,405 589 2,994 274 188 1,727 805 234 571 – 571 556 2,344 2,900 22 68 2,147 663 136 527 1 526 1,164 2,085 3,249 6 39 1,947 1,257 272 985 – 985 345 457 802 (151) 253 723 (23) (347) 324 73 251 8,937 6,992 15,929 764 683 9,452 5,030 874 4,156 74 5,392 4,579 9,971 633 384 5,587 3,367 523 2,844 55 3,496 1,961 5,457 134 292 3,635 1,396 359 1,037 19 4,082 2,789 1,018 49 452 501 (3) 7 230 267 (8) 275 – 275 Average Assets 161,985 61,534 20,354 251,562 48,496 543,931 332,602 190,748 20,581 (1) Corporate Services includes Technology and Operations. (2) Operating groups report on a taxable equivalent basis – see Basis of Presentation section. Certain comparative figures have been restated as a result of the adoption of new accounting principles – see Note 1. N o t e s BMO Financial Group 197th Annual Report 2014 175 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 28: Significant Subsidiaries As at October 31, 2014, the bank, either directly or indirectly through its subsidiaries, owned more than 50% of the issued and outstanding voting securities of each of the following significant operating subsidiaries. The bank also, either directly or indirectly through its subsidiaries, owned more than 50% of the issued and outstanding voting securities of various financing entities, non-operating subsidiaries, holding companies and SEs that are sponsored by the bank for various purposes. Neither these subsidiaries, nor entities in which the bank holds 50% or less of the issued and outstanding voting securities, are specifically referenced in the table below. Head or principal office Book value of shares owned by the bank (Canadian $ in millions) Bank of Montreal Assessoria e Serviços Ltda. Bank of Montreal Capital Markets (Holdings) Limited BMO Capital Markets Limited Pyrford International Limited Bank of Montreal (China) Co. Ltd. Bank of Montreal Finance Ltd. Bank of Montreal Holding Inc. and subsidiaries, including: BMO Investments Limited BMO Reinsurance Limited BMO Nesbitt Burns Holdings Corporation BMO Nesbitt Burns Inc. BMO Harris Investment Management Inc. BMO Asset Management Inc. BMO Capital Markets Real Estate Inc. BMO Nesbitt Burns Securities Ltd. BMO Private Equity (Canada) Inc. and subsidiaries BMO Advisors Private Limited (India) BMO Nesbitt Burns Financial Services Inc. BMO Group Retirement Services Inc. BMO Holding Finance, LLC BMO Investments Inc. and subsidiary BMO InvestorLine Inc. BMO Service Inc. Bank of Montreal Ireland plc Bank of Montreal Mortgage Corporation BMO Mortgage Corp. BMRI Realty Investments Bay Street Holdings, LLC BMO Financial Corp. BMO Asset Management Corp. and subsidiaries BMO Capital Markets Corp. BMO Capital Markets GKST Inc. BMO Delaware Trust Company BMO Global Capital Solutions, Inc. BMO Harris Bank National Association and subsidiaries BMO Harris Central National Association BMO Harris Financial Advisors, Inc. BMO Harris Financing, Inc. and subsidiaries BMO Investment Financing, Inc. BMO Private Equity (U.S.), Inc. and subsidiaries CTC my CFO, LLC Harris Trade Services Limited BMO Investment Distributors LLC (f.k.a M&I Distributors, LLC) psps Holdings, LLC and subsidiary Stoker Ostler Wealth Advisors, Inc. Sullivan, Bruyette, Speros & Blayney, Inc. BMO Global Asset Management (Europe) Limited F&C Asset Management plc and subsidiaries, including: F&C Asset Management Asia Ltd. F&C Management Luxembourg SA F&C Netherlands BV F&C Portugal SA F&C REIT Asset Management LLP and subsidiaries s e t o N BMO Life Insurance Company BMO Life Holdings (Canada), ULC BMO Life Assurance Company BMO Trust Company LGM (Bermuda) Limited Lloyd George Investment Management (Bermuda) Limited BMO Global Asset Management (Asia) Limited LGM Investments Limited (f.k.a Lloyd George Management (Europe) Limited) Lloyd George Management (Singapore) Pte Ltd. 176 BMO Financial Group 197th Annual Report 2014 Rio de Janeiro, Brazil London, England London, England London, England Beijing, China Toronto, Canada Calgary, Canada Hamilton, Bermuda St. Michaels, Barbados Toronto, Canada Toronto, Canada Toronto, Canada Toronto, Canada Toronto, Canada Toronto, Canada Toronto, Canada Gurgaon, India Toronto, Canada Toronto, Canada Wilmington, United States Toronto, Canada Toronto, Canada Toronto, Canada Dublin, Ireland Calgary, Canada Vancouver, Canada Toronto, Canada Chicago, United States Chicago, United States Chicago, United States New York, United States Chicago, United States Greenville, United States Chicago, United States Chicago, United States Roselle, United States Chicago, United States Chicago, United States Wilmington, United States Chicago, United States Palo Alto, United States Hong Kong, China Milwaukee, United States Chicago, United States Scottsdale, United States McLean, United States London, England London, England Hong Kong, China Luxembourg Amsterdam, Netherlands Lisbon, Portugal London, England Toronto, Canada Halifax, Canada Toronto, Canada Toronto, Canada Hamilton, Bermuda Hamilton, Bermuda Hong Kong, China London, England Singapore – 208 371 31 25,347 776 2,483 20 15,481 162 799 948 50 Significant Restrictions Our ability to transfer funds between our subsidiaries may be restricted by statutory, contractual, capital and regulatory requirements. Restrictions include: ‰ Assets pledged as security for various liabilities we incur. Refer to Note 30 for details. ‰ Assets of our consolidated structured entities that are held for the benefit of the note holders. Refer to Note 9 for details. ‰ Assets held by our insurance subsidiaries. Refer to Note 14 for details. ‰ Regulatory and statutory requirements that reflect capital and liquidity requirements. Note 29: Related Party Transactions Related parties include subsidiaries, associates, joint ventures, key management personnel and employee future benefit plans. Key management personnel are defined as those persons having authority and responsibility for planning, directing and/or controlling the activities of an entity, being the directors and ten most senior executives in 2014 (nine in 2013). Key Management Personnel Compensation The following table presents the compensation of key management personnel. (Canadian $ in millions) Base salary and incentives Share-based payments (1) Total key management personnel compensation 2014 2013 18 21 39 15 22 37 Excluded from the table above are post-employment benefits of $2 million in 2014 and 2013. Termination benefits and other long-term benefits were $nil in 2014 and 2013. (1) Amounts included in share-based payments are the fair values of awards granted in the year. We provide certain banking services and loans to our key management personnel at market terms and conditions. Loans to key management personnel totalled $5 million and $3 million as at October 31, 2014 and 2013, respectively. Interest on these loans was less than $1 million in the years ended October 31, 2014 and 2013. None of the loans to key management personnel are at preferred rates. Deferred Stock Units Members of our Board of Directors are required to take 100% of their annual retainers and other fees in the form of either our common shares (purchased on the open market) or deferred stock units until such time as the directors’ shareholdings (including deferred stock units) are greater than eight times their annual cash retainers as directors. Directors receive a specified amount of their annual director retainer fee in deferred stock units. They may elect to take all or part of the remainder of such retainer fee and other remuneration in cash, or in additional common shares or deferred stock units. Deferred stock units are adjusted to reflect reinvested dividends and changes in the market value of our common shares. The value of these deferred stock units is only paid after termination of service as a director. Liabilities related to these plans are recorded in other liabilities in our Consolidated Balance Sheet and totalled $44 million and $37 million as at October 31, 2014 and 2013, respectively. Members of the Board of Directors of our wholly owned subsidiary, BMO Financial Corp., are required to take a specified minimum amount of their annual retainers and other fees in the form of deferred stock units. Joint Ventures and Associates We provide banking services to our joint ventures and associates on the same terms that we offer to our customers for these services. Our investment in a joint venture of which we own 50% totalled $216 million as at October 31, 2014 ($177 million in 2013). Our investments in associates over which we exert significant influence totalled $286 million as at October 31, 2014 ($225 million in 2013). Employees A select suite of customer loan and mortgage products is offered to employees at rates normally accorded to preferred customers. We also offer employees a fee-based subsidy on annual credit card fees. N o t e s BMO Financial Group 197th Annual Report 2014 177 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 30: Provisions and Contingent Liabilities (a) Provisions Provisions are recognized when we have an obligation as a result of past events, such as contractual commitments, legal or other obligations. We recognize as a provision the best estimate of the amount required to settle the obligations as of the balance sheet date, taking into account the risks and uncertainties surrounding the obligations. Contingent liabilities are potential obligations that may arise from past events, the existence of which will only be confirmed by the occurrence or non-occurrence of one or more future events not wholly within our control. Contingent liabilities are disclosed below. Changes in the provision balance during the year were as follows: (Canadian $ in millions) Balance at beginning of year Additional provisions/increase in provisions Provisions utilized Amounts reversed Exchange differences and other movements Balance at end of year 2014 2013 209 177 (77) (25) (3) 237 138 (150) (15) (1) 281 209 (b) Legal Proceedings BMO Nesbitt Burns Inc., an indirect subsidiary of the bank, has been named as a defendant in several individual actions and proposed class actions in Canada and the United States brought on behalf of shareholders of Bre-X Minerals Ltd. Many of the actions have been resolved as to BMO Nesbitt Burns Inc., including two during the year ended October 31, 2010. Management believes that there are strong defenses to the remaining claims and will vigorously defend them. The bank and its subsidiaries are party to other legal proceedings, including regulatory investigations, in the ordinary course of business. While there is inherent difficulty in predicting the outcome of these other proceedings, management does not expect the outcome of any of these proceedings, individually or in the aggregate, to have a material adverse effect on the consolidated financial position or the results of operations of the bank. (c) Collateral When entering into trading activities such as purchases under resale agreements, securities borrowing and lending activities or financing and derivative transactions, we require our counterparties to provide us with collateral that will protect us from losses in the event of the counterparty’s default. The fair value of collateral that we are permitted to sell or repledge (in the absence of default by the owner of the collateral) was $52,602 million as at October 31, 2014 ($38,606 million in 2013). The fair value of collateral that we have sold or repledged was $35,451 million as at October 31, 2014 ($24,795 million in 2013). Collateral transactions (received or pledged) are typically conducted under terms that are usual and customary in standard trading activities. If there is no default, the securities or their equivalents must be returned to or returned by the counterparty at the end of the contract. (d) Pledged Assets In the normal course of business, we pledge assets as security for various liabilities that we incur. The following tables summarize our pledged assets, to whom they are pledged and in relation to what activity: (Canadian $ in millions) Cash and securities Issued or guaranteed by Canada Issued or guaranteed by a Canadian province, municipality or school corporation Other Mortgages, securities borrowed or purchased under resale agreements and other Total assets pledged (1) Excludes restricted cash resources disclosed in Note 2. (Canadian $ in millions) Assets pledged to: Clearing systems, payment systems and depositories Foreign governments and central banks Assets pledged in relation to: Obligations related to securities sold under repurchase agreements Securities borrowing and lending Derivatives transactions Securitization Covered bonds Other Total assets pledged (1) 2014 2013 7,077 8,917 6,000 40,162 4,749 28,421 59,217 53,220 112,456 95,307 2014 2013 540 2 1,033 2 25,492 32,792 8,682 26,031 7,111 11,806 17,121 23,819 9,676 26,435 7,604 9,617 112,456 95,307 Excludes cash pledged with central banks disclosed as restricted cash in Note 2. Excludes collateral received that has been sold or repledged as disclosed in the Collateral section of this note. (1) Excludes rehypothecated assets of $4,382 million ($4,500 million in 2013) pledged in relation to securities borrowing transactions. (e) Other Commitments As a participant in merchant banking activities, we enter into commitments to fund external private equity funds and investments in equity and debt securities at market value at the time the commitments are drawn. In addition, we act as underwriter for certain new issuances under which we alone or together with a syndicate of financial institutions purchase the new issue for resale to investors. In connection with these activities, our related commitments were $2,261 million as at October 31, 2014 ($4,280 million in 2013). Note 31: Fair Value of Financial Instruments We record trading assets and liabilities, derivatives, available-for-sale securities and securities sold but not yet purchased at fair value, and other non-trading assets and liabilities at amortized cost less allowances or write-downs for impairment. The fair values presented in this note are based upon the amounts estimated for individual assets and liabilities and do not include an estimate of the fair value of any of the legal entities or underlying operations that comprise our business. Fair value represents the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants at the measurement date (i.e. an exit price). The fair value amounts disclosed represent point-in-time estimates that may change in subsequent reporting periods due to changes in market conditions or other factors. Some financial instruments are not typically exchangeable or exchanged and therefore it is difficult to determine s e t o N 178 BMO Financial Group 197th Annual Report 2014 their fair value. Where there is no quoted market price, we determine fair value using management’s best estimates based on a range of valuation techniques and assumptions; since these involve uncertainties, the fair values may not be realized in an actual sale or immediate settlement of the instruments. Governance Over the Determination of Fair Value Senior executive oversight of our valuation processes is provided through various valuation and risk committees. In order to ensure that all financial instruments carried at fair value are reasonably measured for risk management and financial reporting purposes, we have established governance structures and controls, such as model validation and approval, independent price verification (IPV) and profit and loss attribution analysis (PAA), consistent with industry practice. These controls are applied independently of the relevant operating groups. We establish and regularly update valuation methodologies for each financial instrument that is required to be measured at fair value. The application of valuation models for products or portfolios is subject to independent approval to ensure only validated models are used. The impact of known limitations of models and data inputs is also monitored on an ongoing basis. IPV is a process that regularly and independently verifies the accuracy and appropriateness of market prices or model inputs used in the valuation of financial instruments. This process assesses fair values using a variety of different approaches to verify and validate the valuations. PAA is a daily process used by management to identify and explain changes in fair value positions across all operating lines of business. This process works in concert with other processes to ensure that the fair values being reported are reasonable. Securities For traded securities, quoted market value is considered to be fair value. Quoted market value is based on bid prices. Securities for which no active market exists are valued using all reasonably available market information. Our fair value methodologies are described below. Government Securities The fair value of government issued or guaranteed debt securities in active markets is determined by reference to recent transaction prices, broker quotes or third-party vendor prices. The fair values of securities that are not traded in an active market are modelled using implied yields derived from the prices of similar actively traded government securities and observable spreads. Market inputs to the model include coupon, maturity and duration. Mortgage-Backed Securities and Collateralized Mortgage Obligations The fair value of mortgage-backed securities and collateralized mortgage obligations is determined by independent prices obtained from third-party vendors, broker quotes and relevant market indices, as applicable. If such prices are not available, fair value is determined using cash flow models that make maximum use of observable market inputs or benchmark prices for similar instruments. Mortgage-backed security and collateralized mortgage obligation valuation assumptions include discount rates, expected prepayments, credit spreads and recoveries. Corporate Debt Securities The fair value of corporate debt securities is determined using prices observed in the most recently executed transactions. When observable price quotations are not available, fair value is determined based on discounted cash flow models using discounting curves and spreads observed from independent dealers, brokers and multi-contributor pricing sources. Corporate Equity Securities The fair value of equity securities is based on quoted prices in active markets, where available. Where quoted prices in active markets are not readily available, fair value is determined based on quoted market prices for similar securities or through valuation techniques, including discounted cash flow analysis and multiples of earnings. Privately Issued Securities Privately issued debt and equity securities are valued using recent prices observed in market transactions, where available. Otherwise, fair value is derived from valuation models using a market or income approach. These models consider various factors, including projected cash flows, earnings, revenue and other third-party evidence, as available. The fair value of limited partnership investments is based upon net asset values published by third-party fund managers. Prices from brokers and multi-contributor pricing sources are corroborated as part of our independent review process, which may include using valuation techniques or obtaining consensus or composite prices from other pricing services. We validate the estimates of fair value by independently obtaining multiple quotes for external market prices and input values. We review the approach taken by third-party vendors to ensure that the vendor employs a valuation model which maximizes the use of observable inputs such as benchmark yields, bid- ask spreads, underlying collateral, weighted-average terms to maturity and prepayment rate assumptions. Fair value estimates from internal valuation techniques are verified, where possible, by reference to prices obtained from third-party vendors. Loans In determining the fair value of our fixed rate and floating rate performing loans, we discount the remaining contractual cash flows, adjusted for estimated prepayment, at market interest rates currently offered for loans with similar terms. The value of our loan balances determined using this approach is further adjusted by a credit mark that represents an estimate of the expected credit losses in our loan portfolio. Derivative Instruments A number of valuation techniques are employed to estimate fair value, including discounted cash flow analysis, the Black-Scholes model, Monte Carlo simulation and other accepted market models. These vetted models incorporate current market measures for interest rates, currency exchange rates, equity and commodity prices and indices, credit spreads, recovery rates, corresponding market volatility levels, spot prices, correlation levels and other market-based pricing factors. Option implied volatilities, an input into many valuation models, are either obtained directly from market sources or calculated from market prices. Multi-contributor pricing sources are used wherever possible. In determining the fair value of complex and customized derivatives, we consider all reasonably available information, including dealer and broker quotations, multi-contributor pricing sources and any relevant observable market inputs. Our model calculates fair value based on inputs specific to the type of contract, which may include stock prices, correlation for multiple assets, interest rates, foreign exchange rates, yield curves and volatilities. We calculate a credit valuation adjustment (“CVA”) to recognize the risk that any given derivative counterparty may not ultimately be able to fulfill its obligations. The CVA is derived from market-observed credit spreads or proxy credit spreads and our assessment of the net counterparty credit risk exposure, taking into account credit mitigants such as collateral, master netting agreements and settlements through clearing houses. We also calculate a funding valuation adjustment (“FVA”) to recognize the implicit funding costs associated with over the counter derivative positions. The FVA is determined based on reference to market funding spreads. BMO Financial Group 197th Annual Report 2014 179 N o t e s NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deposits In determining the fair value of our deposits, we incorporate the following assumptions: ‰ For fixed rate, fixed maturity deposits, we discount the remaining contractual cash flows for these deposits, adjusted for expected redemptions, at market interest rates currently offered for deposits with similar terms and risks. ‰ For fixed rate deposits with no defined maturities, we consider fair value to equal carrying value, based on carrying value being equivalent to the amount payable on the reporting date. ‰ For floating rate deposits, changes in interest rates have minimal impact on fair value since deposits re-price to market frequently. On that basis, fair value is assumed to equal carrying value. A portion of our structured note liabilities that have coupons or repayment terms linked to the performance of interest rates, foreign currencies, commodities or equity securities have been designated at fair value through profit or loss. The fair value of these structured notes is estimated using internally vetted valuation models and incorporates observable market prices for identical or comparable securities, and other inputs such as interest rate yield curves, option volatilities and foreign exchange rates, where appropriate. Where observable prices or inputs are not available, management judgment is required to determine the fair value by assessing other relevant sources of information, such as historical data and proxy information from similar transactions. Securities Sold But Not Yet Purchased The fair value of these obligations is based on the fair value of the underlying securities, which can include equity or debt securities. As these obligations are fully collateralized, the method used to determine fair value would be the same as that used for the relevant underlying equity or debt securities. Securities Purchased Under Resale Agreements and Securities Sold Under Repurchase Agreements The fair value of these agreements is determined using a standard discounted cash flow model. Inputs to the model include contractual cash flows and collateral funding spreads. Securitization Liabilities The determination of the fair value of securitization liabilities, recorded in other liabilities, is based on quoted market prices or quoted market prices for similar financial instruments, where available. Where quoted prices are not available, fair value is determined using valuation techniques that maximize the use of observable inputs, as well as assumptions such as discounted cash flows. Subordinated Debt and Capital Trust Securities The fair value of our subordinated debt and capital trust securities is determined by referring to current market prices for similar instruments. Financial Instruments with a Carrying Value Approximating Fair Value Short-term Financial Instruments Carrying value is a reasonable estimate of fair value for certain financial assets and liabilities due to their predominantly short-term nature, such as interest bearing deposits with banks, securities borrowed, customers’ liability under acceptances, other assets, acceptances, securities lent and certain other liabilities. Other Financial Instruments Carrying value is assumed to be a reasonable estimate of fair value for our cash and cash equivalents and certain other securities. Certain assets, including premises and equipment, goodwill and intangible assets as well as shareholders’ equity, are not considered financial instruments and therefore no fair value has been determined for these items. For longer-term financial instruments within other liabilities, fair value is determined as the present value of contractual cash flows using discount rates at which liabilities with similar remaining maturities could be issued as at the balance sheet date. Fair Value of Financial Instruments Not Carried at Fair Value on the Balance Sheet Set out in the following tables are the amounts that would be reported if all financial assets and liabilities not currently carried at fair value were reported at their fair values. For the year ended October 31, 2014 (Canadian $ in millions) Securities Held to maturity Other (1) Securities purchased under resale agreements (2) Loans Residential mortgages Consumer instalment and other personal Credit cards Businesses and governments s e t o N Deposits Securities sold under repurchase agreements (3) Other liabilities (4) Subordinated debt Carrying value Fair value Valued using quoted market prices Valued using models (with observable inputs) Valued using models (without observable inputs) 2014 10,344 510 10,854 33,141 10,490 1,829 12,319 33,095 101,013 64,143 7,972 120,766 101,273 63,280 7,706 119,399 293,894 291,658 393,088 25,485 23,546 4,913 393,242 25,505 23,927 5,192 838 – 838 – – – – – – – – – – 9,652 – 9,652 33,095 – – – – – 393,242 25,505 23,927 5,192 – 1,829 1,829 – 101,273 63,280 7,706 119,399 291,658 – – – – This table excludes financial instruments with a carrying value approximating fair value such as cash and cash equivalents, interest bearing deposits with banks, securities borrowed, customers’ liabilities under acceptances, other assets, acceptances, securities lent and certain other liabilities. (1) Excluded from other securities is $477 million of securities related to our merchant banking business that are carried at fair value on the balance sheet. (2) Excludes $20,414 million of securities borrowed for which carrying value approximates fair value. (3) Excludes $14,210 million of securities lent for which carrying value approximates fair value. (4) Other liabilities include securitization and SE liabilities and certain other liabilities of subsidiaries, other than deposits. 180 BMO Financial Group 197th Annual Report 2014 For the year ended October 31, 2013 (Canadian $ in millions) Securities Held to maturity Other (1) Securities purchased under resale agreements (2) Loans Residential mortgages Consumer instalment and other personal Credit cards Businesses and governments Deposits Securities sold under repurchase agreements (3) Other liabilities (4) Subordinated debt Carrying value Fair value Valued using quoted market prices Valued using models (with observable inputs) Valued using models (without observable inputs) 2013 6,032 411 6,443 23,174 6,041 1,921 7,962 22,998 96,392 63,640 7,870 104,585 95,944 62,770 7,619 103,268 272,487 269,601 368,369 17,215 22,896 3,996 368,521 17,324 23,182 4,217 640 – 640 – – – – – – – – – – 5,401 – 5,401 22,998 – – – – – 368,521 17,324 23,182 4,217 – 1,921 1,921 – 95,944 62,770 7,619 103,268 269,601 – – – – This table excludes financial instruments with a carrying value approximating fair value such as cash and cash equivalents, interest bearing deposits with banks, securities borrowed, customers’ liabilities under acceptances, other assets, acceptances, securities lent and certain other liabilities. (1) Excluded from other securities is $488 million of securities related to our merchant banking business that are carried at fair value on the balance sheet. (2) Excludes $16,625 million of securities borrowed for which carrying value approximates fair value. (3) Excludes $11,669 million of securities lent for which carrying value approximates fair value. (4) Other liabilities include securitization and SE liabilities and certain other liabilities of subsidiaries, other than deposits. N o t e s BMO Financial Group 197th Annual Report 2014 181 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Fair Value Hierarchy We use a fair value hierarchy to categorize financial instruments according to the inputs we use in valuation techniques to measure fair value. The extent of our use of actively quoted market prices (Level 1), internal models using observable market information as inputs (Level 2) and internal models without observable market information as inputs (Level 3) in the valuation of securities, fair value liabilities, derivative assets and derivative liabilities was as follows: (Canadian $ in millions) 2014 2013 Valued using quoted market prices Valued using models (with observable inputs) Valued using models (without observable inputs) Valued using quoted market prices Valued using models (with observable inputs) Valued using models (without observable inputs) Trading Securities Issued or guaranteed by: Canadian federal government Canadian provincial and municipal governments U.S. federal government U.S. states, municipalities and agencies Other governments Mortgage-backed securities and collateralized mortgage obligations Corporate debt Corporate equity Available-for-Sale Securities Issued or guaranteed by: Canadian federal government Canadian provincial and municipal governments U.S. federal government U.S. states, municipalities and agencies Other governments Mortgage-backed securities and collateralized mortgage obligations Corporate debt Corporate equity Other Securities Fair Value Liabilities Securities sold but not yet purchased Structured note liabilities and other note liabilities Annuity liabilities Derivative Assets Interest rate contracts Foreign exchange contracts Commodity contracts Equity contracts Credit default swaps Derivative Liabilities Interest rate contracts Foreign exchange contracts Commodity contracts Equity contracts Credit default swaps Certain comparative figures have been reclassified to conform with the current year’s presentation. Valuation Techniques and Significant Inputs We determine the fair value of publicly traded fixed maturity and equity securities using quoted prices in active markets (Level 1) when these are available. When quoted prices in active markets are not available, we determine the fair value of financial instruments using models such as discounted cash flows with observable market data for inputs such as yield and prepayment rates or broker quotes and other third-party vendor quotes (Level 2). Fair value may also be determined using models where significant market inputs are not observable due to inactive markets or minimal market activity (Level 3). We maximize the use of market inputs to the extent possible. s e t o N 182 BMO Financial Group 197th Annual Report 2014 8,737 3,134 5,725 – 124 – 1,974 37,221 1,725 4,062 440 626 99 702 9,319 10,511 56,915 27,484 4,946 1,679 1,093 – 2,136 – 5,687 422 5,555 2,425 – 5,814 3,996 9,949 1,971 146 15,963 29,856 10 – 23,615 – – 3,733 7,785 407 23,615 11,925 23 32 653 51 – 759 33 33 1,101 38 – 1,205 18,241 12,649 30 896 68 31,884 16,983 12,110 233 3,002 116 32,444 – – – 85 – – 538 – 623 – – – 1 – – 8 1,138 1,147 467 – – – – – – – – 12 12 – – – – 8 8 8,569 1,578 5,903 – 132 – 2,032 28,073 2,255 4,133 – 681 4 652 8,233 12,014 46,287 27,972 8,260 1,881 4,660 3 1,697 – 4,283 460 4,855 1,817 – 5,388 4,466 8,805 6,004 151 21,244 31,486 – – 20,024 – – 20,024 7 9 673 16 – 705 8 5 695 70 – 778 2,422 6,439 329 9,190 22,215 6,663 66 520 62 29,526 21,516 6,443 138 2,997 83 31,177 – – – 78 – – 822 – 900 – – – 1 – – 30 949 980 488 – – – – – – – – 28 28 – – – – 19 19 Our Level 2 trading securities are primarily valued using discounted cash flow models with observable spreads or broker quotes. The fair value of Level 2 available-for-sale securities is determined using discounted cash flow models with observable spreads or third-party vendor quotes. Level 2 structured note liabilities are valued using models with observable market information. Level 2 derivative assets and liabilities are valued using industry-standard models and observable market information. Quantitative Information about Level 3 Fair Value Measurements The table below presents the fair values of our significant Level 3 financial instruments, the valuation techniques used to determine their fair values and the value ranges of significant unobservable inputs used in the valuations. As at October 31, 2014 (Canadian $ in millions, except as noted) Reporting line in fair value hierarchy table Assets Liabilities Valuation techniques Significant unobservable inputs Low High Fair value Range of input values (1) Securities Private equity (2) Corporate equity 1,138 Collateralized loan obligations securities (3) Merchant banking securities Corporate debt Other 546 467 – Net Asset Value EV/EBITDA na 8.9x – Discounted Cash Flow Model Yield/Discount Margin 1.15% 1.15% – na 9.2x Net Asset Value Multiple Net Asset Value EV/EBITDA Net Asset Value Multiple na 5.5x na 4.4x (1) The low and high input values represent the actual highest and lowest level of inputs used (2) Included in private equity is $600 million of Federal Reserve Bank and U.S. Federal Home to value a group of financial instruments in a particular product category. These input ranges do not reflect the level of input uncertainty, but are affected by the specific underlying instruments within the product category. The input ranges will therefore vary from period to period based on the characteristics of the underlying instruments held at each balance sheet date. Loan Bank shares that we hold to meet regulatory requirements. These shares are carried at cost, which is deemed to approximate fair value as a result of these shares not being traded in the market. (3) Includes both trading and available-for-sale instruments. na – not applicable Significant Unobservable Inputs in Level 3 Instrument Valuations Net Asset Value Net asset value represents the estimated value of a security based on valuations received from the investment or fund manager. The valuation of certain private equity securities is based on the economic benefit derived from our investment. EV/EBITDA Multiple The fair value of private equity and merchant banking investments is derived by calculating an enterprise value (“EV”) using the EV/EBITDA multiple and then proceeding through a waterfall of the company’s capital structure to determine the value of the assets or securities we hold. The EV/EBITDA multiple is determined using judgment in considering factors such as multiples for comparable listed companies, recent transactions and company-specific factors, as well as liquidity discounts that account for the lack of active trading in these assets and securities. Yield/Discount Margin A financial instrument’s yield is the interest rate used to discount future cash flows in a valuation model. An increase in the yield, in isolation, would result in a decrease in the related fair value measurement. The discount margin is the difference between a debt instrument’s yield and a benchmark instrument’s yield. Benchmark instruments have high credit quality ratings and similar maturities and are often government bonds. The discount margin for an instrument forms part of the yield used in a discounted cash flow calculation. Generally, an increase in the discount margin will result in a decrease in fair value. Sensitivity Analysis of Level 3 Instruments Sensitivity analysis at October 31, 2014 for significant Level 3 instruments, that is securities which represent greater than 10% of Level 3 instruments, is provided below. Within Level 3 trading securities is corporate debt of $538 million related to securities that are hedged with credit default swaps that are also considered to be Level 3 instruments. As at October 31, 2014, the derivative assets and derivative liabilities were valued at $12 million and $8 million, respectively. We have determined the valuation of these derivatives and the related securities based on market-standard models we use to model the specific collateral composition and cash flow structure of the related deal. As at October 31, 2014, the impact of assuming a 10 basis point increase or decrease in the discount margin would be a $1 million decrease or increase in fair value, respectively. We have not applied another reasonably possible alternative assumption to the significant Level 3 categories of private equity investments and merchant banking securities, as the net asset values are provided by the investment or fund managers. Significant Transfers Our policy is to record transfers of assets and liabilities between fair value hierarchy levels at their fair values as at the end of each reporting period, consistent with the date of the determination of fair value. Transfers are made between the various fair value hierarchy levels that result from changes in the availability of quoted market prices or observable market inputs that result from changing market conditions. The following is a discussion of the significant transfers between Level 1, Level 2 and Level 3 balances for the year ended October 31, 2014. During the year ended October 31, 2014, $584 million of trading securities and $8 million of available-for-sale securities were transferred from Level 1 to Level 2 due to reduced observability of the inputs used to value these securities. During the year ended October 31, 2014, $1,140 million of trading securities and $1,481 million of available-for- sale securities were transferred from Level 2 to Level 1 due to increased availability of quoted prices in active markets. During the year ended October 31, 2014, $4 million of available-for- sale securities were transferred from Level 2 to Level 3 as a result of fewer available prices for these securities during the year. During the year ended October 31, 2014, $15 million of trading securities and $12 million of available-for-sale securities were transferred from Level 3 to Level 2 as market information became available for certain corporate debt securities. N o t e s BMO Financial Group 197th Annual Report 2014 183 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Changes in Level 3 Fair Value Measurements The table below presents a reconciliation of all changes in Level 3 financial instruments during the year ended October 31, 2014, including realized and unrealized gains (losses) included in earnings and other comprehensive income. For the year ended October 31, 2014 (Canadian $ in millions) Trading Securities Issued or guaranteed by: U.S. states, municipalities and agencies Corporate debt Total trading securities Available-for-Sale Securities Issued or guaranteed by: U.S. states, municipalities and agencies Corporate debt Corporate equity Total available-for-sale securities Other Securities Derivative Assets Credit default swaps Derivative Liabilities Credit default swaps Change in fair value Balance October 31, 2013 Included in earnings Included in other compre- hensive income Purchases Sales Maturities/ Settlement (1) Transfers into Level 3 Transfers out of Level 3 Fair value as at October 31, 2014 Unrealized gains (losses) (2) 78 822 900 1 30 949 980 488 28 19 7 65 72 – (1) (37) (38) 17 (16) (11) – – – – – 94 94 – – – – – – – – 193 193 – (66) (66) – (21) (53) (74) 118 (156) – – – – – (268) (268) – – – – – – – – – – – – 4 4 – – – – (15) (15) – – (12) (12) – – – 85 538 623 1 8 1,138 1,147 467 12 8 7 65 72 – – 94 94 17 (16) (11) (1) Includes cash settlement of derivative assets and derivative liabilities. (2) Unrealized gains or losses on trading securities, derivative assets and derivative liabilities held on October 31, 2014 are included in earnings in the year. For available-for-sale securities, the unrealized gains or losses on securities held on October 31, 2014 are included in Accumulated Other Comprehensive Income. s e t o N 184 BMO Financial Group 197th Annual Report 2014 The table below presents a reconciliation of all changes in Level 3 financial instruments during the year ended October 31, 2013, including realized and unrealized gains (losses) included in earnings and other comprehensive income. For the year ended October 31, 2013 (Canadian $ in millions) Trading Securities Issued or guaranteed by: Canadian provincial and municipal governments U.S. states, municipalities and agencies Mortgage-backed securities and collateralized mortgage obligations Corporate debt Total trading securities Available-for-Sale Securities Issued or guaranteed by: U.S. states, municipalities and agencies Corporate debt Corporate equity Total available-for-sale securities Other Securities Derivative Assets Interest rate contracts Equity contracts Credit default swaps Total derivative assets Derivative Liabilities Interest rate contracts Equity contracts Foreign exchange contracts Credit default swaps Total derivative liabilities Change in fair value Balance October 31, 2012 Included in earnings Included in other compre- hensive income Purchases Sales Maturities / Settlement (1) Transfers into Level 3 Transfers out of Level 3 Fair value as at October 31, 2013 Unrealized gains (losses) (2) 73 78 372 1,331 1,854 9 42 942 993 526 3 5 37 45 20 44 2 2 68 1 – 28 42 71 – – (19) (19) 14 (3) – (9) (12) (20) 15 – 17 12 – – – – – – 2 46 48 – – – – – – – – – – – – – 3 3 (46) – (378) (227) (651) – 27 119 (8) (10) (135) 146 (153) 86 (138) – – – – – – – – – – (1) – (1) – (3) – – (3) – – (39) (327) (366) – (2) – (2) – – – – – – – – – – – – 17 – 17 – – – – – – – – – – 6 – – 6 (28) – – – (28) – (29) (4) (33) – – (4) – (4) – (62) (2) – (64) – 78 – 822 900 1 30 949 980 488 – – 28 28 – – – 19 19 – – – 39 39 – 1 44 45 9 (3) – (9) (12) (20) – – (17) (37) (1) Includes cash settlement of derivative assets and derivative liabilities. (2) Unrealized gains or losses on trading securities, derivative assets and derivative liabilities held on October 31, 2013 are included in earnings in the year. For available-for-sale securities, the unrealized gains or losses on securities held on October 31, 2013 are included in Accumulated Other Comprehensive Income. N o t e s BMO Financial Group 197th Annual Report 2014 185 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 32: Contractual Maturities of Assets and Liabilities and Off-Balance Sheet Commitments The tables below show the remaining contractual maturity of on-balance sheet assets and liabilities and off-balance sheet commitments. The contractual maturity of financial assets and liabilities is an input to, but is not necessarily consistent with, the expected maturity of assets and liabilities that is used in the management of liquidity and funding risk. We forecast asset and liability cash flows both under normal market conditions and under a number of stress scenarios to manage liquidity and funding risk. Stress scenarios include assumptions for loan (Canadian $ in millions) repayments, deposit withdrawals, and credit commitment and liquidity facility drawdowns by counterparty and product type. Stress scenarios also consider the time horizon over which liquid assets can be monetized and the related haircuts and potential collateral requirements that may result from both market volatility and credit rating downgrades, among other assumptions. For further details, see the Liquidity and Funding Risk section on pages 95 to 99 of our 2014 Management’s Discussion and Analysis. 0 to 1 month 1 to 3 months 3 to 6 months 6 to 9 months 9 to 12 months 1 to 2 years 2 to 5 years Over 5 years No maturity 2014 Total On-Balance Sheet Financial Instruments Assets Cash and cash equivalents Interest bearing deposits with banks Securities Trading securities Available-for-sale securities Held-to-maturity securities Other securities Total securities Securities borrowed or purchased under resale agreements Loans 27,625 – 4,124 1,420 542 1,014 – – 1,159 345 – 10 – 521 584 553 113 3 – 14 – 31 – – – – – – 761 28,386 – 6,110 1,344 1,138 98 2 1,274 714 294 – 5,255 8,750 1,356 – 9,722 21,047 4,172 45 17,409 11,699 4,311 19 47,733 1,706 – 908 85,022 46,966 10,344 987 1,556 1,514 1,253 2,582 2,282 15,361 34,986 33,438 50,347 143,319 39,014 10,255 2,536 678 938 134 – – – 53,555 Residential mortgages Consumer instalment and other personal Credit cards Businesses and governments Customers’ liability under acceptances Allowance for credit losses 1,284 386 – 7,701 8,871 – 1,528 458 – 9,520 1,920 – 3,763 1,097 – 3,438 77 – 4,725 1,193 – 4,201 1 – 4,470 1,257 – 11,019 9 – 20,497 6,491 – 10,315 – – 55,659 20,847 – 37,537 – – 9,087 8,981 – 6,294 – – – 23,433 7,972 30,741 – (1,734) 101,013 64,143 7,972 120,766 10,878 (1,734) Total loans and acceptances, net of allowance 18,242 13,426 8,375 10,120 16,755 37,303 114,043 24,362 60,412 303,038 Other Assets Derivative instruments Premises and equipment Goodwill Intangible assets Current tax assets Deferred tax assets Other Total other assets Total Assets 2,703 – – – – – 1,509 2,348 – – – – – 271 1,387 – – – – – 149 1,746 – – – – – 4 4,212 2,619 1,536 1,750 796 – – – – – – 796 3,436 – – – – – – 3,436 8,955 – – – – – 64 11,284 – – – – – 3,545 – 2,276 5,353 2,052 665 3,019 2,689 32,655 2,276 5,353 2,052 665 3,019 8,231 9,019 14,829 16,054 54,251 94,773 29,234 14,221 15,144 20,802 56,234 158,048 72,629 127,574 588,659 s e t o N 186 BMO Financial Group 197th Annual Report 2014 (Canadian $ in millions) Liabilities and Equity Deposits (1) Banks Businesses and governments Individuals Total deposits Other liabilities Derivative instruments Acceptances Securities sold but not yet purchased Securities lent or sold under repurchase agreements Current tax liabilities Deferred tax liabilities Securitization and liabilities related to structured entity Other Total other liabilities Subordinated debt Total Equity 0 to 1 month 1 to 3 months 3 to 6 months 6 to 9 months 9 to 12 months 1 to 2 years 2 to 5 years Over 5 years No maturity 2014 Total 7,495 26,644 2,039 4,680 25,061 3,290 1,067 20,255 5,472 597 10,157 4,296 2 8,439 5,288 – 16,347 6,386 – 23,914 16,454 – 8,198 1,528 4,402 100,124 90,953 18,243 239,139 135,706 36,178 33,031 26,794 15,050 13,729 22,733 40,368 9,726 195,479 393,088 1,545 8,871 27,348 36,757 – – 3 7,226 2,321 1,920 – 2,624 – – 1,325 77 – 2,095 1 – 1,399 9 – 4,565 – – 9,633 – – 10,774 – – 149 – – 95 – – 70 – – – – – – – – – – – – – – – 235 178 33,657 10,878 27,348 39,695 235 178 429 142 1,560 16 341 330 1,135 26 3,976 193 10,066 3,577 4,955 1,723 – 7,565 22,465 20,798 81,750 7,436 3,127 2,862 2,639 8,734 23,276 17,452 7,978 155,254 – – – – – – – – – – – – 100 4,813 – 4,913 – – 35,404 35,404 Total Liabilities and Equity 117,928 40,467 29,921 17,912 16,368 31,467 63,744 31,991 238,861 588,659 (1) Deposits payable on demand and payable after notice have been included under no maturity. (Canadian $ in millions) 0 to 1 month 1 to 3 months 3 to 6 months 6 to 9 months 9 to 12 months 1 to 2 years 2 to 5 years Over 5 years No maturity 2014 Total Off-Balance Sheet Commitments Commitments to extend credit (1) Operating leases Financial guarantee contracts (1) Purchase obligations 1,313 26 5,269 58 1,717 52 – 113 3,844 77 – 169 6,048 77 – 169 3,830 76 – 169 15,872 281 – 586 51,086 630 – 783 1,549 638 – 209 – – – – 85,259 1,857 5,269 2,256 (1) A large majority of these commitments expire without being drawn upon. As a result, the total contractual amounts may not be representative of the funding likely to be required for these commitments. N o t e s BMO Financial Group 197th Annual Report 2014 187 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Canadian $ in millions) On-Balance Sheet Financial Instruments Assets Cash and cash equivalents Interest bearing deposits with banks Securities Trading securities Available-for-sale securities Held-to-maturity securities Other securities Total securities Securities borrowed or purchased under resale agreements Loans Residential mortgages Consumer instalment and other personal Credit cards Businesses and governments Customers’ liability under acceptances Allowance for credit losses 0 to 1 month 1 to 3 months 3 to 6 months 6 to 9 months 9 to 12 months 1 to 2 years 2 to 5 years Over 5 years No maturity 2013 Total 25,323 – 4,592 1,295 1,209 2,026 – – 1,284 3,628 – – – 471 480 1,439 – 18 – 84 1,521 2,076 – – – 76 442 2,820 – – – – – – – – 766 26,089 – 6,518 4,781 6,729 562 3 10,593 22,170 4,864 34 14,762 11,262 606 17 40,087 1,560 – 827 75,159 53,710 6,032 899 3,235 4,912 1,937 3,597 3,262 12,075 37,661 26,647 42,474 135,800 26,421 9,627 2,949 597 205 – – – – 39,799 832 323 – 7,965 8,367 – 1,276 294 – 7,555 103 – 2,716 643 – 3,400 1 – 4,553 890 – 3,955 1 – 3,787 834 – 8,850 – – 17,441 4,730 – 9,697 – – 56,630 23,285 – 30,574 – – 9,157 9,636 – 5,087 – – – 23,005 7,870 27,502 – (1,665) 96,392 63,640 7,870 104,585 8,472 (1,665) Total loans and acceptances, net of allowance 17,487 9,228 6,760 9,399 13,471 31,868 110,489 23,880 56,712 279,294 Other Assets Derivative instruments Premises and equipment Goodwill Intangible assets Current tax assets Deferred tax assets Other Total other assets Total Assets 874 – – – – – 1,561 925 – – – – – 148 969 – – – – – 137 2,435 1,073 1,106 724 – – – – – – 724 555 – – – – – – 555 4,281 – – – – – – 10,374 – – – – – 14 11,557 – – – – – 3,320 – 2,168 3,819 1,511 1,065 3,027 2,515 30,259 2,168 3,819 1,511 1,065 3,027 7,695 4,281 10,388 14,877 14,105 49,544 79,493 26,135 13,223 14,401 17,569 48,224 158,538 65,404 114,057 537,044 s e t o N 188 BMO Financial Group 197th Annual Report 2014 (Canadian $ in millions) Liabilities and Equity Deposits (1) Banks Businesses and governments Individuals Total deposits Other liabilities Derivative instruments Acceptances Securities sold but not yet purchased Securities lent or sold under repurchase agreements Current tax liabilities Deferred tax liabilities Securitization and liabilities related to structured entity Other Total other liabilities Subordinated debt Total Equity 0 to 1 month 1 to 3 months 3 to 6 months 6 to 9 months 9 to 12 months 1 to 2 years 2 to 5 years Over 5 years No maturity 2013 Total 10,241 26,276 2,253 3,733 29,246 3,761 140 10,524 5,203 231 6,186 4,618 563 5,591 5,513 – 13,983 7,228 – 30,668 11,450 – 8,212 1,526 5,683 91,660 83,880 20,591 222,346 125,432 38,770 36,740 15,867 11,035 11,667 21,211 42,118 9,738 181,223 368,369 703 8,367 22,446 24,483 – – 1,221 6,793 1,308 103 – 2,953 – – 1,481 140 1,244 1 – 1,448 – – 998 13 801 1 – – – – – 5 711 – – – – – 318 26 4,928 – – – – – 10,828 – – – – – 11,451 – – – – – – – – – 438 107 31,974 8,472 22,446 28,884 438 107 3,295 427 10,395 3,205 4,653 1,255 – 6,954 22,361 18,818 64,013 5,985 3,704 807 1,055 8,650 24,428 17,359 7,499 133,500 – – – – – – – – – – – – 100 3,896 – 3,996 – – 31,179 31,179 Total Liabilities and Equity 102,783 42,725 19,571 11,842 12,722 29,861 66,646 30,993 219,901 537,044 (1) Deposits payable on demand and payable after notice have been included under no maturity. (Canadian $ in millions) 0 to 1 month 1 to 3 months 3 to 6 months 6 to 9 months 9 to 12 months 1 to 2 years 2 to 5 years Over 5 years No maturity 2013 Total Off-Balance Sheet Commitments Commitments to extend credit (1) Operating leases Financial guarantee contracts (1) Purchase obligations 1,169 25 4,778 71 907 46 – 141 3,246 69 – 211 4,444 69 – 216 3,850 69 – 207 13,381 262 – 729 42,510 618 – 1,115 2,353 640 – 275 – – – – 71,860 1,798 4,778 2,965 (1) A large majority of these commitments expire without being drawn upon. As a result, the total contractual amounts may not be representative of the funding likely to be required for these commitments. N o t e s BMO Financial Group 197th Annual Report 2014 189 GLOSSARY OF FINANCIAL TERMS Glossary of Financial Terms Adjusted Earnings and Measures present results adjusted to exclude the impact of certain items as set out in the Non-GAAP Measures section. Management considers both reported and adjusted results to be useful in assessing underlying ongoing business performance. Allowance for Credit Losses repre- sents an amount deemed adequate by management to absorb credit- related losses on loans and accept- ances and other credit instruments. Allowances for credit losses can be specific or collective and are recorded on the balance sheet as a deduction from loans and accept- ances or, as they relate to credit instruments, as other liabilities. Pages 71, 87, 136 Assets under Administration and under Management refers to assets administered or managed by a finan- cial institution that are beneficially owned by clients and therefore not reported on the balance sheet of the administering or managing financial institution. Asset-Backed Commercial Paper (ABCP) is a short-term investment. The commercial paper is backed by physical assets such as trade receiv- ables, and is generally used for short-term financing needs. Assets-to-Capital Multiple reflects total assets, including specified off- balance sheet items net of other specified deductions, divided by Total capital. Pages 66, 163 Average Earning Assets represents the daily or monthly average balance of deposits with other banks and loans and securities, over a one- year period. Bankers’ Acceptances (BAs) are bills of exchange or negotiable instruments drawn by a borrower for payment at maturity and accepted by a bank. BAs constitute a guarantee of payment by the bank and can be traded in the money market. The bank earns a “stamping fee” for providing this guarantee. Basis Point is one one-hundredth of a percentage point. Business Risk arises from the specific business activities of a company and the effects these could have on its earnings. Page 103 Collective Allowance is maintained to cover impairment in the existing credit portfolio that cannot yet be associated with specific credit assets. Our approach to establishing and maintaining the collective allowance is based on the requirements of IFRS, considering guidelines issued by our regulator, OSFI. The collective allow- ance is assessed on a quarterly basis and a number of factors are considered when determining its level, including the long-run expected loss amount and manage- ment’s credit judgment with respect to current macroeconomic and portfolio conditions. Pages 40, 87, 136 Common Equity Tier 1 (CET1) capital is comprised of common shareholders’ equity less deductions for goodwill, intangible assets, pension assets, certain deferred tax assets and other items. Pages 64, 163 Common Equity Tier 1 Ratio reflects CET1, divided by CET1 capital risk- weighted assets. Pages 64, 163 Common Shareholders’ Equity is the most permanent form of capital. For regulatory capital purposes, common shareholders’ equity is comprised of common shareholders’ equity, net of capital deductions. 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. Page 84 Derivatives are contracts with a value that is “derived” from move- ments in interest or foreign exchange rates, equity or commodity prices or other indices. Derivatives allow for the transfer, modification or reduction of current or expected risks from changes in rates and prices. Dividend Payout Ratio represents common share dividends as a per- centage of net income available to common shareholders. It is com- puted by dividing dividends per share by basic earnings per share. Earnings Per Share (EPS) is calcu- lated by dividing net income attributable to bank shareholders, after deduction of preferred share dividends, by the average daily number of fully paid common shares outstanding throughout the year. Diluted EPS, which is our basis for measuring performance, adjusts for possible conversions of financial instruments into common shares if those conversions would reduce EPS. Adjusted EPS is calculated in the same manner, using adjusted net income. Pages 33, 173 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. Page 95 Economic Capital is our internal assessment of the risks underlying BMO’s business activities. It repre- sents management’s estimate of the likely magnitude of economic losses that could occur if adverse situations arise, and allows returns to be measured on a basis that considers the risks taken. Economic Capital is calculated for various types of risk – credit, market (trading and non- trading), operational and business – where measures are based on a time horizon of one year. Economic Capital is a key element of our risk-based capital management and ICAAP framework. Pages 67, 68, 83 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 posi- tions in response to prescribed parallel interest rate movements. Page 95 Efficiency Ratio (or Expense-to- Revenue Ratio) is a key measure of efficiency. It is calculated as non- interest expense divided by total revenue, expressed as a percentage. The adjusted efficiency ratio is calcu- lated in the same manner, utilizing adjusted total revenue and non- interest expense. Page 41 Environmental and Social Risk is the risk of loss or damage to BMO’s reputation resulting from environ- mental and social concerns related to BMO or its customers. Environmental and social risk is often associated with credit, operational and reputa- tion risk. Page 105 Fair Value is the amount of consid- eration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act. Forwards and Futures are con- tractual agreements to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a specific price and date in the future. Forwards are customized contracts transacted in the over-the-counter market. Futures are transacted in standardized amounts on regulated exchanges and are subject to daily cash margining. Page 146 Hedging is a risk management tech- nique used to neutralize, manage or offset interest rate, foreign currency, equity, commodity or credit exposures arising from normal banking activities. Impaired Loans are loans for which there is no longer reasonable assur- ance of the timely collection of principal or interest. Innovative Tier 1 Capital is a form of Tier 1 capital issued by structured entities that can be included in calcu- lating a bank’s Tier 1 Capital Ratio, Total Capital Ratio and Assets-to- Capital Multiple. Under Basel III, Innovative Tier 1 Capital is non- qualifying and is part of the grand- fathered capital being phased out between 2013 and 2022. Insurance Risk is the risk of loss due to actual experience being different from that assumed when an insurance product was designed and priced. It generally entails inherent unpredictability that can arise from assuming long-term policy liabilities or from the uncertainty of future events. Insurance risk exists in all our insurance businesses, including annuities and life, accident and sickness, and creditor insurance, as well as our reinsurance business. Page 102 Legal and Regulatory Risk is the risk of not complying with laws, contractual undertakings or other legal requirements, as well as regu- latory requirements and regulators’ expectations. Failure to properly manage legal and regulatory risk may result in litigation claims, finan- cial losses, regulatory sanctions, an inability to execute our business strategies and harm to our reputation. Page 102 Leverage Ratio is comprised of Tier 1 capital, divided by total assets including specified off-balance sheet items, net of other specified deductions. Pages 65, 66 Liquidity and Funding Risk is the potential for loss if BMO is unable to meet financial commitments in a timely manner at reasonable prices as they fall due. Financial commit- ments include liabilities to depositors and suppliers, and lending, invest- ment and pledging commitments. Pages 95, 142 Market Risk is the potential for adverse changes in the value of BMO’s assets and liabilities resulting from changes in market variables such as interest rates, foreign exchange rates, equity and commodity prices and their implied volatilities, and credit spreads, as well as the risk of credit migration and default. Pages 91, 142 Mark-to-Market represents the valuation of financial instruments at market rates as of the balance sheet date, where required by accounting rules. Model Risk is the potential for adverse consequences from deci- sions based on incorrect or misused model outputs. The adverse con- sequences can be financial loss, poor business decision-making or damage to reputation. Page 103 190 BMO Financial Group 197th Annual Report 2014 Net Interest Income is comprised of earnings on assets, such as loans and securities, including interest and dividend income and BMO’s share of income from investments accounted for using the equity method of accounting, less interest expense paid on liabilities, such as deposits. Page 37 Net Interest Margin is the ratio of net interest income to average earning assets, expressed as a percentage or in basis points. Net interest margin is sometimes com- puted using total assets. Page 37 Notional Amount refers to the principal used to calculate interest and other payments under derivative contracts. The principal amount does not change hands under the terms of a derivative contract, except in the case of cross-currency swaps. Off-Balance Sheet Financial Instruments consist of a variety of financial arrangements offered to clients, which include credit derivatives, written put options, backstop liquidity facilities, standby letters of credit, performance guaran- tees, credit enhancements, commit- ments to extend credit, securities lending, documentary and commer- cial letters of credit, and other indemnifications. Office of the Superintendent of Financial Institutions Canada (OSFI) is the government agency responsible for regulating banks, insurance companies, trust compa- nies, loan companies and pension plans in Canada. Operating Leverage is the differ- ence between revenue and expense growth rates. Adjusted operating leverage is the difference between adjusted revenue and adjusted expense growth rates. Pages 27, 41 Operational Risk is the potential for loss resulting from inadequate or failed internal processes or systems, human interactions or external events, but excludes business risk. Page 101 Options are contractual agreements that convey to the buyer the right but not the obligation to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a fixed future date or at any time within a fixed future period. Page 146 acceptances and other credit instru- ments, given the composition of the portfolio, the probability of default, the economic environment and the allowance for credit losses already established. Pages 40, 86, 136 Reputation Risk is the risk of a negative impact on BMO that results from the deterioration of BMO’s reputation. Potential negative impacts include revenue loss, decline in client loyalty, litigation, regulatory sanction or additional oversight, or decline in BMO’s share price. Page 105 Return on Equity or Return on Common Shareholders’ Equity (ROE) is calculated as net income, less non-controlling interest in sub- sidiaries and preferred dividends, as a percentage of average common shareholders’ equity. Common shareholders’ equity is comprised of common share capital, contributed surplus, accumulated other compre- hensive income (loss) and retained earnings. Adjusted ROE is calculated using adjusted net income. Page 34 Risk-Weighted Assets (RWA) are defined as on- and off-balance sheet exposures that are risk-weighted based on counterparty, collateral, guarantee arrangements and possibly product and term for capital management and regulatory reporting purposes. Page 64 Securities Borrowed or Purchased under Resale Agreements are low- cost, low-risk instruments, often supported by the pledge of cash collateral, which arise from transactions that involve the borrowing or purchasing of securities. Securities Lent or Sold under Repurchase Agreements are low- cost, low-risk liabilities, often sup- ported by cash collateral, which arise from transactions that involve the lending or selling of securities. Securitization is the practice of selling pools of contractual debts, such as residential mortgages, commercial mortgages, auto loans and credit card debt obligations, to third parties. Page 143 Specific Allowances reduce the carrying value of specific credit assets to the amount we expect to recover if there is evidence of deterioration in credit quality. Pages 87, 136 Provision for Credit Losses is a charge to income that represents an amount deemed adequate by management to fully provide for impairment in a portfolio of loans and Strategic Risk is the potential for loss due to fluctuations in the external business environment and/or failure to properly respond to these fluctuations as a result of inaction, ineffective strategies or poor implementation of strategies. Page 104 Stressed Value at Risk (SVaR) is measured for specific classes of risk in BMO’s trading and underwriting activities: interest rate, foreign exchange rate, credit spreads, equity and commodity prices and their implied volatilities, where model inputs are calibrated to historical data from a period of significant financial stress. This measure calcu- lates the maximum loss likely to be experienced in the portfolios, meas- ured at a 99% confidence level over a specified holding period. Page 91 Structured Entities (SEs) include entities for which voting or similar rights are not the dominant factor in determining control of the entity. We are required to consolidate an SE if we control the entity by having power over the entity, exposure or rights to variable returns from our involvement and the ability to exercise power to affect the amount of our returns. Pages 70, 144 Swaps are contractual agreements between two parties to exchange a series of cash flows. The various swap agreements that we enter into are as follows: • Commodity swaps – counterparties generally exchange fixed-rate and floating-rate payments based on a notional value of a single commodity. • Credit default swaps – one counterparty pays the other a fee in exchange for that other counter- party agreeing to make a payment if a credit event occurs, such as bankruptcy or failure to pay. • Cross-currency interest rate swaps – fixed-rate and floating-rate interest payments and principal amounts are exchanged in different currencies. • Cross-currency swaps – fixed-rate interest payments and principal amounts are exchanged in different currencies. • Equity swaps – counterparties exchange the return on an equity security or a group of equity secu- rities for the return based on a fixed or floating interest rate or the return on another equity security or group of equity securities. • Interest rate swaps – counter- parties generally exchange fixed- rate and floating-rate interest payments based on a notional value in a single currency. Page 146 Taxable Equivalent Basis (teb): Revenues of operating groups reflected in our MD&A are presented on a taxable equivalent basis (teb). To facilitate comparisons, the teb adjustment increases reported revenues and the provision for income taxes by an amount that would increase revenues on certain tax-exempt securities to a level that would incur tax at the statutory rate. Pages 36, 174 Tier 1 Capital is primarily comprised of CET1, preferred shares and other qualifying or grandfathered non- common equity capital, net of certain deductions. Pages 64, 163 Tier 1 Capital Ratio reflects Tier 1 capital divided by Tier 1 capital risk- weighted assets. Pages 64, 163 Total Capital includes Tier 1 and Tier 2 capital. Tier 2 capital is primarily comprised of subordinated debentures and a portion of the collective allowance for credit losses, net of certain deductions. Pages 64, 163 Total Capital Ratio reflects Total capital divided by Total capital risk- weighted assets. Pages 64, 163 Total Shareholder Return: The three-year and five-year average annual total shareholder return (TSR) represents the average annual total return earned on an investment in BMO common shares made at the beginning of a three-year and five- year period, respectively. The return includes the change in share price and assumes that dividends received were reinvested in additional common shares. The one-year TSR also assumes that dividends were reinvested in shares. Page 31 Trading-Related Revenues include net interest income and non-interest revenue earned from on- and off- balance sheet positions undertaken for trading purposes. The manage- ment of these positions typically includes marking them to market on a daily basis. Trading-related rev- enues include income (expense) and gains (losses) from both on-balance sheet instruments and interest rate, foreign exchange (including spot positions), equity, commodity and credit contracts. Page 39 Value at Risk (VaR) is measured for specific classes of risk in BMO’s trading and underwriting activities: interest rate, foreign exchange rate, credit spreads, equity and commodity prices and their implied volatilities. This measure calculates the maximum loss likely to be experienced in the portfolios, meas- ured at a 99% confidence level over a specified holding period. Pages 91, 92 BMO Financial Group 197th Annual Report 2014 191 Where to Find More Information Corporate Governance Our website provides information on our corporate governance practices, including our code of conduct, FirstPrinciples, our Director Independence Standards and our board mandate and committee charters. www.bmo.com/corporategovernance Management Proxy Circular Our management proxy circular contains information on our directors, board committee reports and a detailed discussion of our corporate governance practices. It will be published in March 2015 and will be available on our website. www.bmo.com/corporategovernance New York Stock Exchange Governance Requirements A summary of the significant ways in which our corporate governance practices differ from the corporate governance practices required to be followed by U.S. domestic companies under New York Stock Exchange Listing Standards is posted on our website. www.bmo.com/corporategovernance Sustainability Performance BMO’s Environmental, Social and Governance Report and Public Accountability Statement (ESG Report/PAS) outlines how we manage the environmental, social and governance impacts of our business while creating value for our many stakeholders. We use the Global Report- ing Initiative (GRI) as a framework for reporting on our sustainability performance. This report is available on our website. www.bmo.com/corporateresponsibility Corporate Responsibility BMO’s Corporate Responsibility Report, a companion piece to the ESG Report/PAS, illustrates the way we conduct our business, what we stand for and the commitments we’ve made to our customers and the communities where we operate. This report and additional information are available on our website. www.bmo.com/corporateresponsibility Have Your Say If you have a question you would like to ask at our annual meeting of shareholders, you can submit your question in person or during the webcast. You can also submit a question to the board by writing to the Corporate Secretary at Corporate Secretary’s Office, 21st Floor, 1 First Canadian Place, Toronto, ON M5X 1A1, or emailing corp.secretary@bmo.com. 192 BMO Financial Group 197th Annual Report 2014 Shareholders Contact our Transfer Agent and Registrar for: • Dividend information • Change in share registration or address • Lost certificates • Estate transfers • Duplicate mailings • Direct registration Computershare Trust Company of Canada 100 University Avenue, 8th Floor, Toronto, ON M5J 2Y1 Email: service@computershare.com www.computershare.com/investor Canada and the United States Call: 1-800-340-5021 Fax: 1-888-453-0330 International Call: 514-982-7800 Fax: 416-263-9394 Computershare Trust Company, N.A. Co-Transfer Agent (U.S.) Employees For information on BMO’s Employee Share Ownership Plan: Call: 1-877-266-6789 General To obtain printed copies of the annual report or make inquiries about company news and initiatives: Corporate Communications Department BMO Financial Group 28th Floor, 1 First Canadian Place Toronto, ON M5X 1A1 On peut obtenir sur demande un exemplaire en français. www.bmo.com Customers For assistance with your investment portfolio or other financial needs: BMO Bank of Montreal English and French: 1-877-225-5266 Cantonese and Mandarin: 1-800-665-8800 Outside Canada and the continental United States: 514-881-3845 TTY service for hearing impaired customers: 1-866-889-0889 www.bmo.com BMO InvestorLine: 1-888-776-6886 www.bmoinvestorline.com BMO Harris Bank United States: 1-888-340-2265 Outside the United States: 1-847-238-2265 www.harrisbank.com BMO Nesbitt Burns: 416-359-4000 www.bmonesbittburns.com Online filing information: BMO filings in Canada Canadian Securities Administrators www.sedar.com BMO filings in the United States Securities and Exchange Commission www.sec.gov/edgar.shtml For all other shareholder inquiries: Shareholder Services BMO Financial Group Corporate Secretary’s Office 21st Floor, 1 First Canadian Place Toronto, ON M5X 1A1 Email: corp.secretary@bmo.com Call: 416-867-6785 Fax: 416-867-6793 Institutional Investors and Research Analysts To obtain additional financial information: Head, Investor Relations BMO Financial Group 18th Floor, 1 First Canadian Place Toronto, ON M5X 1A1 Email: investor.relations@bmo.com Call: 416-867-6656 Fax: 416-867-3367 The following are trademarks of Bank of Montreal or its subsidiaries: BMO Harris Healthy Credit, BMO World Elite, UPGRADE, BMO DepositEdge The following are trademarks of other parties: Interac is a registered trademark of Interac Inc. MasterCard is a registered trademark of MasterCard International Incorporated 4 Your vote matters. Look out for your proxy circular in March and remember to vote. Shareholder Information Important Dates Fiscal Year End Annual Meeting March 31, 2015, October 31 9:30 a.m. (local time) The annual meeting of shareholders will be held in Toronto, Ontario, at the BMO Institute for Learning, 3550 Pharmacy Avenue. The meeting will be webcast. Details are available on our website. www.bmo.com/investorrelations 2015 Dividend Payment Dates* Common and preferred shares record dates February 2 August 3 May 1 November 2 Common shares payment dates February 26 August 26 May 26 November 26 Preferred shares payment dates February 25 August 25 May 25 November 25 *Subject to approval by the Board of Directors. The Bank Act prohibits a bank from declaring or paying a dividend if it is or would thereby be in contravention of regulations or an order from the Super- intendent of Financial Institutions Canada dealing with adequacy of capital or liquidity. Currently, this limitation does not restrict the payment of dividends on Bank of Montreal’s common or preferred shares. Employee Ownership* 82.4% of Canadian employees participate in the BMO Employee Share Ownership Plan – a clear indication of their commitment to the company. *As of October 31, 2014. Auditors KPMG LLP Direct Deposit You can choose to have your dividends deposited directly to an account in any financial institution in Canada or the United States that provides electronic funds transfer. Personal Information Security We advise our shareholders to be diligent in protecting their personal information. Details are available on our website. www.bmo.com/security m o c . n g i s e d e v o w w w . | n g i s e D d n a r B e v O : n g i s e d c i g e t a r t S Market for Shares of Bank of Montreal The common shares of Bank of Montreal are listed on the Toronto Stock Exchange (TSX) and New York Stock Exchange (NYSE). The preferred shares of Bank of Montreal are listed on the TSX. Common Share Trading in Fiscal 2014 Primary stock exchanges Closing price October 31, 2014 Ticker High Low TSX NYSE BMO BMO $81.73 US$72.60 $85.71 US$78.56 $67.04 US$60.34 Total volume of shares traded 304.5 million 91.8 million Common Share History Date Action March 14, 2001 March 20, 1993 June 23, 1967 100% stock dividend 100% stock dividend Stock split Common share effect Equivalent to a 2-for-1 stock split Equivalent to a 2-for-1 stock split 5-for-1 stock split Dividends Paid per Share in 2014 and Prior Years Bank of Montreal has paid dividends for 186 years – the longest-running dividend payout record of any company in Canada. Issue/Class Common Ticker BMO Shares outstanding at October 31, 2014 2014 2013 2012 2011 2010 649,050,049 $ 3.04 (a) $ 2.92 $ 2.80 $ 2.80 $ 2.80 Preferred Class B Series 5 (b) Series 10 (c) Series 13 (d) Series 14 (e) Series 15 (f) Series 16 (g) Series 17 (h) Series 18 (i) Series 21 (j) Series 23 (k) Series 25 (l) Series 27 (m) Series 29 (n) Series 31 (o) – BMO.PR.H – BMO.PR.V 14,000,000 BMO.PR.J 10,000,000 BMO.PR.K 10,000,000 BMO.PR.L 6,267,391 BMO.PR.M 5,732,609 BMO.PR.R – BMO.PR.N – BMO.PR.O 16,000,000 BMO.PR.P 11,600,000 BMO.PR.Q 20,000,000 BMO.PR.S 16,000,000 BMO.PR.T BMO.PR.W 12,000,000 – – $ 1.13 $ 1.31 $ 1.45 $ 0.85 $ 0.65 $ 0.81 $ 1.22 $ 1.35 $ 0.98 $ 0.34 – – $ 0.66 – $ 1.13 $ 1.31 $ 1.45 $ 1.30 – $ 1.63 $ 1.63 $ 1.35 $ 0.98 – – – $ 1.33 $ 1.33 $ 1.33 US$ 0.37 US$ 1.49 US$ 1.49 $ 1.13 $ 1.31 $ 1.45 $ 1.30 – $ 1.63 $ 1.63 $ 1.35 – – – – $ 1.13 $ 1.31 $ 1.45 $ 1.30 – $ 1.63 $ 1.63 $ 1.35 $ 0.69 – – – $ 1.13 $ 1.31 $ 1.45 $ 1.30 – $ 1.63 $ 1.63 $ 1.35 $ 0.98 – – – (a) Dividend amount paid in 2014 was $3.04. Dividend amount declared in 2014 was $3.08. (b) The Class B Preferred Shares Series 5 were issued in February 1998 and were redeemed in February 2013. Dividend amount declared in 2013 of $0.33 was included in the redemption price. (c) The Class B Preferred Shares Series 10 were issued in December 2001 and were redeemed in February 2012. (d) The Class B Preferred Shares Series 13 were issued in January 2007. (e) The Class B Preferred Shares Series 14 were issued in September 2007. (f) The Class B Preferred Shares Series 15 were issued in March 2008. (g) The Class B Preferred Shares Series 16 were issued in June 2008. (h) The Class B Preferred Shares Series 17 were issued in August 2013. (i) The Class B Preferred Shares Series 18 were issued in December 2008 and were redeemed in February 2014. (j) The Class B Preferred Shares Series 21 were issued in March 2009 and were redeemed in May 2014. (k) The Class B Preferred Shares Series 23 were issued in June 2009. (l) The Class B Preferred Shares Series 25 were issued in March 2011. (m) The Class B Preferred Shares Series 27 were issued in April 2014. (n) The Class B Preferred Shares Series 29 were issued in June 2014. (o) The Class B Preferred Shares Series 31 were issued in July 2014. Credit Ratings Credit rating information appears on pages 25 and 100 of this annual report and on our website. www.bmo.com/creditratings Managing Your Shares Our Transfer Agent and Registrar Computershare Trust Company of Canada serves as Transfer Agent and Registrar for common and preferred shares, with transfer facilities in Halifax, Montreal, Toronto, Winnipeg, Calgary and Vancouver. Computershare Investor Services PLC and Computershare Trust Company, N.A. serve as Transfer Agents and Registrars for common shares in London, England and Golden, Colorado, respec- tively. See previous page for contact information. Reinvesting Your Dividends and Purchasing Additional Common Shares Through the Shareholder Dividend Reinvestment and Share Purchase Plan, you can reinvest cash dividends from your BMO common shares to purchase additional BMO common shares without paying a commission or service charge. You can also purchase additional common shares in amounts up to $40,000 per fiscal year. Contact Computershare Trust Company of Canada or Shareholder Services for details. Who We Are Established in 1817, BMO Financial Group is a highly diversified financial services provider based in North America. With total assets of $589 billion and more than 46,000 employees, BMO provides a broad range of retail banking, wealth management and investment banking products and services to more than 12 million customers and conducts business through three operating groups: Personal and Commercial Banking, Wealth Management and BMO Capital Markets. This annual report is carbon neutral. Carbon offsets provided by: