National Bank of Canada Annual Report 2019

Plain-text annual report

ANNUAL REPORT 1920 t r o p e R l a u n n A 9 1 0 2 ® The NATIONAL BANK logo is a registered trademark of National Bank of Canada. HHeeaadd OOffffiiccee National Bank of Canada 600 De La Gauchetière Street West, 4th Floor Montreal, Quebec H3B 4L2 Canada Telephone: 514-394-5000 Website: nbc.ca AAnnnnuuaall MMeeeettiinngg The Annual Meeting of Holders of Common Shares of the Bank will be held on April 24, 2020, at National Bank of Canada’s head Office in Montreal, Quebec, Canada. PPuubblliicc AAccccoouunnttaabbiilliittyy SSttaatteemmeenntt The 2019 Social Responsibility Report will be available in March 2020 on the Bank’s website at nbc.ca. CCoommmmuunniiccaattiioonn wwiitthh SShhaarreehhoollddeerrss For information about stock transfers, address changes, dividends, lost certificates, tax forms and estate transfers, shareholders of record may contact the Transfer Agent at the following address: CCoommppuutteerrsshhaarree TTrruusstt CCoommppaannyy ooff CCaannaaddaa Share Ownership Management 100 University Avenue, 8th Floor Toronto, Ontario M5J 2Y1 Canada Telephone: 1-888-838-1407 1-888-453-0330 Fax: service@computershare.com E-mail: computershare.com Website: CCaauuttiioonn RReeggaarrddiinngg FFoorrwwaarrdd--LLooookkiinngg SSttaatteemmeennttss From time to time, National Bank of Canada makes written and oral forward-looking statements, including in this Annual Report, in other filings with Canadian regulators, in reports to shareholders, in press releases and in other communications. All such statements are made pursuant to the Canadian and American securities legislation and the provisions of the United States Private Securities Litigation Reform Act of 1995. Additional information about these statements can be found on page 13 of this Annual Report. TTrraaddeemmaarrkkss The trademarks belonging to National Bank of Canada and used in this report include National Bank of Canada, Private Wealth 1859, CashPerformer, NBC CapS II, NBC Asset Trust, NBC Capital Trust, and National Bank All-in-One and their respective logos. Certain trademarks owned by third parties are also mentioned in this report. PPoouurr oobbtteenniirr uunnee vveerrssiioonn ffrraannççaaiissee dduu RRaappppoorrtt aannnnuueell,, vveeuuiilllleezz vvoouuss aaddrreesssseerr àà :: Relations avec les investisseurs Banque Nationale du Canada 600, rue De La Gauchetière Ouest, 7e étage Montréal (Québec) H3B 4L2 Canada Téléphone : Adresse électronique : relationsinvestisseurs@bnc.ca 1 866 517-5455 LLeeggaall DDeeppoossiitt ISBN 978-2-921835-63-3 Legal deposit – Bibliothèque et Archives nationales du Québec, 2019 Legal deposit – Library and Archives Canada, 2019 Shareholders whose shares are held by a market intermediary are asked to contact the market intermediary concerned. PPrriinnttiinngg L’Empreinte Other shareholder inquiries can be addressed to: Investor Relations National Bank of Canada National Bank Tower 600 De La Gauchetière Street West, 7th Floor Montreal, Quebec H3B 4L2 Canada Telephone: 1-866-517-5455 E-mail: Website: investorrelations@nbc.ca nbc.ca/investorrelations NNoorrmmaall CCoouurrssee IIssssuueerr BBiidd The Bank began a normal course issuer bid (NCIB) to repurchase for cancellation up to 6,000,000 common shares for the period starting June 10, 2019 and ending June 9, 2020. Shareholders may obtain, free of charge, a copy of the notice of intent regarding this NCIB, which was approved by the Toronto Stock Exchange, by writing to the Corporate Secretary, National Bank of Canada, 600 De La Gauchetière Street West, 4th floor, Montreal, Quebec, Canada H3B 4L2. National Bank of Canada is proud to help save the environment by using EcoLogo and Forest Stewardship Council® (FSC®) certified paper. At a Glance Founded in 1859, National Bank of Canada offers financial services to individuals, businesses, institutional clients and governments across Canada. We are one of Canada’s six systemically important banks and among the most profitable banks on a global basis by return on equity. We operate through three business segments in Canada—Personal and Commercial Banking, Wealth Management and Financial Markets—which represent our main sources of revenue. A fourth segment—U.S. Specialty Finance and International—complements the growth of our domestic operations. We are a leading bank in our core Quebec market and also hold leadership positions across the country in selected activities. We strive to meet the highest standards of social responsibility while creating value for our shareholders. We are proud to be recognized as an employer of choice and for promoting diversity and inclusion. We are headquartered in Montreal, and our securities are listed on the Toronto Stock Exchange (TSX: NA). Table of Contents 3 Message From the President and Chief Executive Officer 5 Members of the Office of the President 6 Message From the Chairman of the Board 7 Members of the Board of Directors 8 Our One Mission 9 Environmental, Social and Governance (ESG) 12 Risk Disclosures 13 Management’s Discussion and Analysis 111 Audited Consolidated Financial Statements 212 Statistical Review 214 Glossary of Financial Terms 216 Information for Shareholders 2.7 million Clients(1) 25,487 Employees(2) 495 Branches(3) 1,480 Banking Machines(4) $565 B Assets Under Administration $281 B Total Assets $7,432 M Total Revenues $2,322 M Net Income $22.7 B Market Capitalization and Under Management 9% 23% 45% 23% 19% 26% 55% 2019 Total Revenues by Business Segment(5) 2019 Total Revenues by Geographic Distribution(5) Personal and Commercial Province of Quebec Wealth Management Financial Markets Other Canadian provinces Outside of Canada U.S. Specialty Finance and International (1 ) Clients of the Personal and Commercial segment (2) Worldwide (3) 422 in Canada, 70 in Cambodia and 3 in the United States (Florida) (4) 939 in Canada and 541 in Cambodia (5) Excluding the Other heading Investing in National Bank Strong Earnings Growth(1) 2015–2019 / CAGR (2) > Canadian super-regional bank with leading franchise in core Quebec market + 8.9% – Favourable economic conditions in both Quebec and Canada > Targeted growth strategy across Canada and focused international strategy delivering high returns > Transformation driving efficiencies and enhanced customer experience > Strong credit quality supported by sound geographic and product diversification Consistent Dividend Growth (3) 2015–2019 / CAGR (2) > Industry-leading ROE (5) > Strong capital position providing flexibility + 6.9% > Attractive dividend yield and consistent annual dividend growth > Track record of delivering superior total shareholder returns 2019 RETURN ON EQUITY 18.0% Solid Capital Position (4) As at October 31, 2019 Industry-Leading Total Shareholder Returns (CAGR(2)) (for the periods ended October 31, 2019) 11.7% National Bank Canadian Peers(6) TSX Ranking(7) 1 year 3 years 10 years 18.9% 17.1% 13.9% 8.4% 9.4% 11.4% 13.1% 7.1% 7.4% # 1 # 1 # 1 (1 ) Based on diluted earnings per share (2) Compound annual growth rate (3) Based on annual dividends per common share (4) Common Equity Tier 1 (CET1) capital ratio (5) Based on adjusted ROE as reported by Canadian peers, including Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Bank of Nova Scotia and Toronto-Dominion Bank (6) Includes Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Bank of Nova Scotia and Toronto-Dominion Bank (7) Among Canadian peers, as defined above National Bank of Canada 2019 Annual Report 1 Financial Overview Medium-Term Objectives and 2019 Results Growth in diluted earnings per share excluding specified items(1) ROE excluding specified items(1) Dividend payout ratio excluding specified items(1) CET1 capital ratio Leverage ratio Financial Highlights Medium-term objectives 5–10% 15–20% 40–50% > 10.75% > 3.75% 2019 results 7.1 % 18.0 % 41.6 % 11.7 % 4.0 % As at October 31 or for the year ended October 31 (millions of Canadian dollars, except per share amounts) Operating results Total revenues Net income Diluted earnings per share Return on common shareholdersʼ equity Operating results on a taxable equivalent basis and excluding specified items(1) Total revenues on a taxable equivalent basis and excluding specified items Net income excluding specified items Diluted earnings per share excluding specified items Return on common shareholders’ equity excluding specified items Dividend payout ratio excluding specified items Efficiency ratio on a taxable equivalent basis and excluding specified items Dividends declared Total assets Regulatory ratios under Basel III Common Equity Tier 1 (CET1) capital ratio Leverage ratio Liquidity coverage ratio (LCR) 2019 2018 % change 7,432 2,322 $ 6.34 7,166 2,232 $ 5.94 18.0 % 18.4 % 7,666 2,328 $ 6.36 18.0 % 42 % 54.5 % 7,411 2,232 $ 5.94 18.4 % 41 % 54.8 % $ 2.66 281,458 $ 2.44 262,471 11.7 % 4.0 % 146 % 11.7 % 4.0 % 147 % 4 4 7 3 4 7 9 7 (1 ) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. 2 National Bank of Canada 2019 Annual Report MMeessssaaggee FFrroomm tthhee PPrreessiiddeenntt aanndd CChhiieeff EExxeeccuuttiivvee OOffffiicceerr AAnnootthheerr SSttrroonngg YYeeaarr ffoorr NNaattiioonnaall BBaannkk Fiscal 2019 was another strong year for National Bank. Across the Bank, we achieved solid business growth and record profitability. Our performance reflects our commitment to delivering consistent value to all stakeholders: our clients, our employees, our shareholders and our communities. In 2019, we generated diluted earnings per share of $6.34, up 7% from last year, and we met all of our medium-term objectives. Our credit quality is excellent, lending. Our transformation translated into further improvements in our efficiency ratio. Again this year, we delivered an industry-leading return on equity of 18.0%. reflecting our prudent approach to National Bank’s share price reached new highs in 2019, and the Bank is in the unique position of having delivered industry-leading compound annual total shareholder returns of 18.9%, 17.1%, 13.9% and 15.1% over the one, three, ten and twenty-year periods, respectively. National Bank’s share price reached new highs in 2019, and the Bank is in the unique position of having delivered industry-leading compound annual total shareholders returns, […] Our capital deployment strategy is clear and remains unchanged. Our top priority is to maintain strong capital levels, providing us with the flexibility to invest in growth initiatives in our core markets and to return capital to shareholders. In 2019, we raised our dividend by 9% and returned $281 million of additional capital through share repurchases. WWeellll--PPoossiittiioonneedd ffoorr GGrroowwtthh As a Canadian super-regional bank with a leading franchise in Quebec, we continue to benefit from favourable economic conditions both in our home province and across Canada. The Quebec economy remains strong, with historically low unemployment rates, sound public finances and housing affordability well above the national average. At this point of the economic cycle, we remain very comfortable with our business positioning and our prudent approach to risk. As we are entering a new year, we will maintain our overweight positions in the province of Quebec as well as in secured lending, which we view as favourable in the current environment. We will also continue to strive to achieve the right balance between volume growth, healthy margins, and strong credit quality. Our overall objective is to position the Bank to perform well through the cycle. At this point of the economic cycle, we remain very comfortable with our business positioning and our prudent approach to risk. […] Our overall objective is to position the Bank to perform well through the cycle. Our Personal and Commercial Banking segment is benefitting from our strong market position in Quebec. In the retail market, we are deepening relationships with clients, focusing on advice and leveraging our digital platforms to create a compelling and secure client experience, which drives customer loyalty and acquisition. In Commercial Banking, we are pursuing a focused growth strategy across Canada in specialized markets, harnessing our in healthcare, agriculture, technology, creative industries and real estate. recognized strengths As a leading franchise in Quebec and firmly established in Canada, we are pleased with the differentiated positioning of our Wealth Management segment. With a focus on distribution, our open-architecture model responds to client needs for choice and unbiased advice. We are proud to be the Canadian leader in providing administrative services to independent asset managers. Our Financial Markets segment is a strong pillar for the Bank. Our established leadership in selected niches across Canada is underpinned by our entrepreneurial culture, our differentiated business mix and our flexible approach to capital allocation. We continue to invest in our franchise to further our presence domestically and capitalize on targeted opportunities abroad. We are very satisfied with the overall performance of our international strategy, which generates strong growth and superior returns. Both Credigy in the U.S. and ABA Bank in Cambodia have greatly exceeded our expectations, and we continue to see attractive growth potential for each platform. Looking ahead, our efforts and capital dedicated to international markets will be concentrated on these two successful subsidiaries. National Bank of Canada 3 National Bank of Canada2019 Annual ReportMMeessssaaggee FFrroomm tthhee PPrreessiiddeenntt aanndd CChhiieeff EExxeeccuuttiivvee OOffffiicceerr ((ccoonntt..)) PPeeooppllee aanndd CCuullttuurree:: AA CCoommppeettiittiivvee AAddvvaannttaaggee At a time of profound change, we believe that people and culture are the cornerstone of our long-term success. Our entrepreneurial culture, deeply rooted within the organization, is a key differentiator in the way we transform the Bank, serve our clients, and attract people with the right skills and values. Our evolution as an agile organization goes hand-in-hand with our digital transformation—all essential components to delivering superior customer experience, sustainable revenue growth and higher operating efficiency. At National Bank, we are putting People First. In 2019, we adjusted our mission statement to respond to the rapid evolution of our operating environment. At National Bank, we are putting People First. We believe that building long-term relationships with our clients, our employees and our communities is key to creating sustainable long-term value for all stakeholders. EEnnssuurriinngg LLoonngg--TTeerrmm SSuussttaaiinnaabbiilliittyy The long-term sustainability of an institution like ours depends on the ability to maintain a healthy balance between the interests of all stakeholders. As a proud founding signatory of the UN Principles for Responsible Banking and joining the UN Principle for Responsible Investment in 2019, we are putting the full strength of our organization behind our environmental, social and governance guiding principles with the aim to develop a green economy, enrich our communities, and uphold the highest standards in corporate governance. How we achieve success is crucial and our principles must translate into tangible action. As we look forward, we are more committed than ever to maximizing the positive impact of our actions to the benefit of our clients, employees, communities and shareholders. MMoovviinngg FFoorrwwaarrdd WWiitthh CCoonnffiiddeennccee As we embark on a new year, I look to the future with cautious optimism. The outlook in Quebec remains favourable and we continue to take advantage of Canada’s broader economic soundness. Our credit quality is excellent, our capital ratios are strong, and disciplined cost management remains a priority throughout the organization. In an environment of macroeconomic and geopolitical uncertainties, we are comfortable with our current positioning and we remain vigilant in balancing our objectives of sustainable growth with prudent risk management. As we mark our 160th anniversary, I am proud of the Bank’s influential role in the economic and social development of Quebec and Canada. I wish to sincerely thank my colleagues of the Office of the President for their leadership and our more than 25,000 employees for their contribution in achieving our mission each day. I thank the Board of Directors for its judicious counsel and support. I also thank our 2.7 million clients and our shareholders for their trust and continued support. We have the right team in place to ensure the Bank’s long-term success and truly live our mission of putting People First. LLoouuiiss VVaacchhoonn President and Chief Executive Officer 4 National Bank of Canada2019 Annual ReportMembers of the Office of the President Louis Vachon President and Chief Executive Officer Stéphane Achard Executive Vice-President, Commercial Banking and Insurance Lucie Blanchet Executive Vice-President, Personal Banking and Client Experience William Bonnell Executive Vice-President, Risk Management Dominique Fagnoule Executive Vice-President, Information Technology Laurent Ferreira Executive Vice-President and Co-Head, Financial Markets Martin Gagnon Executive Vice-President, Wealth Management; Co-President and Co-Chief Executive Officer, National Bank Financial Nathalie Généreux Executive Vice-President, Operations Denis Girouard Executive Vice-President and Co-Head, Financial Markets Brigitte Hébert Executive Vice-President, Employee Experience Ghislain Parent Chief Financial Officer and Executive Vice-President, Finance National Bank of Canada 2019 Annual Report 5 MMeessssaaggee FFrroomm tthhee CChhaaiirrmmaann ooff tthhee BBooaarrdd National Bank celebrated its 160th anniversary in 2019, and the Board is truly proud of its heritage and rich history. Over the last century and a half, the Bank has successfully evolved and made positive contributions to the economic and social development of its communities. Against this backdrop, the Board is very pleased with the Bank’s strong performance in 2019 and with the continued execution of its strategy. The Bank has demonstrated, once again, its capacity to create tangible value for all stakeholders: its clients, employees, communities and shareholders. SSttrraatteeggiicc OOvveerrssiigghhtt As stewards of the Bank, the Board plays a critical and active role in overseeing the sound execution of the Bank’s strategy to ensure its long- term success. The Board participates in annual strategic reviews with the senior leadership team and in monitoring the progress of the Bank’s initiatives and key performance indicators. In order to provide sound guidance to management, the Board remains at the forefront of new realities facing the financial services industry and stays abreast of emerging technologies and other innovations. The Board also continues including to engage meaningfully with stakeholders, shareholders, to always keep its finger on the pulse of its industry. FFooccuusseedd oonn TTaalleenntt aanndd CCuullttuurree The Board works closely with management to ensure talent development. Succession planning is also a key Board responsibility, and we have great confidence in the strength of the leadership team and a solid pipeline of talent across the Bank. People and culture are the cornerstone of the Bank’s long-term success. As the banking industry evolves in an ever-changing environment, a strong entrepreneurial culture with the ability to adapt rapidly have become competitive advantages in the pursuit of our transformation. SSttrroonngg RRiisskk MMaannaaggeemmeenntt CCuullttuurree The Board champions a strong risk management culture, strengthened through active compliance, controls, and audits across all business lines. The Board assesses the soundness of business opportunities against the Bank’s risk management framework, which considers both financial and non-financial risks. In 2019, cybersecurity remained a key priority for the Board, and the Bank continued its significant investments in this critical aspect of our industry. Protecting client information is of the utmost importance, and risk- reduction strategies are continually being assessed by the Board. BBeesstt--iinn--CCllaassss BBooaarrdd GGoovveerrnnaannccee Leadership in the area of governance is fundamental. We have a strong Board, thanks to the active engagement of its dedicated members who put forth diverse perspectives, backgrounds, and expertise, all critical to strong oversight. To ensure that the Board’s composition is both aligned with and can anticipate the Bank’s ever-evolving needs, we remain proactive in promoting the highest standards of board renewal and committee chair rotations. In 2019, we welcomed Patricia Curadeau-Grou to the Board, a National Bank alumna who brings deep knowledge of the banking industry and solid expertise in finance and risk management. EEmmbbeeddddiinngg EESSGG PPrriinncciipplleess IInnttoo oouurr DDeecciissiioonn--MMaakkiinngg The Bank recognizes that its long-term success is directly tied to its ability to create sustainable value for all stakeholders. Corporate responsibility and ethical standards have always been embedded into the Bank’s culture. The Board understands the increasing importance of environmental, social, and governance (ESG) factors to all stakeholders. In 2019, we made significant progress in this regard, with the development and formal adoption of the Bank’s ESG principles by the Board. RReeaaddyy ffoorr tthhee FFuuttuurree On behalf of the Board, I would like to thank Louis Vachon and our executive team for their leadership and lasting contributions. I would also like to thank the Bank’s more than 25,000 employees for their unwavering commitment and for being dedicated Bank ambassadors in their communities. Our passion for people has allowed us to successfully build lasting relationships for the past 160 years, and we look forward to continuing to do so in the future. I wish to conclude by thanking our customers for their loyalty, our shareholders for their support, and all our stakeholders for the confidence they continue to manifest in National Bank. JJeeaann HHoouuddee Chairman of the Board of Directors For more information regarding the Bank’s governance, please refer to the Statement of Corporate Practices available on the Bank’s website at nbc.ca. 6 National Bank of Canada2019 Annual ReportMMeemmbbeerrss ooff tthhee BBooaarrdd ooff DDiirreeccttoorrss JJeeaann HHoouuddee Montreal, Quebec, Canada Chairman of the Board of Directors, National Bank of Canada and Corporate Director Director since March 2011 RRaayymmoonndd BBaacchhaanndd Montreal, Quebec, Canada Strategic Advisor, Norton Rose Fulbright Canada LLP and Corporate Director Director since October 2014 MMaarryyssee BBeerrttrraanndd Westmount, Quebec, Canada Corporate Director Director since April 2012 PPiieerrrree BBlloouuiinn Town of Mount-Royal, Quebec, Canada Corporate Director Director since September 2016 PPiieerrrree BBooiivviinn Montreal, Quebec, Canada President and Chief Executive Officer, Claridge inc. Director since April 2013 PPaattrriicciiaa CCuurraaddeeaauu--GGrroouu Montreal, Quebec, Canada Corporate Director Director since April 2019 GGiilllliiaann HH.. DDeennhhaamm Toronto, Ontario, Canada Corporate Director Director since October 2010 KKaarreenn KKiinnsslleeyy Ottawa, Ontario, Canada Corporate Director Director since December 2014 RReebbeeccccaa MMccKKiilllliiccaann Oakville, Ontario, Canada Chief Retail Officer, McKesson Canada Director since October 2017 PPiieerrrree TThhaabbeett St-Georges, Quebec, Canada President, Boa-Franc inc. Director since March 2011 RRoobbeerrtt PPaarréé Westmount, Quebec, Canada Strategic Advisor, Fasken Martineau DuMoulin LLP and Corporate Director Director since April 2018 LLoouuiiss VVaacchhoonn Beaconsfield, Quebec, Canada President and Chief Executive Officer, National Bank of Canada Director since August 2006 LLiinnoo AA.. SSaappuuttoo JJrr.. Montreal, Quebec, Canada Chief Executive Officer and Chairman of the Board of Directors, Saputo Inc. Director since April 2012 AAnnddrrééee SSaavvooiiee Dieppe, New Brunswick, Canada President and Chair of the Board of Directors, Acadian Properties Ltd. Director since April 2015 BBooaarrdd CCoommmmiitttteeeess AAuuddiitt CCoommmmiitttteeee Karen Kinsley (Chair) Maryse Bertrand Pierre Blouin Andrée Savoie Pierre Thabet RRiisskk MMaannaaggeemmeenntt CCoommmmiitttteeee Pierre Thabet (Chair) Raymond Bachand Patricia Curadeau-Grou Karen Kinsley Lino A. Saputo Jr. HHuummaann RReessoouurrcceess CCoommmmiitttteeee Pierre Boivin (Chair) Maryse Bertrand Pierre Blouin Gillian H. Denham Rebecca McKillican CCoonndduucctt RReevviieeww aanndd CCoorrppoorraattee GGoovveerrnnaannccee CCoommmmiitttteeee Lino A. Saputo Jr. (Chair) Raymond Bachand Jean Houde Robert Paré Andrée Savoie National Bank of Canada 7 National Bank of Canada2019 Annual Report OUR ONE MISSION We exist to have a POSITIVE IMPACT in people’s lives. By building long-term relationships with our clients, employees and communities. People first. Integral to our one mission is support for sustainable development. We incorporate environmental, social, and governance matters into our business and operating decisions. The Board of Directors has approved a sustainable development framework and principles that inspire our thoughts and actions. The Bank’s Commitments This past year, National Bank signed some major agreements: > One of the first North American signatories to the United Nations’ Principles for Responsible Banking > United Nations’ Global Standards of Conduct for Business: Tackling Discrimination Against Lesbian, Gay, Bi, Trans and Intersex People (LGBTI) > United Nations Environment Programme Finance Initiative (UNEP FI) > National Bank Investments: Signatory to the United Nations’ Principles for Responsible Investment (PRI) National Bank supports the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD). The Bank has therefore agreed to include, as part of its disclosure activities, information on the various questions addressed by this group. In addition, in collaboration with banking industry partners, the Bank is working to develop a relevant disclosure methodology. The Bank is committed to having a positive impact on people’s lives. Our principles reflect the importance of striking a balance among society’s stakeholders. We are working to develop a green economy We enrich communities We govern according to the highest standards 1. We consider the fight against 4. We maximize the potential climate change in our economic and community actions of individuals and the community 5. We promote inclusion 2. We guide and advise our clients and diversity in their energy transition 3. We manage and reduce our environmental footprint in all of our business segments 6. We foster entrepreneurship, financial literacy, philanthropy, and support for health and education 7. We promote a strong ethics culture, sound governance practices, and rigorous risk management 8. We manage according to responsible business practices 9. We ensure the long-term viability of the institution Key United Nations sustainable development goals covered by our principles 10 National Bank of Canada 2019 Annual Report Our Accomplishments Environmental We are working to develop a green economy > Renewable energy loan portfolio growing faster than the non-renewable energy portfolio in support of the energy transition > Equal investment allocated to the renewable and non-renewable energy sectors > Multi-award winning energy efficiency program > Several LEED® certifications > New head office designed to meet the highest standards of sustainable construction and occupant health and well-being (LEED v4 Gold certification) > External disclosure of a framework for issuing NBC Sustainability Bonds, an environmental policy, and a code of supplier conduct > Completion of four sustainability bond issuances, including the first international issuance of USD Sustainability Bonds by a North American bank > Assets under management governed by National Bank Investments’ OP4+ process: 95% (↑) of our fund managers meet the Principles for Responsible Investment > Several initiatives put in place by the Positive Environmental Impact Committee (end of purchase of disposable water bottles, eco-friendly lunches, etc.) Social We enrich communities Helping our clients power their ideas > Leading-edge digital and mobile banking solutions and many specialized services > New branch concepts where advice and technology converge > Active participation in developing the entrepreneurial ecosystem Supporting the community > Many millions of dollars paid to the community in the form of donations and sponsorships and through fundraisers > Hundreds of organizations supported Canada-wide > Committed to enhancing the impact of our social investments Stimulating economic development > $121 million invested in our facilities > $1.1 billion spent on goods and services Promoting diversity and inclusion > Listed in the 2019 Bloomberg Gender-Equality Index > Active support of women, cultural communities, and the LGBTQ+ community > Listed as one of Canada’s Best Diversity Employers for many years Governance We govern according to the highest standards > Mandates of the Conduct Review and Corporate Governance Committee, the Audit Committee, and the Risk Management Committee include ESG-related responsibilities > Policy regarding diversity on the Board of Directors (diversity of gender, age, designated groups, sexual orientation, ethnocultural groups, and geographic origins) > Listed in the 2019 FTSE4 Good Index of ethical companies recognized for social responsibility For more information: nbc.ca National Bank of Canada 2019 Annual Report 11 RRiisskk DDiisscclloossuurreess In 2012, the Financial Stability Board (FSB) formed a working group, the Enhanced Disclosure Task Force (EDTF), that was mandated to develop principles for enhancing the risk disclosures of major banks, to recommend improvements to current risk disclosures, and to identify risk disclosure best practices used by major financial institutions. The EDTF published a report entitled Enhancing the Risk Disclosures of Banks, which contains 32 recommendations. The Bank makes every effort to ensure overall compliance with those recommendations and is continuing to enhance its risk disclosures to meet the best practices on an ongoing basis. The risk disclosures required by the EDTF are provided in this Annual Report and in the document entitled Supplementary Regulatory Capital and Pillar 3 Disclosure available on the Bank’s website at nbc.ca. AAnnnnuuaall RReeppoorrtt PPaaggeess SSuupppplleemmeennttaarryy RReegguullaattoorryy CCaappiittaall aanndd PPiillllaarr 33 DDiisscclloossuurree(1) GGeenneerraall 1 2 3 4 Location of risk disclosures Management’s Discussion and Analysis Consolidated Financial Statements Supplementary Financial Information Supplementary Regulatory Capital and Pillar 3 Disclosure Risk terminology and risk measures Top and emerging risks New key regulatory ratios RRiisskk ggoovveerrnnaannccee aanndd rriisskk mmaannaaggeemmeenntt 5 6 7 8 Risk management organization, processes and key functions Risk management culture Key risks by business segment, risk management and risk appetite Stress testing 9 10 11 12 13 CCaappiittaall aaddeeqquuaaccyy aanndd rriisskk--wweeiigghhtteedd aasssseettss ((RRWWAA)) Minimum Pillar 1 capital requirements Reconciliation of the accounting balance sheet to the regulatory balance sheet Movements in regulatory capital Capital planning RWA by business segment and by risk type Capital requirements by risk and RWA calculation method Banking book credit risk Movements in RWA by risk type Assessment of credit risk model performance 14 15 16 17 LLiiqquuiiddiittyy 18 Liquidity management and components of the liquidity buffer FFuunnddiinngg 19 20 21 Summary of encumbered and unencumbered assets Residual contractual maturities of balance sheet items and off-balance-sheet commitments Funding strategy and funding sources MMaarrkkeett rriisskk 22 23 24 25 Linkage of market risk measures to balance sheet Market risk factors VaR: Assumptions, limitations and validation procedures Stress tests, stressed VaR and backtesting CCrreeddiitt rriisskk 26 27 28 29 30 Credit risk exposures Policies for identifying impaired loans Movements in impaired loans and allowances for credit losses Counterparty credit risk relating to derivatives transactions Credit risk mitigation OOtthheerr rriisskkss 31 32 Other risks: Governance, measurement and management Publicly known risk events (1) (2) Fourth quarter 2019. These pages are included in the document entitled Supplementary Financial Information  Fourth Quarter 2019. 12 19 to 29(2) 5 to 52 7 to 13, 16 and 17 6 6 6 6 35 12 50 to 94, 107, 109 and 110 Notes 1, 7, 16, 23 and 29 58 to 94 63 to 67 51 to 53, 80, 82 and 86 58 to 76, 82 and 83 58 and 59 57 to 59 and 63 50, 59, 71, 80, 81 and 83 51 to 53 55 50 to 57 57 67 to 71 56 62, 68 to 70 and 75 82 to 87 84 and 85 203 to 207 87 to 89 77 and 78 75 to 81, 191 and 192 78 and 79 75 to 81 74 and 151 to 163 72, 126 and 127 107, 109, 110 and 151 to 163 72, 73 and 171 to 174 70 to 72 and 148 18 to 44 and 19 to 27(2) 24 to 26(2) 37 to 44 and 28(2) and 29(2) 20, 24 and 42 to 52 66, 67 and 90 to 94 90 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis DDeecceemmbbeerr 33,, 22001199 The following Management’s Discussion and Analysis (MD&A) presents the financial condition and operating results of National Bank of Canada (the Bank). This analysis was prepared in accordance with the requirements set out in National Instrument 51-102, Continuous Disclosure Obligations, released by the Canadian Securities Administrators (CSA). It is based on the audited annual consolidated financial statements for the year ended October 31, 2019 (the consolidated financial statements) and prepared in accordance with International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB), unless otherwise indicated. IFRS represent Canadian generally accepted accounting principles (GAAP). This MD&A should be read in conjunction with the consolidated financial statements and accompanying notes for the year ended October 31, 2019. All amounts are presented in Canadian dollars. Additional information about the Bank, including the Annual Information Form, can be obtained from the Bank’s website at nbc.ca and SEDAR’s website at sedar.com. Financial Reporting Method Financial Disclosure Overview Financial Analysis Business Segment Analysis Personal and Commercial Wealth Management Financial Markets U.S. Specialty Finance and International (USSF&I) Other 1144 1166 1177 2211 2244 2255 2299 3333 3388 4422 Quarterly Financial Information Analysis of the Consolidated Balance Sheet Securitization and Off-Balance-Sheet Arrangements Capital Management Risk Management Critical Accounting Estimates Future Accounting Policy Changes Additional Financial Information 4433 4444 4488 5500 5588 9955 110011 110022 CCaauuttiioonn RReeggaarrddiinngg FFoorrwwaarrdd--LLooookkiinngg SSttaatteemmeennttss From time to time, the Bank makes written and oral forward-looking statements, such as those contained in the Economic Review and Outlook section of this Annual Report, in other filings with Canadian securities regulators, and in other communications, for the purpose of describing the economic environment in which the Bank will operate during fiscal 2020 and the objectives it hopes to achieve for that period. These forward-looking statements are made in accordance with current securities legislation in Canada and the United States. They include, among others, statements with respect to the economy—particularly the Canadian and U.S. economies—market changes, observations regarding the Bank’s objectives and its strategies for achieving them, Bank-projected financial returns and certain risks faced by the Bank. These forward-looking statements are typically identified by future or conditional verbs or words such as “outlook,” “believe,” “anticipate,” “estimate,” “project,” “expect,” “intend,” “plan,” and similar terms and expressions. By their very nature, such forward-looking statements require assumptions to be made and involve inherent risks and uncertainties, both general and specific. Assumptions about the performance of the Canadian and U.S. economies in 2020 and how that will affect the Bank’s business are among the main factors considered in setting the Bank’s strategic priorities and objectives and in determining its financial targets, including provisions for credit losses. In determining its expectations for economic growth, both broadly and in the financial services sector in particular, the Bank primarily considers historical economic data provided by the Canadian and U.S. governments and their agencies. There is a strong possibility that express or implied projections contained in these forward-looking statements will not materialize or will not be accurate. The Bank recommends that readers not place undue reliance on these statements, as a number of factors, many of which are beyond the Bank’s control, could cause actual future results, conditions, actions or events to differ significantly from the targets, expectations, estimates or intentions expressed in the forward-looking statements. These factors include credit risk, market risk, liquidity and funding risk, operational risk, regulatory compliance risk, reputation risk, strategic risk and environmental risk, all of which are described in more detail in the Risk Management section beginning on page 58 of this Annual Report, and more specifically, general economic environment and financial market conditions in Canada, the United States and certain other countries in which the Bank conducts business, including regulatory changes affecting the Bank’s business; changes in the accounting policies the Bank uses to report its financial condition, including uncertainties associated with assumptions and critical accounting estimates; tax laws in the countries in which the Bank operates, primarily Canada and the United States (including the U.S. Foreign Account Tax Compliance Act (FATCA)); changes to capital and liquidity guidelines and to the manner in which they are to be presented and interpreted; changes to the credit ratings assigned to the Bank; and potential disruptions to the Bank’s information technology systems, including evolving cyberattack risk. The foregoing list of risk factors is not exhaustive. Additional information about these factors can be found in the Risk Management section of this Annual Report. Investors and others who rely on the Bank’s forward-looking statements should carefully consider the above factors as well as the uncertainties they represent and the risk they entail. Except as required by law, the Bank does not undertake to update any forward-looking statements, whether written or oral, that may be made from time to time, by it or on its behalf. The forward-looking information contained in this document is presented for the purpose of interpreting the information contained herein and may not be appropriate for other purposes. Management’s Discussion and Analysis FFiinnaanncciiaall RReeppoorrttiinngg MMeetthhoodd As stated in Note 1 to the consolidated financial statements, the Bank adopted IFRS 15 on November 1, 2018. As permitted by IFRS 15, the Bank did not restate comparative consolidated financial statements, and Note 1 to the consolidated financial statements presents the impact of IFRS 15 adoption on the Bank’s Consolidated Balance Sheet as at November 1, 2018. The presentation of segment disclosures is consistent with the presentation adopted by the Bank for the year beginning November 1, 2018. This presentation reflects the fact that advisor banking service activities, which had previously been presented in the Wealth Management segment, are now presented in the Personal and Commercial segment. The Bank made this change to better align the monitoring of its activities with its management structure. NNoonn--GGAAAAPP FFiinnaanncciiaall MMeeaassuurreess The Bank uses a number of financial measures when assessing its results and measuring its overall performance. Some of these financial measures are not calculated in accordance with GAAP, which are based on IFRS. Presenting non-GAAP financial measures helps readers to better understand how management analyzes results, shows the impacts of specified items on the results of the reported periods, and allows readers to assess results without the specified items if they consider such items not to be reflective of the underlying performance of the Bank’s operations. Securities regulators require companies to caution readers that non-GAAP measures do not have a standardized meaning under GAAP and therefore may not be comparable to similar measures used by other companies. Like many other financial institutions, the Bank uses the taxable equivalent basis to calculate net interest income, non-interest income and income taxes. This calculation method consists of grossing up certain tax-exempt income (particularly dividends) by the income tax that would have been otherwise payable. An equivalent amount is added to income taxes. This adjustment is necessary in order to perform a uniform comparison of the return on different assets regardless of their tax treatment. The specified items related to the acquisitions of recent years (mainly those of the Wealth Management segment) are no longer presented as specified items as of November 1, 2018, since the amounts are not considered significant. The figures for the year ended October 31, 2018 reflect this change. 14 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Financial Reporting Method RReeccoonncciilliiaattiioonn ooff NNoonn--GGAAAAPP FFiinnaanncciiaall MMeeaassuurreess Year ended October 31 (millions of Canadian dollars) PPeerrssoonnaall aanndd CCoommmmeerrcciiaall WWeeaalltthh MMaannaaggeemmeenntt FFiinnaanncciiaall MMaarrkkeettss UUSSSSFF&&II Net interest income Taxable equivalent NNeett iinntteerreesstt iinnccoommee oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss Non-interest income Taxable equivalent Gain on disposal of Fiera Capital shares(2) Gain on disposal of premises and equipment(3) Remeasurement at fair value of an investment(4) NNoonn--iinntteerreesstt iinnccoommee oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss aanndd eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss TToottaall rreevveennuueess oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss aanndd eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss Non-interest expenses Impairment losses on premises and equipment and on intangible assets(5) Provisions for onerous contracts(6) Charge related to Maple(7) Severance pay(8) NNoonn--iinntteerreesstt eexxppeennsseess eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss CCoonnttrriibbuuttiioonn oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss aanndd eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss Provisions for credit losses IInnccoommee bbeeffoorree iinnccoommee ttaaxxeess oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss aanndd eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss Income taxes Taxable equivalent Income taxes on the gain on disposal of Fiera Capital shares(2) Income taxes on the gain on disposal of premises and equipment(3) Income taxes on the remeasurement at fair value of an investment(4) Income taxes related to impairment losses on premises and equipment and on intangible assets(5) Income taxes on provisions for onerous contracts(6) Income taxes on the charge related to Maple(7) Income taxes on severance pay(8) IInnccoommee ttaaxxeess oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss aanndd eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss NNeett iinnccoommee eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss SSppeecciiffiieedd iitteemmss aafftteerr iinnccoommee ttaaxxeess NNeett iinnccoommee NNoonn--ccoonnttrroolllliinngg iinntteerreessttss NNeett iinnccoommee aattttrriibbuuttaabbllee ttoo tthhee BBaannkk’ss sshhaarreehhoollddeerrss 22,,338833 −− 22,,338833 11,,006699 −− −− −− −− 11,,006699 33,,445522 11,,881166 −− −− −− −− 11,,881166 11,,663366 223377 11,,339999 337722 −− −− −− −− −− −− −− −− 337722 11,,002277 −− 11,,002277 −− 11,,002277 446699 11 447700 11,,227733 −− −− −− −− 228833 119911 447744 11,,114411 113355 −− −− −− 11,,227733 11,,227766 11,,774433 11,,006677 −− −− −− −− 11,,006677 667766 −− 667766 117766 11 −− −− −− −− −− −− −− 117777 449999 −− 449999 −− 449999 11,,775500 774433 −− −− −− −− 774433 11,,000077 3300 997777 ((6666)) 332266 −− −− −− −− −− −− −− 226600 771177 −− 771177 −− 771177 665566 −− 665566 5599 −− −− −− −− 5599 771155 228855 −− −− −− −− 228855 443300 8800 335500 7711 −− −− −− −− −− −− −− −− 7711 227799 −− 227799 4400 223399 22001199 2018(1) 33,,559966 119955 33,,779911 33,,883366 113355 ((7799)) ((5500)) 3333 3,382 144 3,526 3,784 101 − − − 33,,887755 3,885 77,,666666 44,,330011 ((5577)) ((4455)) ((1111)) ((1100)) 44,,117788 33,,448888 334477 7,411 4,063 − − − − 4,063 3,348 327 OOtthheerr ((119955)) 33 ((119922)) 229944 −− ((7799)) ((5500)) 3333 119988 66 339900 ((5577)) ((4455)) ((1111)) ((1100)) 226677 ((226611)) −− ((226611)) 33,,114411 3,021 ((9911)) 33 ((1111)) ((77)) 66 1155 1122 33 33 ((6677)) ((119944)) ((66)) ((220000)) 2266 ((222266)) 446622 333300 ((1111)) ((77)) 66 1155 1122 33 33 881133 22,,332288 ((66)) 22,,332222 6666 22,,225566 544 245 − − − − − − − 789 2,232 − 2,232 87 2,145 (1) (2) (3) (4) (5) (6) (7) (8) For the year ended October 31, 2018, certain amounts have been reclassified, mainly amounts related to advisor banking service activities, which have been transferred from the Wealth Management segment to the Personal and Commercial segment. During the year ended October 31, 2019, following the Bank’s disposal of a portion of its investment in Fiera Capital Corporation (Fiera Capital) the Bank recorded a gain on disposal of $79 million ($68 million net of income taxes), including a gain of $31 million ($27 million net of income taxes) upon remeasurement at fair value of the retained interest. During the year ended October 31, 2019, the Bank completed the sale of its head office land and building located at 600 De La Gauchetière Street West, Montreal, Quebec, Canada, for gross proceeds of $187 million, and a gain on disposal of premises and equipment of $50 million ($43 million net of income taxes) was recorded. During the year ended October 31, 2019, the Bank remeasured at fair value its investment in NSIA Participations (NSIA) and recorded a loss of $33 million ($27 million net of income taxes). During the year ended October 31, 2019, the Bank recorded $57 million ($42 million net of income taxes) in impairment losses on premises and equipment and on intangible assets related to computer equipment and technology developments. During the year ended October 31, 2019, the Bank reviewed all of its corporate building leases and recorded provisions for onerous contracts of $45 million ($33 million net of income taxes). During the year ended October 31, 2019, the Bank recorded a charge of $11 million ($8 million net of income taxes) related to the company Maple Financial Group Inc. (Maple) following the event of November 19, 2019, as described in the section entitled Event After the Consolidated Balance Sheet on page 47. During the year ended October 31, 2019, following an optimization of certain organizational structures, the Bank recorded $10 million ($7 million net of income taxes) in severance pay. National Bank of Canada 15 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis FFiinnaanncciiaall DDiisscclloossuurree DDiisscclloossuurree CCoonnttrroollss aanndd PPrroocceedduurreess The Bank’s financial information is prepared with the support of a set of disclosure controls and procedures (DC&P) that are implemented by the President and Chief Executive Officer (CEO) and by the Chief Financial Officer and Executive Vice-President, Finance (CFO). During the year ended October 31, 2019, in accordance with Regulation 52-109 Respecting Certification of Disclosure in Issuers’ Annual and Interim Filings (Regulation 52-109), released by the CSA, the design and operation of these controls and procedures were evaluated to determine their effectiveness. As at October 31, 2019, the CEO and the CFO confirmed the effectiveness of the DC&P. These controls are designed to provide reasonable assurance that the information disclosed in annual and interim filings and in other reports filed or submitted under securities legislation is recorded, processed, summarized and reported within the time periods specified by that legislation. These controls and procedures are also designed to ensure that such information is accumulated and communicated to the Bank’s management, including its signing officers, as appropriate, to allow for timely decisions regarding disclosure. This Annual Report was reviewed by the Disclosure Committee, the Audit Committee, and the Bank’s Board of Directors (the Board), which approved it prior to publication. IInntteerrnnaall CCoonnttrroollss OOvveerr FFiinnaanncciiaall RReeppoorrttiinngg The internal controls over financial reporting (ICFR) are designed to provide reasonable assurance that the financial information presented is reliable and that the consolidated financial statements were prepared in accordance with GAAP, which are based on IFRS, unless indicated otherwise as explained on pages 14 and 15 of this MD&A. Due to inherent limitations, the ICFR may not prevent or detect all misstatements in a timely manner. The CEO and the CFO oversaw the evaluation work performed on the design and operation of the Bank’s ICFR in accordance with Regulation 52-109. These controls were evaluated in accordance with the control framework of the Committee of Sponsoring Organizations of the Treadway Commission (COSO — 2013) for financial controls and in accordance with the control framework of the Control Objectives for Information and Related Technologies (COBIT) for general information technology controls. Based on the evaluation results, the CEO and CFO concluded, as at October 31, 2019, that there are no material weaknesses, that the ICFR are effective and provide reasonable assurance that the financial reporting is reliable, and that the Bank’s consolidated financial statements were prepared in accordance with GAAP. CChhaannggeess ttoo IInntteerrnnaall CCoonnttrroollss OOvveerr FFiinnaanncciiaall RReeppoorrttiinngg The CEO and CFO also undertook work whereby they were able to conclude that, during the year ended October 31, 2019, no changes were made to the ICFR that have materially affected, or are reasonably likely to materially affect, the design or operation of the ICFR. DDiisscclloossuurree CCoommmmiitttteeee The Disclosure Committee assists the CEO and CFO by ensuring that disclosure controls and procedures and internal control procedures for financial reporting are implemented and operational. In so doing, the committee ensures that the Bank is meeting its disclosure obligations under current regulations and that the CEO and CFO are producing the requisite certifications. 16 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis OOvveerrvviieeww HHiigghhlliigghhttss As at October 31 or for the year ended October 31 (millions of Canadian dollars, except per share amounts) OOppeerraattiinngg rreessuullttss Total revenues Net income Net income attributable to the Bank’s shareholders Return on common shareholders’ equity Dividend payout ratio EEaarrnniinnggss ppeerr sshhaarree Basic Diluted OOppeerraattiinngg rreessuullttss oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss aanndd eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss(1) Total revenues on a taxable equivalent basis and excluding specified items Net income excluding specified items Return on common shareholders’ equity excluding specified items Dividend payout ratio excluding specified items Efficiency ratio on a taxable equivalent basis and excluding specified items EEaarrnniinnggss ppeerr sshhaarree eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss(1) Basic Diluted CCoommmmoonn sshhaarree iinnffoorrmmaattiioonn Dividends declared Book value Share price High Low Close Number of common shares (thousands) Market capitalization BBaallaannccee sshheeeett aanndd ooffff--bbaallaannccee--sshheeeett Total assets Loans and acceptances, net of allowances Deposits Equity attributable to common shareholders Assets under administration and under management RReegguullaattoorryy rraattiiooss uunnddeerr BBaasseell IIIIII Capital ratios Common Equity Tier 1 (CET1) Tier 1 Total Leverage ratio Liquidity coverage ratio (LCR) OOtthheerr IInnffoorrmmaattiioonn Number of employees – worldwide Number of branches in Canada Number of banking machines in Canada 22001199 2018 %% cchhaannggee $$ $$ $$ 77,,443322 22,,332222 22,,225566 1188..00 %% 4422 %% 66..3399 66..3344 $ 77,,666666 22,,332288 1188..00 %% 4422 %% 5544..55 %% $ $ 66..4400 66..3366 22..6666 3366..8899 6688..0022 5544..9977 6688..0022 333344,,117722 2222,,773300 228811,,445588 115533,,225511 118899,,556666 1122,,332288 556655,,339966 7,166 2,232 2,145 18.4 % 41 % 6.01 5.94 7,411 2,232 18.4 % 41 % 54.8 % 6.01 5.94 2.44 34.40 65.63 58.69 59.76 335,071 20,024 262,471 146,082 170,830 11,526 485,080 1111..77 %% 1155..00 %% 1166..11 %% 44..00 %% 114466 %% 2255,,448877 442222 993399 11.7 % 15.5 % 16.8 % 4.0 % 147 % 23,450 428 937 44 44 55 66 77 33 44 66 77 99 77 55 1111 77 1177 99 ((11)) –– (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. National Bank of Canada 17 National Bank of Canada2019 Annual ReportAbout National Bank The Bank carries out its activities in four business segments: Personal and Commercial, Wealth Management, Financial Markets, and U.S. Specialty Finance and International. For presentation purposes, other operating activities, certain non-recurring items, and treasury activities are grouped in the Other heading of segment results. Each reportable segment is distinguished by services offered, type of clientele, and marketing strategy. Additional information is provided in the Business Segment Analysis section of this MD&A. % 1 . 1 1 % 7 . 9 % 3 . 9 Objectives and 2019 Results When setting its objectives, the Bank aims for a realistic challenge in the current business environment and factors in the predictable evolution in banking industry financial results as well as the Bank’s business development plan. When the Bank sets its medium-term objectives, it does not take specified items(1) into consideration, as they are inherently unpredictable or non-recurring. Management therefore excludes specified items when assessing the Bank’s performance against its objectives. In fiscal 2019, the Bank recorded $2,322 million in net income compared to $2,232 million in fiscal 2018. Its 2019 diluted earnings per share stood at $6.34 versus $5.94 in fiscal 2018, and its 2019 return on common shareholders’ equity (ROE) was 18.0% versus 18.4% in 2018. Net income excluding specified items totalled $2,328 million in fiscal 2019, up 4% year over year, and diluted earnings per share excluding specified items stood at $6.36, up 7% from $5.94 in 2018. Furthermore, ROE excluding specified items was 18.0% in 2019 versus 18.4% in 2018. The following table compares the Bank’s medium-term objectives with its 2019 results. MMeeddiiuumm--TTeerrmm OObbjjeeccttiivveess aanndd 22001199 RReessuullttss Growth in diluted earnings per share excluding specified items(1) ROE excluding specified items(1) Dividend payout ratio excluding specified items(1) CET1 capital ratio Leverage ratio MMeeddiiuumm-- tteerrmm oobbjjeeccttiivveess ((%%)) 55--1100 1155--2200 4400--5500 >> 1100..7755 >> 33..7755 22001199 rreessuullttss ((%%)) 77 1188..00 4422 1111..77 44..00 (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. In 2019, the Bank’s financial results met all of the medium-term objectives. The 7% growth in diluted earnings per share excluding specified items was driven by solid net income growth in all business segments, except in the Financial Markets segment, where net income was affected by a slowdown during the first six months of fiscal 2019. And, even though the dividend per share was raised twice, for a 9% increase in fiscal 2019, the dividend payout ratio excluding specified items was at the lower end of the target range, mainly due to rapid growth in diluted earnings per share. Management’s Discussion and Analysis Overview BBuussiinneessss MMiixx(1) Year ended October 31, 2019 (taxable equivalent basis)(2) % 1 . 5 4 % 7 . 0 4 % 1 . 4 3 % 0 . 5 4 % 4 . 8 2 % 8 . 2 2 % 8 . 2 2 % 8 . 9 1 % 2 . 1 1 Personal and Commercial Wealth Management Financial Markets USSF&I Total revenue Net income Economic capital NNeett iinnccoommee Year ended October 31 (millions of Canadian dollars) 2 3 2 , 2 2 3 2 , 2 2 2 3 , 2 8 2 3 , 2 2018 22001199 Including specified items Excluding specified items(2) DDiilluutteedd eeaarrnniinnggss ppeerr sshhaarree Year ended October 31 (Canadian dollars) 4 9 . 5 4 9 . 5 4 3 . 6 6 3 . 6 2018 22001199 Including specified items Excluding specified items(2) (1) Excluding the Other heading. (2) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. 18 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Overview For fiscal 2019, the Bank declared $892 million in dividends to common shareholders (2018: $829 million), representing 42% of net income attributable to common shareholders (2018: 41%). Year ended October 31 (Canadian dollars) As at October 31, 2019, the Bank’s CET1, Tier 1 and Total capital ratios were, respectively, 11.7%, 15.0% and 16.1%, i.e., above the regulatory requirements, compared to ratios of, respectively, 11.7%, 15.5% and 16.8% as at October 31, 2018. The CET1 capital ratio remained stable. Net income net of dividends, and common share issuances under the Stock Option Plan offset the application of the Standardized Approach for measuring Counterparty Credit Risk (SA-CCR) rules for measuring counterparty credit risk, growth in risk-weighted assets, the common share repurchases during the year ended October 31, 2019, and remeasurements of pension plans and other post-employment benefit plans. The decreases in the Tier 1 capital ratio and the Total capital ratio were essentially due to growth in risk-weighted assets. As at October 31, 2019, the leverage ratio was 4.0%, stable compared to October 31, 2018. The growth in Tier 1 capital was offset by growth in total leverage exposure. High-Quality Loan Portfolio For fiscal 2019, the Bank recorded $347 million in provisions for credit losses, $20 million more than those recorded in fiscal 2018. The higher year-over-year provisions stem mainly from provisions for credit losses on credit card receivables and on loans in the Financial Markets segment. However, the provisions for credit losses on loans of the USSF&I segment were down, essentially related to the Credigy Ltd. (Credigy) subsidiary. The 2019 provisions for credit losses represented 0.23% of average loans and acceptances, unchanged from fiscal 2018. As at October 31 or for the year ended October 31 (millions of Canadian dollars) Provisions for credit losses Provisions for credit losses as a % of average loans and acceptances Provisions for credit losses on impaired loans as a % of average loans and acceptances Net write-offs as a % of average loans and acceptances Gross impaired loans(1) Net impaired loans(2) 2018 327 0.23 % 0.23 % 0.23 % 630 404 (1) (2) All loans classified in Stage 3 of the expected credit loss model are impaired loans. The impaired loans presented in this table exclude purchased or originated credit-impaired (POCI) loans. Net impaired loans are presented net of allowances for credit losses on Stage 3 loan amounts drawn. The net impaired loans presented in this table exclude POCI loans. 2015 2016 2017 2018 % 1 . 6 1 % 0 . 5 1 % 7 . 1 1 % 0 . 4 % 0 . 4 As at October 31 % 8 . 6 1 % 5 . 5 1 % 7 . 1 1 2018 CET1 Tier 1 Total Leverage ratio As at October 31, 2019 (1) 6 % 12 % 4 % 25 % 53 % Personal Banking (2018: 54%) Commercial Banking (2018: 25%) Wealth Management (2018: 4%) Financial Markets – Corporate Banking (2018: 11%) U.S. Specialty Finance and International (2018: 6%) (1) Excluding loans and acceptances in the Other heading National Bank of Canada 2019 Annual Report 19 Management’s Discussion and Analysis Overview EEccoonnoommiicc RReevviieeww aanndd OOuuttllooookk GGlloobbaall EEccoonnoommyy While talks between China and the Unites States in the trade war opposing the two countries seem to be making headway, the damage to the global economy has already been considerable. Worldwide, the manufacturing sector has been contracting for the past six months, but the services sector has kept the economy afloat. Washington, like Beijing, stands to benefit from a truce. The trade war has hurt the Middle Kingdom, where slower growth is in large part due to a downturn not only in exports but also in investment. To address the situation, Chinese authorities have had to implement stimulus measures via monetary and budgetary policy in order to achieve their growth target of 6-6.5%. Owing to its relatively intense participation in the global value chain, the eurozone has been hardest hit by the turmoil of the trade war. Germany, for instance, may already be in the midst of a technical recession after its economy contracted again in the second quarter. Given the growing uncertainty, a majority of central banks have opted to ease their monetary policy in the third quarter, a record high since the global recession of 2008-2009. This should be enough for the global economy to keep expanding. We expect global economic growth to reach 3.2% in 2020(1), up slightly from 2019 (3.0%)(1). In the U.S., the longest growth streak in history is showing signs of losing steam, thus reviving fears of recession in the present context of strained international trade relations. In our opinion, the probability of a recession in the next twelve months does not exceed 30%, as a truce remains the most likely scenario in light of the coming U.S. presidential election. Moreover, the resilience of consumption and of the labour market is largely compensating for the weakness in foreign trade, which is putting the brakes on business investment. By lowering interest rates in October after twice doing so this summer, the U.S. Federal Reserve has contributed to setting the yield curve back on an upward slope after its inversion in 2019 had raised alarm bells. We believe that this rate adjustment will suffice for now. With the 2020 election in the offing, we can expect both monetary and budgetary policy to remain accommodative. We expect U.S. GDP to grow 2.3% and 1.9% in 2019 and 2020(1), respectively. CCaannaaddiiaann EEccoonnoommyy The Canadian economy has once again proven the skeptics wrong after weakness in the energy and real estate sectors early in the year was seen as a bad omen. As it happens, the economy bounced back spectacularly in the second quarter, growing at an annualized rate of 3.7%. Job creation in the first ten months of the year has been the strongest ever since 2002 and wage growth has picked up relentlessly. The vitality of the labour market and lower interest rates have energized the housing market, which has managed to rebound in both Ontario and British Columbia. There is no denying that household debt levels are high and the savings rate very low at present. This should translate into moderate consumption growth. However, other sectors should step up in 2020 and push the economy to grow near potential (1.6%)(1). Canadian exports should benefit from persistently strong U.S. demand and a weak currency. Furthermore, given the federal election results, a fiscal stimulus is in the cards for 2020. Given the economy’s resilience and an annual core inflation rate essentially on target, the Bank of Canada should not have to follow the Fed’s lead in easing monetary policy, unless hostilities flare up again between China and the United States. QQuueebbeecc EEccoonnoommyy The Quebec economy continues to forge ahead at a sustained pace. GDP has grown for ten months in a row, the longest such streak since statistics began to be calculated in 1997. The economy and the labour market are being spurred on by an accommodative monetary policy and budgetary stimulus. Over 87,000 net new jobs have been created in the province since the beginning of 2019, the best showing in this regard since 2012. The unemployment rate could hit a record low for a fourth straight year in 2019. Labour shortages are no doubt having an impact on the hourly wages of permanent employees, which in the past year have registered their steepest increase by far since 1998 (6.1% in 2019 third quarter). In this context, the real estate market, which remains more affordable in Quebec than elsewhere in Canada, is headed for a record year in terms of home sales. Economic growth is expected to slow down but should remain solid at 1.5% in 2020 (2.5% in 2019)(1). The household savings rate is high and household debt is lower than in the rest of the country, which bodes well for consumption in the coming quarters. (1) GDP growth expectations, Economy and Strategy Group 20 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis FFiinnaanncciiaall AAnnaallyyssiiss CCoonnssoolliiddaatteedd RReessuullttss Year ended October 31 (millions of Canadian dollars) OOppeerraattiinngg rreessuullttss Net interest income Non-interest income Total revenues Non-interest expenses Contribution Provisions for credit losses Income before income taxes Income taxes Net income Diluted earnings per share (dollars) TTaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss(1) Net interest income Non-interest income Income taxes Impact of taxable equivalent basis on net income SSppeecciiffiieedd iitteemmss(1) Gain on disposal of Fiera Capital shares Gain on disposal of premises and equipment Remeasurement at fair value of an investment Impairment losses on premises and equipment and on intangible assets Provisions for onerous contracts Charge related to Maple Severance pay Specified items before income taxes Income taxes on specified items Specified items after income taxes OOppeerraattiinngg rreessuullttss oonn aa ttaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss aanndd eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss(1) Net interest income on a taxable equivalent basis Non-interest income on a taxable equivalent basis and excluding specified items Total revenues on a taxable equivalent basis and excluding specified items Non-interest expenses excluding specified items Contribution on a taxable equivalent basis and excluding specified items Provisions for credit losses Income before income taxes on a taxable equivalent basis and excluding specified items Income taxes on a taxable equivalent basis and excluding specified items Net income excluding specified items Diluted earnings per share excluding specified items (dollars) Average assets Average loans and acceptances Average deposits Efficiency ratio on a taxable equivalent basis and excluding specified items(1) 22001199 2018 %% cchhaannggee 33,,559966 33,,883366 77,,443322 44,,330011 33,,113311 334477 22,,778844 446622 22,,332222 66..3344 119955 113355 333300 −− 7799 5500 ((3333)) ((5577)) ((4455)) ((1111)) ((1100)) ((2277)) ((2211)) ((66)) 33,,779911 33,,887755 77,,666666 44,,117788 33,,448888 334477 33,,114411 881133 22,,332288 66..3366 228866,,116622 114488,,776655 118844,,446600 3,382 3,784 7,166 4,063 3,103 327 2,776 544 2,232 5.94 144 101 245 − − − − − − − − − − − 3,526 3,885 7,411 4,063 3,348 327 3,021 789 2,232 5.94 265,940 139,603 167,176 5544..55 %% 54.8 % 66 11 44 66 11 66 −− ((1155)) 44 77 88 −− 33 33 44 66 44 33 44 77 88 77 1100 (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. National Bank of Canada 21 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Financial Analysis AAnnaallyyssiiss ooff CCoonnssoolliiddaatteedd RReessuullttss FFiinnaanncciiaall RReessuullttss For fiscal 2019, the Bank’s net income totalled $2,322 million compared to $2,232 million in fiscal 2018, a year-over-year increase owing essentially to net income growth across most of the business segments, tempered by a slowdown in the Financial Markets segment during the first six months of fiscal 2019. Specified items, net of income taxes, had a $6 million unfavourable impact on net income in fiscal 2019. The fiscal 2019 specified items, net of income taxes, include a $68 million gain on disposal of Fiera Capital shares, a $43 million gain on disposal of premises and equipment, a $27 million loss on the remeasurement at fair value of the Bank’s investment in NSIA, $42 million in impairment losses on premises and equipment and on intangible assets, $33 million in provisions for onerous contracts, an $8 million charge related to Maple, and $7 million in severance pay. For fiscal 2019, the Bank’s net income excluding specified items(1) totalled $2,328 million, up 4% from $2,232 million in fiscal 2018. TToottaall RReevveennuueess For fiscal 2019, the Bank’s total revenues amounted to $7,432 million, up $266 million or 4% from $7,166 million in fiscal 2018. The fiscal 2019 total revenues include a $79 million gain on disposal of Fiera Capital shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss arising from the remeasurement at fair value of the Bank’s investment in NSIA. The increase in total revenues was driven by revenue growth across all of the Bank’s business segments. The 2019 total revenues on a taxable equivalent basis and excluding specified items(1) were up $255 million or 3% year over year. For additional information about total revenues on a taxable equivalent basis(1), see Table 2 on page 104. Net Interest Income For fiscal 2019, the Bank’s net interest income totalled $3,596 million, rising $214 million from $3,382 million in fiscal 2018. The 2019 net interest income on a taxable equivalent basis(1) was $3,791 million compared to $3,526 million in fiscal 2018 (Table 3, page 104). In the Personal and Commercial (P&C) segment, the fiscal 2019 net interest income totalled $2,383 million, a $107 million or 5% year-over-year increase driven mainly by growth in loan volumes (primarily from mortgage and commercial lending activity) and in deposit volumes, which rose 5% and 7%, respectively. This increase in P&C’s net interest income was tempered by a narrowing of the net interest margin, which was 2.23% in fiscal 2019 versus 2.24% in fiscal 2018, that was largely due to a decrease in loan margins. In the Wealth Management segment, the fiscal 2019 net interest income on a taxable equivalent basis(1) totalled $470 million, a $24 million year-over-year increase owing to growth in loan and deposit volumes. As for the Financial Markets segment, its 2019 net interest income on a taxable equivalent basis(1) was up $65 million or 16% year over year, mainly due to trading activities, and should be examined together with the other items of trading activity revenues. In the USSF&I segment, the fiscal 2019 net interest income was up $72 million year over year owing to growth in loan and deposit volumes at the Advanced Bank of Asia Limited (ABA Bank) subsidiary, tempered by a decrease in net interest income at the Credigy subsidiary. Non-Interest Income For fiscal 2019, non-interest income totalled $3,836 million versus $3,784 million in fiscal 2018. The 2019 non-interest income includes a $79 million gain on disposal of Fiera Capital shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss arising from the remeasurement at fair value of the Bank’s investment in NSIA. Non-interest income on a taxable equivalent basis and excluding specified items(1) amounted to $3,875 million in fiscal 2019 compared to $3,885 million in fiscal 2018. For additional information on non-interest income on a taxable equivalent basis(1), see Table 4 on page 105. The fiscal 2019 revenues from underwriting and advisory fees were down 19% when compared to fiscal 2018, in particular due to merger and acquisition activities in the Financial Markets segment. Revenues from securities brokerage commissions were also down, declining $17 million as a result of lower transaction volume during fiscal 2019. Together, mutual fund revenues and trust service revenues totalled $1,058 million in fiscal 2019, a $33 million year-over- year increase resulting from growth in fee-based revenues and from an increase in assets under administration and under management arising from stronger stock market performance in 2019. The trading revenues recorded in non-interest income amounted to $829 million in fiscal 2019 compared to $840 million in fiscal 2018. Trading revenues on a taxable equivalent basis(1) recorded in non-interest income totalled $964 million, an increase from $941 million in 2018. Including the portion recorded in net interest income, trading activity revenues on a taxable equivalent basis(1) amounted to $1,199 million in 2019, a $50 million year-over-year increase (Table 5, page 105) attributable to revenues from equity securities and from fixed-income securities, whereas revenues from commodities and foreign exchange activities and revenues from other segments decreased year over year. (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. 22 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Financial Analysis In fiscal 2019, revenues from credit fees and revenues from acceptances and letters of credit and guarantee were up $14 million year over year, as there was increased credit activity in Commercial Banking, the Financial Markets segment, and the Credigy subsidiary. Card revenues posted 10% year-over-year growth during fiscal 2019, whereas revenues from deposit and payment service charges were down $9 million given a revision to rates. The Bank’s fiscal 2019 insurance revenues were up $15 million year over year, partly due to a revision to actuarial reserves. As for other-than-trading foreign exchange revenues and gains on non-trading securities, they remained stable when compared to fiscal 2018. The Bank’s share in the net income of associates and joint ventures was also up, rising $6 million year over year. Other revenues amounted to $251 million in fiscal 2019, a $78 million year-over-year increase owing mainly to the 2019 specified items, which include a gain on disposal of Fiera Capital shares and a gain on disposal of premises and equipment, tempered by a loss arising from a fair value remeasurement of the Bank’s investment in NSIA. NNoonn--IInntteerreesstt EExxppeennsseess Non-interest expenses stood at $4,301 million in fiscal 2019, up $238 million from fiscal 2018 (Table 6, page 106). The 2019 non-interest expenses include $57 million in impairment losses on premises and equipment and on intangible assets, $45 million in provisions for onerous contracts, an $11 million charge related to Maple, and $10 million in severance pay. Non-interest expenses excluding specified items(1) stood at $4,178 million, up $115 million or 3% year over year. Compensation and employee benefits stood at $2,532 million in fiscal 2019, a 3% year-over-year increase resulting from an increase in the number of employees, which essentially stems from the expansion of ABA Bank’s banking network, and an annual increase in salaries, tempered somewhat by a lower pension expense. Occupancy expenses were also up, rising year over year due to provisions for onerous contracts recorded during the year in addition to business growth at ABA Bank. The increase in technology expenses, including amortization, came from the technology investments made to execute the Bank’s transformation plan and for business development activities, in addition to impairment losses on premises and equipment and intangible assets recorded in fiscal 2019. Other expenses were also up, mainly due to expenses related to the activities of the Financial Markets segment and to the charge related to Maple. PPrroovviissiioonnss ffoorr CCrreeddiitt LLoosssseess For fiscal 2019, the Bank recorded $347 million in provisions for credit losses, $20 million more than the provisions recorded in fiscal 2018 (Table 7, page 107). This increase came mainly from higher credit loss provisions on credit card receivables, which rose $7 million year over year, and from higher credit loss provisions on loans in the Financial Markets segment, which rose $26 million year over year. These higher provisions relate mainly to provisions on impaired loans. In the USSF&I segment, provisions for credit losses on loans were down $14 million, essentially attributable to the Credigy subsidiary. At $313 million, the fiscal 2019 provisions for credit losses on impaired loans represent 0.21% of average loans and acceptances, less than last year’s 0.23%, notably due to a decrease in the credit losses on impaired loans of the Credigy subsidiary, tempered by an increase in credit losses on impaired loans in the Financial Markets segment. IInnccoommee TTaaxxeess Detailed information about the Bank’s income taxes is provided in Note 24 to the consolidated financial statements. For fiscal 2019, income taxes stood at $462 million, representing an effective tax rate of 17% compared to $544 million and an effective tax rate of 20% in 2018. This change in effective tax rate was created mainly by a realization of capital gains taxed at a lower rate, by higher income from lower tax rate jurisdictions, and by a year-over-year increase in the 2019 tax-exempt dividend income. (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. National Bank of Canada 23 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis BBuussiinneessss SSeeggmmeenntt AAnnaallyyssiiss The Bank carries out its activities in four business segments, which are defined below. For presentation purposes, other activities are grouped in the Other heading. Each reportable segment is distinguished by services offered, type of clientele and marketing strategy. The presentation of segment disclosures is consistent with the presentation adopted by the Bank for the year beginning November 1, 2018. This presentation reflects the fact that advisor banking service activities, which had previously been presented in the Wealth Management segment, are now presented in the Personal and Commercial segment. The Bank made this change to better align the monitoring of its activities with its management structure. National Bank of Canada Business Segments Personal and Commercial Wealth Management Financial Markets U.S. Specialty Finance and International  Banking services  Credit services  Financing  Investment solutions  Insurance Major Activities  Full-service brokerage  Private banking  Direct brokerage  Investment solutions  Administrative and trade execution services  Transaction products for advisors  Trust and estate services  Equities, fixed-income,  U.S. Specialty Finance commodities and foreign exchange  Corporate banking  Investment banking  Credigy  International  ABA Bank (Cambodia)  Minority interests in emerging markets Other: Treasury activities, liquidity management, Bank funding, asset/liability management, corporate units RReessuullttss bbyy BBuussiinneessss SSeeggmmeenntt Year ended October 31(1) (millions of Canadian dollars) Net interest income(2) Non-interest income(2) Total revenues Non-interest expenses Contribution Provisions for credit losses Income before income taxes (recovery) Income taxes (recovery)(2) Net income Non-controlling interests Net income attributable to the Bank’s shareholders Average assets Personal and Commercial 2018 22001199 Wealth Management 2018 22001199 22,,338833 11,,006699 33,,445522 11,,881166 11,,663366 223377 11,,339999 337722 11,,002277 −− 2,276 1,033 3,309 1,782 1,527 228 1,299 347 952 − 447700 11,,227733 11,,774433 11,,006677 667766 −− 667766 117777 449999 −− 446 1,243 1,689 1,058 631 1 630 166 464 − 22001199 447744 11,,227766 11,,775500 774433 11,,000077 3300 997777 226600 771177 −− Financial Markets 2018 22001199 USSF&I 2018 409 1,334 1,743 697 1,046 4 1,042 278 764 − 665566 5599 771155 228855 443300 8800 335500 7711 227799 4400 584 55 639 251 388 94 294 72 222 38 22001199 ((338877)) 115599 ((222288)) 339900 ((661188)) −− ((661188)) ((441188)) ((220000)) 2266 Other 2018 (333) 119 (214) 275 (489) − (489) (319) (170) 49 22001199 Total 2018 33,,559966 33,,883366 77,,443322 44,,330011 33,,113311 334477 22,,778844 446622 22,,332222 6666 3,382 3,784 7,166 4,063 3,103 327 2,776 544 2,232 87 11,,002277 952 111122,,779988 106,857 449999 66,,221199 464 6,167 771177 111122,,449933 764 100,721 223399 1100,,998855 184 9,270 ((222266)) 4433,,666677 (219) 42,925 22,,225566 228866,,116622 2,145 265,940 (1) (2) For the year ended October 31, 2018, certain amounts have been reclassified, mainly amounts related to advisor banking service activities, which have been transferred from the Wealth Management segment to the Personal and Commercial segment. The Net interest income, Non-interest income and Income taxes (recovery) items of the business segments are presented on a taxable equivalent basis. See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. 24 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis BBuussiinneessss SSeeggmmeenntt AAnnaallyyssiiss || PPeerrssoonnaall aanndd CCoommmmeerrcciiaall The Personal and Commercial segment meets the financial needs of close to 2.6 million individuals and approximately 137,000 businesses across Canada. These clients entrust the Bank to manage, invest, and safeguard their assets and to finance their projects. Clients turn to the Bank’s experienced advisors who take the time to understand their specific needs and help them reach their financial goals. And thanks to the Bank’s convenient self-banking channels, 422 branches and 939 banking machines across Canada, clients can do their daily banking whenever and wherever they wish. PPeerrssoonnaall BBaannkkiinngg Personal Banking provides a complete range of financing and investment products and services, mainly in Quebec, to help clients reach their financial goals throughout every stage in their lives. It offers everyday transaction solutions, mortgage loans and home equity lines of credit, consumer loans, payment solutions, savings and investment solutions as well as a diverse range of insurance products. CCoommmmeerrcciiaall BBaannkkiinngg Commercial Banking serves the financial needs of small and medium-sized enterprises and large corporations, helping them to achieve growth. It offers a full line of financial products and services, including credit, deposit and investment solutions, international trade, foreign exchange transactions, payroll, cash management, insurance, electronic transactions and complementary services. With deep roots in the business community for 160 years, Commercial Banking is Quebec’s leading provider of the core banking products for businesses and is also known across Canada for its expertise in targeted specialized industries such as health, agriculture and agri-food, technology, creative industries, real estate, and energy. EEccoonnoommiicc aanndd MMaarrkkeett RReevviieeww The economic environment is resilient in Quebec and in the rest of the country, driven by accommodative monetary policy and fiscal stimulus. Consumers are benefitting from strong employment gains and accelerating wages. The unemployment rate is on track to hit a record low for a fourth straight year in 2019 in Quebec. Wages are rising at the fastest pace among provinces, and the savings rate stands at a multi-year high, providing a cushion that can support consumption. Furthermore, both consumer and business confidence are high in Quebec. The province’s household debt level is below the Canadian average, and housing affordability is better. Business investment is being supported by accelerated depreciation measures implemented by the federal and some provincial governments. The financial sector is quickly transforming toward digital and mobile services, and there is vigorous competition between established entities and new market participants that are distinguishing themselves through new technologies. The economic environment in 2019 and the outlook for 2020 are discussed in more detail in the Economic Review and Outlook section on page 20. KKeeyy SSuucccceessss FFaaccttoorrss Strong penetration in our core Quebec market thanks to a full range of personal and commercial services.   Well-established and enduring client relationships grounded in an ability to provide both advice and a full range of solutions tailored to specific client needs.     The largest sales force in Quebec, consisting of both generalists and specialists, positioning us to offer the best advice to clients. Unmatched closeness to Quebec entrepreneurs, with leading expertise in business lending and risk management solutions. Recognized expertise across Canada in specialized industries. Ability to meet all of the needs facing businesses and entrepreneurs in collaboration with other Bank segments. National Bank of Canada 25 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | Personal and Commercial OObbjjeeccttiivveess aanndd SSttrraatteeggiieess The Personal and Commercial segment is targeting growth by becoming a more simple, efficient bank focused on constantly improving the client experience. Strategic Priorities 2019 Achievements and Highlights Maintain volume growth and accelerate net client acquisition Improve the client experience Accelerate the digital transformation Improve efficiency  Raised our presence through greater geographic coverage, a larger sales force, and an enhanced advisory offering, including a partnership with M3 Mortgage Group whereby mortgage brokers can offer Bank products to their clients.  Personalized our advisory services to target strategic clients such as newcomers, millennials, professionals, people aged 50 to 64 and SMEs.  Assisted Canadian SMEs with their export activities through a partnership with Export Development Canada (EDC).  Maintained a high credit quality, with credit loss provisions on impaired loans at 22 basis points for Personal Banking and at 10 basis points for Commercial Banking.  Enhanced the capabilities of the transactional platform and mobile app to deliver a simpler, safer, and more intuitive digital experience.  Placed emphasis on a team approach, one that combines generalists and specialists, to give customers the  best possible advice and solutions. Transformed 35 branches to assist clients in their switch to self-service, by removing physical barriers, and by being proactive with the advisory offering.  Strengthened business relations with companies and improved the advisory offering to entrepreneurs through strategic partnerships, such as the partnership with Operio whereby SMEs can benefit from integrated accounting and advisory services.  Enhanced online origination processes (account opening and mortgage preapproval). Launched NATgo, an entirely digital investment experience based on client goals.   Won three major Boomerang Awards, which recognize outstanding digital branding performance, for the experience provided on our transactional sites, mobile apps and website.  Simplified our product offering, particularly for savings accounts.  Unified client processes, both for retail clients (account openings, payments, residential financing and investing) and for business clients (account openings, financing, and cash management). PPrriioorriittiieess aanndd OOuuttllooookk ffoorr 22002200 MMaaiinnttaaiinn vvoolluummee ggrroowwtthh aanndd aacccceelleerraattee nneett cclliieenntt aaccqquuiissiittiioonn  Grow our client base, particularly among newcomers, millennials, professionals, peopled aged 50 to 64 and SMEs, with our online origination capabilities, while enhancing the Bank’s presence with clients who have strong growth potential. Continue to tailor our offering to market particularities, competition, geographic location and micromarkets.  OOppttiimmiizzee tthhee cclliieenntt eexxppeerriieennccee      Provide clients with a simple, unified experience characterized by an integrated approach across all products and distribution channels. Expand self-service options on our digital channels. Continue to deploy an innovative experience within 100-some branches in the network. Enhance the user experience by providing a consolidated view of all investments and a fully automated savings service. Help business clients to grow by giving them access to the Bank’s network of entrepreneurs. FFooccuuss oonn eeffffiicciieennccyy  Continue simplification and automation of certain targeted processes (transactional solutions, payments, and commercial financing). 26 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Business Segment Analysis | Personal and Commercial SSeeggmmeenntt RReessuullttss –– PPeerrssoonnaall aanndd CCoommmmeerrcciiaall Year ended October 31 (millions of Canadian dollars) Net interest income Non-interest income Total revenues Non-interest expenses Contribution Provisions for credit losses Income before income taxes Income taxes NNeett iinnccoommee Net interest margin(2) Average interest-bearing assets Average assets Average loans and acceptances Net impaired loans(3) Net impaired loans(3) as a % of average loans and acceptances Average deposits Efficiency ratio 22001199 2018(1) %% cchhaannggee 22,,338833 11,,006699 33,,445522 11,,881166 11,,663366 223377 11,,339999 337722 11,,002277 22..2233 %% 110066,,999955 111122,,779988 111122,,229900 440099 00..44 %% 6622,,448877 5522..66 %% 2,276 1,033 3,309 1,782 1,527 228 1,299 347 952 2.24 % 101,446 106,857 106,513 386 0.4 % 58,383 53.9 % 55 33 44 22 77 44 88 77 88 55 66 55 66 77 (1) (2) (3) For the year ended October 31, 2018, certain amounts have been reclassified, mainly amounts related to advisor banking service activities, which have been transferred from the Wealth Management segment to the Personal and Commercial segment. Net interest margin is calculated by dividing net interest income by average interest-bearing assets. Net impaired loans are presented net of allowances for credit losses on Stage 3 loan amounts drawn. AAvveerraaggee LLooaannss aanndd AAcccceeppttaanncceess aanndd DDeeppoossiittss Year ended October 31 (millions of Canadian dollars) 106,513 111122,,229900 58,383 6622,,448877 TToottaall RReevveennuueess bbyy GGeeooggrraapphhiicc DDiissttrriibbuuttiioonn Year ended October 31, 2019 21% 79% Loans and acceptances Deposits Loans and acceptances Deposits 2018 22001199 Personal Banking Commercial Banking Province of Quebec (2018: 79%) Other provinces (2018: 21%) National Bank of Canada 27 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | Personal and Commercial FFiinnaanncciiaall RReessuullttss In the Personal and Commercial segment, net income totalled $1,027 million in fiscal 2019, up 8% from $952 million in fiscal 2018. The segment’s total revenues rose $143 million or 4% year over year, primarily owing to growth in net interest income, which was up $107 million, as well as to a $36 million increase in non-interest income. The growth in net interest income was driven mostly by higher personal and commercial loan and deposit volumes but was tempered by a narrowing of the net interest margin, which was 2.23% in fiscal 2019 versus 2.24% in fiscal 2018, a decrease resulting mainly from loan margins. The segment’s non-interest expenses stood at $1,816 million in fiscal 2019, a 2% year-over-year increase attributable mainly to increases in operations support charges and in amortization expense arising from the segment's activities as well as in compensation and employee benefits. Given these results, the segment’s fiscal 2019 contribution was up 7% year over year. And, at 52.6% for fiscal 2019, the segment’s efficiency ratio improved by 1.3 percentage points from 53.9% in 2018. For fiscal 2019, the segment recorded $237 million in provisions for credit losses, $9 million more than the $228 million recorded in fiscal 2018. This increase came mainly from higher credit loss provisions on credit card receivables. PPeerrssoonnaall BBaannkkiinngg TToottaall RReevveennuueess bbyy CCaatteeggoorryy Year ended October 31, 2019 37% 46% 4% 13% Retail (2018: 46%) Payment Solutions (2018: 13%) Insurance (2018: 4%) Commercial Banking (2018: 37%) For fiscal 2019, Personal Banking’s total revenues amounted to $2,164 million, up 4% from $2,085 million in fiscal 2018. This growth came mainly from a 4% increase in loan volumes, mainly mortgage loans, and a 6% increase in deposit volumes. Non-interest income was up $21 million, essentially due to card revenues and to insurance revenues, reflecting revisions made to actuarial reserves. Personal Banking’s non-interest expenses rose by $19 million in 2019, resulting mainly from higher technology investment expenses as well as higher operations support charges related to the segment's activities. OOppeerraattiinngg RReessuullttss Year ended October 31 (millions of Canadian dollars) 3,309 33,,445522 CCoommmmeerrcciiaall BBaannkkiinngg For fiscal 2019, Commercial Banking’s total revenues amounted to $1,288 million, rising 5% from $1,224 million in fiscal 2018. Its net interest income was up, essentially due to growth in loan volumes and deposit volumes, both of which rose 8%, tempered by a narrowing of the net interest margin on loan and deposit volumes. Non-interest income grew $15 million year over year owing to increases in revenues from bankers’ acceptances and in revenues from derivative financial instruments. Commercial Banking’s non-interest expenses rose $15 million in fiscal 2019, mainly due to higher compensation and employee benefits as well as to higher operations support charges related to the segment's activities. 1,782 11,,881166 952 11,,002277 Total revenues Non- interest expenses Net income Total revenues Non- interest expenses Net income 2018 22001199 Personal Banking Commercial Banking 28 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis BBuussiinneessss SSeeggmmeenntt AAnnaallyyssiiss || WWeeaalltthh MMaannaaggeemmeenntt As a leader in Quebec and firmly established across Canada, the Wealth Management segment serves all market segments by emphasizing advisory services and close client relationships. It delivers a full range of wealth management products and solutions through a multi-channel distribution network and a differentiated business model. The Wealth Management segment also proposes investment solutions to independent advisors as well as solutions to institutional clients. BBuussiinneessss UUnniittss FFuullll--SSeerrvviiccee BBrrookkeerraaggee Drawing on the largest network of investment advisors in Quebec, National Bank Financial – Wealth Management (NBFWM) provides wealth management advisory services through close to 1,000 advisors at over 100 service points across Canada. Its advisors serve over 400,000 retail clients, proposing portfolio management services, financial and succession planning services, and insurance services while working in close collaboration with other segments of the Bank. PPrriivvaattee BBaannkkiinngg Private Banking 1859 (PB1859) offers highly personalized wealth management services and advice across Canada, helping affluent clients to benefit from comprehensive management of their personal and family fortunes. As a true market leader in Quebec, PB1859 continues to expand its operations across Canada with its extensive range of financial solutions and strategies covering the protection, growth, and transition of wealth. DDiirreecctt BBrrookkeerraaggee National Bank Direct Brokerage (NBDB) offers a multitude of financial products and investment tools to self-directed investors across Canada through its online investment solution. NBDB helps customers who want to manage their own investments to do so through a trading platform and an optimized mobile trading platform or by speaking directly to a representative on the phone. IInnvveessttmmeenntt SSoolluuttiioonnss National Bank Investments Inc. (NBI) manufactures and offers mutual funds, investment solutions, and services to consumers and institutional investors through the Bank’s extended network. With its open architecture model, NBI is Canada’s largest investment fund manager to entrust the management of its investments exclusively to external portfolio managers. AAddmmiinniissttrraattiivvee aanndd TTrraaddee EExxeeccuuttiioonn SSeerrvviicceess National Bank Independent Network (NBIN) is a Canadian leader in providing administrative services such as trade execution, custodial services, and brokerage solutions to many independent financial services firms across Canada, in particular to introducing brokers, portfolio managers, and investment fund managers. TTrraannssaaccttiioonn PPrroodduuccttss The Wealth Management segment provides independent advisors across Canada with an extensive range of investment products, including guaranteed investment certificates (GICs), mutual funds, notes, structured products, and monetization, helping to support their own business needs and client relationships. TTrruusstt aanndd EEssttaattee SSeerrvviicceess Through National Bank Trust Inc. (NBT), the Wealth Management segment provides retail and institutional clients with turnkey services and solutions. Its team of experts offers a full range of high value-added services designed to consolidate, protect, and transfer its customers’ wealth and give them peace of mind. NBT also offers integrated trustee and depository services as well as securities custody services. EEccoonnoommiicc aanndd MMaarrkkeett RReevviieeww Policymakers acted pre-emptively as a fear of the global economy sliding into a recession increased as a result of the trade conflict between the United States and China. The U.S. Federal Reserve applied a rate-cut, realizing a 75-basis point decline in its policy rate. Given the resilience of the Canadian economy and inflation, the Bank of Canada did not deem stimulus as necessary as the Canadian economy is benefitting from lower long-term rates and improving global financial conditions. Those welcomed developments, combined with resilience in the labour market and housing market, suggest steady growth in the coming quarters. The economic environment in 2019 and the outlook for 2020 are discussed in more detail in the Economic Review and Outlook section on page 20. National Bank of Canada 29 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | Wealth Management KKeeyy SSuucccceessss FFaaccttoorrss         Leadership position in Quebec in terms of market share and brand recognition. Largest manager of managers in Canada (open architecture); clients benefit from objective advice. Leadership position in Canada in securities custody and brokerage services for independent wealth management firms. Firmly rooted across Canada in full-service brokerage and private management services. Ability to forge solid, lasting client relationships built on personalized advice and solutions provided at every life stage. High level of client satisfaction with direct brokerage services. Proven track record and excellent reputation as a business partner among non-bank financial institutions. Ability to work closely with the Personal and Commercial segment and to leverage its distribution platform. OObbjjeeccttiivveess aanndd SSttrraatteeggiieess The Wealth Management segment will capitalize on the strength of the Bank's brand, distribution capacity, and differentiated business model to grow market shares in the mass and mass affluent markets. The segment seeks to increase market penetration across Canada through organic growth as well as targeted actions and partnerships. Strategic Priorities 2019 Achievements and Highlights Transform the partnership with clients Launched National Bank exchange-traded funds (ETFs). Launched NATgo, an entirely digital investment experience based on client goals.    Deployed a strategy that centres on goals and life stages.  Deployed a new online brokerage platform. Invest in high-growth markets  Gradually deploying a new MFDA (Mutual Fund Dealers Association of Canada) platform for B2B clients.  Developed a new cross-selling strategy in partnership with other Bank segments.  Developed a strategy for women investors. Continue transforming Wealth Management’s culture  Promoted a joint mission and an integrated client approach within Wealth Management. Implemented concrete measures to promote innovation and accelerate transformation.  PPrriioorriittiieess aanndd OOuuttllooookk ffoorr 22002200 TTrraannssffoorrmm tthhee wwaayy wwee sseerrvvee cclliieennttss    Deploy a customer relationship management (CRM) system for employees of NBFWM. Enhance the online brokerage and account opening platform. Increase the usability of the new MFDA platform, which is designed to replace certain existing asset management platforms. CCoonncceennttrraattee oonn ffaasstt--ggrroowwiinngg mmaarrkkeettss   Launch new types of investment products. Develop markets outside Quebec, including the Ontario strategy to grow PB1859’s market presence, and its acquisition of high net worth customers and increase synergies with the Personal and Commercial segment. Implement the multi-family office strategy.  CCoonnttiinnuuee ttrraannssffoorrmmiinngg WWeeaalltthh MMaannaaggeemmeenntt’’ss ccuullttuurree   Invest in client satisfaction measures in various Wealth Management subsidiaries. Fine-tune the leadership skills of managers using best management practices. 30 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Business Segment Analysis | Wealth Management SSeeggmmeenntt RReessuullttss –– WWeeaalltthh MMaannaaggeemmeenntt Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) Net interest income on a taxable equivalent basis Fee-based revenues Transaction and other revenues Total revenues on a taxable equivalent basis Non-interest expenses Contribution on a taxable equivalent basis Provisions for credit losses Income before income taxes on a taxable equivalent basis Income taxes on a taxable equivalent basis NNeett iinnccoommee Average assets Average loans and acceptances Net impaired loans(3) Average deposits Efficiency ratio on a taxable equivalent basis(1) 22001199 2018(2) %% cchhaannggee 447700 11,,001133 226600 11,,774433 11,,006677 667766 −− 667766 117777 449999 66,,221199 44,,885555 33 3322,,332211 446 983 260 1,689 1,058 631 1 630 166 464 6,167 4,720 3 31,261 6611..22 %% 62.6 % 55 33 −− 33 11 77 77 77 88 11 33 −− 33 (1) (2) (3) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. For the year ended October 31, 2018, certain amounts have been reclassified, mainly amounts related to advisor banking service activities, which have been transferred from the Wealth Management segment to the Personal and Commercial segment. Net impaired loans are presented net of allowances for credit losses on Stage 3 loan amounts drawn. AAsssseettss UUnnddeerr AAddmmiinniissttrraattiioonn aanndd UUnnddeerr MMaannaaggeemmeenntt –– WWeeaalltthh MMaannaaggeemmeenntt As at October 31 (millions of Canadian dollars) AAsssseettss uunnddeerr aaddmmiinniissttrraattiioonn AAsssseettss uunnddeerr mmaannaaggeemmeenntt Individual Mutual funds AAsssseettss uunnddeerr aaddmmiinniissttrraattiioonn aanndd uunnddeerr mmaannaaggeemmeenntt 22001199 448844,,663366 4433,,994411 3366,,881199 8800,,776600 556655,,339966 2018 %% cchhaannggee 416,199 37,007 31,874 68,881 485,080 1166 1199 1166 1177 1177 AAsssseettss UUnnddeerr AAddmmiinniissttrraattiioonn aanndd UUnnddeerr MMaannaaggeemmeenntt Year ended October 31 (millions of Canadian dollars) TToottaall RReevveennuueess bbyy GGeeooggrraapphhiicc DDiissttrriibbuuttiioonn Year ended October 31, 2019 (on a taxable equivalent basis)(1) 9 9 1 , 6 1 4 1 8 8 , 8 6 66 33 66 ,, 44 88 44 00 66 77 ,, 00 88 36% 64% 2018 22001199 Assets under administration Assets under management Province of Quebec (2018: 62%) Other provinces (2018: 38%) (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. National Bank of Canada 31 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | Wealth Management FFiinnaanncciiaall RReessuullttss In the Wealth Management segment, net income totalled $499 million in fiscal 2019, up $35 million or 8% from $464 million in fiscal 2018. The segment’s total revenues on a taxable equivalent basis(1) amounted to $1,743 million in fiscal 2019, up $54 million from $1,689 million in fiscal 2018. This increase stems mainly from a 5% increase in net interest income on a taxable equivalent basis(1) owing to growth in the segment’s loan and deposit volumes. The fiscal 2019 fee-based revenues were up 3% year over year given growth in assets under administration and under management generated by net inflows into various solutions and due to stronger stock market performance in fiscal 2019. As for the transaction-based and other revenues category, it remained stable when compared to fiscal 2018. The segment’s non-interest expenses stood at $1,067 million in fiscal 2019, a $9 million year-over- year increase attributable mainly to higher compensation and employee benefits as well as to higher operations support charges related to the segment's initiatives. The 2019 efficiency ratio on a taxable equivalent basis(1) was 61.2% in fiscal 2019, an improvement of 1.4 percentage points from 62.6% in 2018. The segment’s provisions for credit losses were negligible in fiscal years 2019 and 2018. AAsssseettss UUnnddeerr AAddmmiinniissttrraattiioonn aanndd UUnnddeerr MMaannaaggeemmeenntt As at October 31, 2019, assets under administration and under management totalled $565.4 billion, rising $80.3 billion or 17% from October 31, 2018 due to net inflows into various solutions and to stronger stock market performance in fiscal 2019. Assets under administration totalled $484.6 billion as at October 31, 2019, up $68.4 billion compared to October 31, 2018. This increase came from net inflows into various solutions and to stronger stock market performance in fiscal 2019. In the individuals category, assets under management amounted to $43.9 billion as at October 31, 2019 compared to $37.0 billion as at October 31, 2018. The mutual funds category totalled $36.8 billion as at October 31, 2019, rising 16% from October 31, 2018. TToottaall RReevveennuueess bbyy CCaatteeggoorryy Year ended October 31, 2019 (on a taxable equivalent basis)(1) 15% 27% 58% Net interest income (2018: 27%) Fee-based services (2018: 58%) Transaction-based and other revenues (2018: 15%) OOppeerraattiinngg RReessuullttss Year ended October 31 (on a taxable equivalent basis)(1) (millions of Canadian dollars) 1,689 11,,774433 1,058 11,,006677 464 449999 2018 22001199 Total revenues Non-interest expenses Net income (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. 32 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis BBuussiinneessss SSeeggmmeenntt AAnnaallyyssiiss || FFiinnaanncciiaall MMaarrkkeettss The Financial Markets segment offers a complete suite of products and services to corporations, institutional clients, and public-sector entities. Whether providing comprehensive advisory services and research or capital markets products and services, its focus is on client relationships and their growth. Over 800 professionals serve client needs through offices in North America, Europe, the U.K. and Asia. BBuussiinneessss UUnniittss The Financial Markets segment operates two main business lines: Global Markets and Corporate and Investment Banking. GGlloobbaall MMaarrkkeettss Financial Markets is a Canadian leader in risk management solutions and structured products and is the largest market-maker in exchange-traded funds (ETFs) in Canada by volume. The segment offers solutions covering fixed income securities, currencies, equities and commodities in order to mitigate the financial and business risks of clients. It also provides new product development expertise to asset managers and fund companies and supports their success by providing liquidity, research, and counterparty services. Financial Markets also provides tailored investment products across all asset classes to institutional and retail distribution channels. CCoorrppoorraattee aanndd IInnvveessttmmeenntt BBaannkkiinngg Financial Markets provides services in corporate banking, advisory and capital markets. It offers loan origination and syndication to corporations for project financing, merger and acquisition transactions, and corporate financing solutions. The segment is also an investment banking leader in Quebec and across Canada. Its comprehensive services include strategic advisory for financing and mergers and acquisitions as well as for debt and equity underwriting. It is the Canadian leader in government and corporate high-yield debt underwriting. Dominant in Quebec, it leads deals for provincial and municipal governments across Canada while growing its national position in infrastructure and project financing. Financial Markets is active in securitization financing, mainly Government-of- Canada-insured mortgages and mortgage-backed securities. EEccoonnoommiicc aanndd MMaarrkkeett RReevviieeww In 2019, global uncertainties dominated financial headlines. Trade negotiations between the United States and China oscillated between detente and escalation before taking a turn for the better at the end of October with the announcement of significant progress for a truce between the two countries. Given the growing uncertainty and the slowing global economy, a majority of central banks have opted to ease their monetary policy in the third quarter, a record high since the global recession of 2008-2009. The Bank of Canada did not deem it necessary to add stimulus as labour market strength contributed to a housing market rebound. Steady growth is expected in the coming quarters, as financial conditions have improved and some fiscal stimulus is expected next year. The economic environment in 2019 and the outlook for 2020 are discussed in more detail in the Economic Review and Outlook section on page 20. KKeeyy SSuucccceessss FFaaccttoorrss      Pan-Canadian franchise with established leadership in government debt underwriting, ETF market-making, and securities lending and recognized capabilities in risk management solutions, structured products and equity derivatives. Integrated approach, teamwork, and alignment among all groups. Focused on client relationships and diversified client activity and revenue mix. Sound risk management. Flexible approach to capital allocation and proven ability to adapt to evolving capital market conditions and deliver consistent financial performance. National Bank of Canada 33 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | Financial Markets OObbjjeeccttiivveess aanndd SSttrraatteeggiieess Strategic Priorities 2019 Achievements and Highlights Ranked first in government debt underwriting:       Lead and joint lead on Canada Mortgage Bond issuances aggregating $30.25 billion. Lead on multiple deals for the Province of Quebec aggregating $9.5 billion. Inaugural joint lead for the Government of Canada on a US$3.0 billion 3-year offering. Inaugural lead for the Province of Newfoundland and Labrador on a $300 million 10-year offering. Lead on the First Nations Finance Authority’s $163 million 9-year offering. Joint lead for South Coast British Columbia Transportation Authority’s (TransLink) $200 million 31-year Green Bond offering. Joint lead for the City of Toronto’s $200 million 20-year Green Bond offering.  Maintain leadership in Canadian debt underwriting Lead in corporate debt underwriting:    Joint bookrunner on a $300 million senior unsecured note offering for Parkland Fuel Corporation. Joint bookrunner on a $350 million 2.25-year senior unsecured debenture offering for SmartCentres REIT. Joint bookrunner on an inaugural $125 million senior unsecured note offering for Kruger Packaging Holdings L.P. Joint bookrunner on a $200 million 5-year senior unsecured note offering for Cominar REIT.   Sole lead placement agent on a $325 million private placement transaction for Capital Power Corporation.  Joint bookrunner on two U.S.-dollar high-yield transactions for Fairstone Financial Inc., raising US$425 million for the company. Joint bookrunner on a $450 million dual tranche offering for EPCOR Utilities. Joint bookrunner on a $350 million senior unsecured debenture offering for CI Financial Corporation. Joint bookrunner on a $700 million dual-tranche offering for Enbridge Gas Inc. Joint bookrunner on a US$750 million inaugural U.S.-dollar bail-in and first sustainable note offering for National Bank of Canada.     Maintain leadership in investment products Strengthened our relationships with international networks by issuing more than $1 billion of notes outside of Canada, which contributed to the diversification of the Bank’s deposit base. Ranked first in ETF market-making in Canada:  Increased our market share relative to last year, capturing 42% of total buy and sell volume, despite market conditions.  Selected as designated broker 64 times, which represents a 48% increase year over year. Pioneer in overnight offerings, which continue to be a successful means for asset managers to raise capital: Led another $500 million of overnight offerings as a combination of split-share and single-trust unit funds.  Launched the first ever Canadian at-the-market (ATM) issuance programs for two listed investment funds.   Awarded Deal of the Year in rate structures by mtn-i, a global news, data and analytics platform covering the private debt market.  Awarded Most Impressive Financial Institutional Structured MTN Issuer by GlobalCapital, a global service provider of capital markets information whose methodology relies on the views of market participants. 34 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Business Segment Analysis | Financial Markets Strategic Priorities 2019 Achievements and Highlights Awarded the Greenwich Quality Leader in Canadian FX Service by Greenwich Associates, a leading global provider of data, analytics and insights to the financial services industry. Overall, National Bank Financial leads in the ability to understand client needs and deliver intensive sales coverage. Involved in significant mandates including:  Acted as financial advisor to the Special Committee of Dream Global REIT in relation to its acquisition by Blackstone Group Inc.  Advisor to Pipestone Oil Corp. in their $650 million reverse takeover of Blackbird Energy Inc. to form Pipestone Energy Corp. (TSX-V: PIPE) as well as underwriting and currently acting as administrative agent, lead arranger and sole bookrunner with respect to Pipestone’s $198.5 million senior secured credit facilities. Financial advisor to Atlantic Gold Corp. on its sale to Australian-based St Barbara Limited, for a total consideration of $802 million. Also acted as sole lead arranger and bookrunner for Atlantic Gold Corporation’s $150 million revolving credit facility and underwrote the change of control provision for St Barbara in conjunction with the transaction.   Exclusive financial advisor to Osisko Gold Royalties Ltd. on: (i) its acquisition of Barkervillle Gold Mines Ltd. in a transaction valued at $338 million and (ii) its $175 million asset swap transaction with Orion Resource Partners. Also acted as sole lead arranger and bookrunner for Osisko’s $400 million revolving credit facility.  Sole financial advisor to Bombardier Inc. on a US$300 million disposal of the Q Series program and the underlying aftermarket business to Longview Aviation Capital Corp.  Sole financial advisor to Bombardier Inc. on a US$800 million disposal of its Business Aircraft Training activities, including a US$155 million monetization of royalties that were payable by CAE Inc.  Sole financial advisor to Transat A.T. Inc. in its review of strategic alternatives and $720 million disposal to Air Canada.  Joint bookrunner on Lightspeed POS Inc.’s $276 million initial public offering and $217 million follow-on offering.  Co-bookrunner on $144 million equity offering for Park Lawn Corporation.  Co-lead on Northland Power Inc.’s $347 million subscription receipt equity financing.  Co-financial advisor for Crescent Point Energy Corp. on the sale of certain oil & gas assets in southeast Saskatchewan and Manitoba for $219 million.  Co-bookrunner and co-lead on an equity financing and administrative agent for Allied Energy Corp. as well co- lead arranger and joint bookrunner on a $75 million senior secured credit facility to finance the acquisition of certain assets from Crescent Point Energy Corp. Expand our client coverage to increase our presence in advisory services Leverage leadership in equity distribution to increase lead and co- lead positions Priorities and Outlook for 2020 Continue to expand our activities in areas of expertise with a constant focus on Canadian clients. Continue to be a strategic partner for our clients. Increase market share among corporations for all fee-based products. Continue to automate processes, use artificial intelligence, and increase data-sharing across the Financial Markets segment.      Maintain tight cost control and an industry-leading efficiency ratio. National Bank of Canada 35 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | Financial Markets Segment Results – Financial Markets Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) Global markets Equities Fixed-income Commodities and foreign exchange Corporate and investment banking Gains on investments and other Total revenues on a taxable equivalent basis Non-interest expenses Contribution on a taxable equivalent basis Provisions for credit losses Income before income taxes on a taxable equivalent basis Income taxes on a taxable equivalent basis NNeett iinnccoommee Average assets Average loans and acceptances Net impaired loans(3) Average deposits Efficiency ratio on a taxable equivalent basis(1) 22001199 2018(2) %% cchhaannggee 662244 228899 112266 11,,003399 771199 ((88)) 11,,775500 774433 11,,000077 3300 997777 226600 771177 111122,,449933 1166,,557755 2233 3300,,331111 576 267 130 973 750 20 1,743 697 1,046 4 1,042 278 764 100,721 15,116 − 23,510 4422..55 %% 40.0 % 88 88 ((33)) 77 ((44)) −− 77 ((44)) ((66)) ((66)) ((66)) 1122 1100 2299 (1) (2) (3) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. For the year ended October 31, 2018, certain amounts have been reclassified. Net impaired loans are presented net of allowances for credit losses on Stage 3 loan amounts drawn. TToottaall RReevveennuueess bbyy CCaatteeggoorryy Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) 973 11,,003399 750 771199 20 2018 22001199 ((88)) Global markets - Equities Global markets - Fixed-income Global markets - Commodities and foreign exchange Corporate and investment banking Gains on investments and other TToottaall RReevveennuueess bbyy GGeeooggrraapphhiicc DDiissttrriibbuuttiioonn Year ended October 31, 2019 (taxable equivalent basis)(1) 41 % 22 % 37 % Province of Quebec (2018: 31%) Other provinces (2018: 42%) Outside of Canada (2018: 27%) (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. 36 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Business Segment Analysis | Financial Markets Financial Results In the Financial Markets segment, net income totalled $717 million in fiscal 2019, down 6% year over year. The segment’s fiscal 2019 total revenues on a taxable equivalent basis(1) amounted to $1,750 million, up $7 million from $1,743 million in fiscal 2018. Revenues from the Global Markets category posted year-over-year growth of 7%, with revenues from equity securities and from fixed-income securities each rising 8%, tempered by a 3% decrease in revenues from commodities and foreign exchange activities. As for corporate and investment banking revenues, they were down 4% year over year, mainly due to a slowdown in capital markets activity as well as to a decrease in merger and acquisition activities in fiscal 2019. This decrease was partly offset by higher banking services revenues in fiscal 2019. Lastly, higher gains on investments and other revenues were recorded in fiscal 2018. For the year ended October 31, 2019, the segment’s non-interest expenses rose 7% year over year, mainly due to increases in compensation and employee benefits, in expenses related to technological investments, in business development expenses, and in operations support charges. The segment’s fiscal 2019 efficiency ratio on a taxable equivalent basis(1) was 42.5% in fiscal 2019 versus 40.0% in 2018. Financial Markets recorded $30 million in provisions for credit losses during fiscal 2019 compared to $4 million in fiscal 2018, an increase that stems mainly from credit loss provisions on impaired loans. (1) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. TToottaall RReevveennuueess bbyy CCaatteeggoorryy Year ended October 31, 2019 (taxable equivalent basis)(1) 41 % 59 % Global markets (2018: 56%) Corporate and investment banking (2018: 43%) Gains on investments and other (2018: 1%) OOppeerraattiinngg RReessuullttss Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) 1,743 11,,775500 764 697 774433 771177 2018 22001199 Total revenues Non-interest expenses Net income National Bank of Canada 37 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | U.S. Specialty Finance and International The Bank complements its Canadian growth with a targeted, disciplined international strategy that aims for superior returns. The Bank is currently focused on specialty finance in the U.S. through Credigy and on personal and commercial banking in Cambodia through ABA Bank. The Bank also holds minority positions in financial groups operating in French-speaking Africa and Africa-Asia. The Bank has a moratorium in effect on any new significant investments in emerging markets. During fiscal 2019, the U.S. Specialty Finance and International (USSF&I) segment generated 10% of the Bank’s consolidated total revenue and 12% of its net income. UU..SS.. SSppeecciiaallttyy FFiinnaannccee –– CCrreeddiiggyy Founded in 2001, Credigy is a specialty finance company with flexibility across its capital structure to acquire or finance a diverse range of assets. Based in Atlanta, Georgia, Credigy is primarily active in performing assets covering a broad range of asset classes, mostly consumer receivables in the U.S. market. The Bank holds an 80% ownership interest in Credigy. EEccoonnoommiicc aanndd MMaarrkkeett RReevviieeww Despite global uncertainty negatively affecting exports and business investment, the U.S. economy posted steady growth in 2019 thanks to resilience in consumption. Consumer confidence in the U.S. is flying high given a still-hot labour market that is fuelling household income. Lower interest rates and low leverage suggest upside potential for household credit in the U.S. The economic environment in 2019 and the outlook for 2020 are discussed in more detail in the Economic Review and Outlook section on page 20. KKeeyy SSuucccceessss FFaaccttoorrss Ability to seize opportunities in rapidly changing market conditions through a disciplined yet adaptable investment strategy. Diversification across several classes of performing assets.    Market credibility achieved through over 300 transactions life-to-date, representing over US$13 billion in total investments supported by the Bank.   Rigorous pricing approach strengthened by continuous refinement of modelling and analytics capabilities and deep expertise in specific asset classes. Proven expertise in the successful management and servicing of consumer assets. OObbjjeeccttiivveess aanndd SSttrraatteeggiieess Credigy aims to provide customized solutions for the consumer receivables market in pursuit of the best risk-adjusted returns and a return on assets (ROA) of at least 2.5%. Strategic Priorities 2019 Achievements and Highlights Sustain deal flow by being a partner of choice for bank and non-bank institutions facing complex challenges and strategic changes  Maintained average assets of approximately $7 billion. Maintain a diversified mix of performing assets  Performing assets accounted for 96% of assets.  Continued diversification in asset classes focusing on both secured and unsecured consumer assets. Achieve best risk-adjusted returns  Credit model monitoring and refinement helped Credigy focus on the best risk/reward investments.  Maintained a disciplined approach to ensure a risk-return balance and an ROA of at least 2.5%. PPrriioorriittiieess aanndd OOuuttllooookk ffoorr 22002200 Deliver growth by leveraging relationships with current and prospective partners. Leverage committed funding agreements to support asset growth. Capitalize on changing market conditions that have potential for large investment opportunities.     Maintain focus on asset diversification and a balanced risk/return investment profile. 38 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Business Segment Analysis | U.S. Specialty Finance and International IInntteerrnnaattiioonnaall –– AABBAA BBaannkk Established in 1996, ABA Bank provides financial services to individuals and businesses in Cambodia. It is the third largest and fastest-growing commercial bank in the country with an ROE of approximately 30%. It offers a full spectrum of financial services to micro, small and medium enterprises (MSMEs) as well as to individuals through 70 branches, 541 ATM and cash deposit machines, and advanced online banking and mobile banking platforms. For the fifth and sixth straight years respectively, ABA Bank has been selected as the Best Bank in Cambodia by Global Finance and Euromoney magazines. In fiscal 2019, the Bank became 100% shareholder of ABA Bank after acquiring the remaining 10% ownership interest. EEccoonnoommiicc aanndd MMaarrkkeett RReevviieeww The Cambodian economy is rapidly growing, with GDP growth nearing 7% in the past decade. It is a well-diversified economy, largely based on the U.S. dollar. The strong GDP growth is supported by its membership in the Association of Southeast Asian Nations (ASEAN) trade association and an expansionary fiscal policy. The Cambodian market is highly underbanked, with approximately 8% of the population having a credit account and 40% having a deposit account. Mobile technology and social media are widely adopted and used in the country, and over 70% of the population of 16.5 million is under 35 years of age. KKeeyy SSuucccceessss FFaaccttoorrss        Loan strategy targeting MSMEs with simple products. Strong risk management driving high credit quality. Ability to fund loan growth through the deposit strategy. Deposit strategy leveraging state-of-the art technology, leading to an expanding transactional banking ecosystem. Experienced leadership team, and educated workforce supported by robust training programs. Governance structure based on high Canadian standards while providing local management with the autonomy to pursue strategic priorities and business objectives. Leveraging National Bank’s reputation as a world-class financial institution. OObbjjeeccttiivveess aanndd SSttrraatteeggiieess ABA Bank wishes to pursue omnichannel banking strategy focused on being the lending partner of choice to MSMEs while increasing market penetration in deposits and transactional services for retail and business clients. Strategic Priorities 2019 Achievements and Highlights Grow market share in MSME lending while contributing to the economy and maintaining credit quality  Achieved 52% growth in loan volumes, with 100% of loans collateralized.  At 0.7% in 2019, non-performing loans below market average.   Increased market penetration with the opening of 7 new branches for a total of 70 branches country-wide. Improved from fourth to third largest bank in Cambodia by assets. Sustain growth in deposits and transactional services  Deposits increased 82% compared to 2018.  Continued to make enhancements to self-banking capabilities, including the first full-scale mobile banking application in Cambodia.  ABA’s online payment gateway (PayWay) was optimized, adding new functions that facilitate merchant operations and that transform the Cambodian eCommerce landscape.  Self-banking transactions made up 94% of all transactions, compared to 90% in 2018. Retain international recognition of ABA Bank’s progress  Global Finance magazine named ABA Bank as the “Best Bank in Cambodia” for the fifth consecutive year.  Euromoney magazine named ABA Bank as the “Best Bank in Cambodia” for the sixth consecutive year. PPrriioorriittiieess aanndd OOuuttllooookk ffoorr 22002200 LLeevveerraaggee ppoossiittiivvee eeccoonnoommiicc oouuttllooookk bbyy ssttaayyiinngg ffooccuusseedd oonn ccoorree ttaarrggeett mmaarrkkeettss    Continue to offer simple and efficient banking solutions aligned with domestic needs in the underbanked Cambodian market. Focus on MSME clients to achieve loan growth. Increase deposit base by offering convenience to retail customers through an advanced digital and self-banking infrastructure and an expanding branch network. EEnnssuurree ssoolliidd ffoouunnddaattiioonn ffoorr ssuussttaaiinnaabbllee lloonngg--tteerrmm ggrroowwtthh  Open 10 to 12 additional branches in 2020 to extend its reach in Cambodia and gain direct access to a larger pool of MSME customers and retail deposits.  Focus on sound business processes as well as on strong governance and risk management. National Bank of Canada 39 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Business Segment Analysis | U.S. Specialty Finance and International SSeeggmmeenntt RReessuullttss –– UUSSSSFF&&II Year ended October 31 (millions of Canadian dollars) TToottaall rreevveennuueess Credigy ABA Bank International NNoonn--iinntteerreesstt eexxppeennsseess Credigy ABA Bank International Contribution PPrroovviissiioonnss ffoorr ccrreeddiitt lloosssseess Credigy ABA Bank Income before income taxes Income taxes NNeett iinnccoommee Non-controlling interests Net income attributable to the Bank's shareholders Average assets Average loans and receivables Net impaired loans – Stage 3(1) Purchased or originated credit-impaired (POCI) loans Average deposits Efficiency ratio 22001199 2018 %% cchhaannggee 440022 330033 1100 771155 115522 113311 22 228855 443300 6688 1122 8800 335500 7711 227799 4400 223399 1100,,998855 88,,990077 1155 11,,116666 33,,447744 446 192 1 639 156 93 2 251 388 81 13 94 294 72 222 38 184 9,270 7,853 15 1,576 1,907 3399..99 %% 39.3 % ((1100)) 5588 1122 ((33)) 4411 1144 1111 ((1166)) ((88)) ((1155)) 1199 ((11)) 2266 55 3300 1199 1133 −− ((2266)) 8822 (1) Net impaired loans – Stage 3 exclude POCI loans and are presented net of allowances for credit losses on Stage 3 loan amounts drawn. AAvveerraaggee LLooaannss –– CCrreeddiiggyy Year ended October 31 (millions of Canadian dollars) 6,058 66,,117799 AAvveerraaggee LLooaannss aanndd DDeeppoossiittss –– AABBAA BBaannkk Year ended October 31 (millions of Canadian dollars) 33,,447744 22,,772288 1,907 1,790 2018 22001199 2018 22001199 Loans POCI loans Loans Deposits 40 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Business Segment Analysis | U.S. Specialty Finance and International FFiinnaanncciiaall RReessuullttss In the USSF&I segment, the fiscal 2019 net income totalled $279 million compared to $222 million in fiscal 2018. The segment’s fiscal 2019 total revenues amounted to $715 million versus $639 million in fiscal 2018, representing year-over-year growth of 12% that came mainly from a $111 million increase in the revenues of the ABA Bank subsidiary owing to sustained growth in loan and deposit volumes. At the Credigy subsidiary, revenues were down $44 million as a result of changes in the loan portfolio mix. The segment’s non-interest expenses stood at $285 million in fiscal 2019, a $34 million year-over- year increase essentially attributable to all of ABA Bank’s non-interest expenses and related to its growing banking network. At the Credigy subsidiary, non-interest expenses were down slightly year over year. In fiscal 2019, the segment recorded $80 million in provisions for credit losses, consisting essentially of Credigy’s credit loss provisions. CCrreeddiiggyy For fiscal 2019, Credigy's net income totalled $144 million, down $10 million from fiscal 2018. The subsidiary’s total revenues amounted to $402 million compared to $446 million in fiscal 2018, a $44 million or 10% decrease attributable mainly to lower net interest income arising from changes in the loan portfolio mix. Credigy’s fiscal 2019 non-interest expenses stood at $152 million versus $156 million in fiscal 2018, with the decrease being attributable to the variable compensation associated with the subsidiary’s revenues. Credigy recorded $68 million in provisions for credit losses for fiscal 2019 versus $81 million in fiscal 2018, a decrease that is attributable to credit loss provisions on impaired and non-impaired loans following repayments and maturities of certain loan portfolios, whereas credit loss provisions on POCI loans were up compared to fiscal 2018. AABBAA BBaannkk For fiscal 2019, ABA Bank’s net income totalled $128 million, up $59 million or 86% from fiscal 2018. The subsidiary’s total revenues amounted to $303 million compared to $192 million in fiscal 2018, a $111 million or 58% increase driven mainly by higher net interest income owing to sustained growth in loan volumes and deposit volumes, which rose 52% and 82%, respectively. The subsidiary’s fiscal 2019 non-interest expenses stood at $131 million compared to $93 million in fiscal 2018. This increase was attributable to the expansion of the subsidiary’s banking network, including compensation and employee benefits as well as occupancy expenses. For fiscal 2019, ABA Bank recorded $12 million in provisions for credit losses, stable when compared to $13 million in fiscal 2018. TToottaall RReevveennuueess bbyy CCaatteeggoorryy Year ended October 31, 2019 1% 43% 56% Credigy (2018: 70%) ABA Bank (2018: 30%) International (2018: negligible) OOppeerraattiinngg RReessuullttss Year ended October 31 (millions of Canadian dollars) 639 771155 251 222 228855 227799 Total revenues Non- interest expenses Net income Total revenues Non- interest expenses Net income 2018 22001199 Credigy ABA Bank and International National Bank of Canada 41 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis BBuussiinneessss SSeeggmmeenntt AAnnaallyyssiiss || OOtthheerr The Other heading reports on Treasury operations, liquidity management, Bank funding, asset and liability management, certain non-recurring items, and the unallocated portion of corporate units. Corporate units include Information Technology, Risk Management, Employee Experience, Operations, and Finance. These units provide advice and guidance throughout the Bank and to its business segments in addition to expertise and support in their respective fields. SSeeggmmeenntt RReessuullttss –– OOtthheerr Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) Net interest income on a taxable equivalent basis Non-interest income on a taxable equivalent basis Total revenues on a taxable equivalent basis Non-interest expenses Contribution on a taxable equivalent basis Provisions for credit losses Income before income taxes on a taxable equivalent basis Income taxes (recovery) on a taxable equivalent basis NNeett lloossss Non-controlling interests Net loss attributable to the Bank’s shareholders Specified items after income taxes(1) NNeett lloossss eexxcclluuddiinngg ssppeecciiffiieedd iitteemmss(1) Average assets 22001199 2018(2) ((119922)) 229944 110022 339900 ((228888)) −− ((228888)) ((8888)) ((220000)) 2266 ((222266)) 66 ((119944)) 4433,,666677 (189) 220 31 275 (244) − (244) (74) (170) 49 (219) − (170) 42,925 (1) (2) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. For the year ended October 31, 2018, certain amounts have been reclassified. FFiinnaanncciiaall RReessuullttss For the Other heading of segment results, there was a net loss of $200 million in fiscal 2019 compared to a net loss of $170 million in fiscal 2018. This change in net loss was essentially due to a lower contribution from treasury activities during fiscal 2019 arising in part from the impact of market volatility on the Bank’s asset/liability management portfolio during the first quarter of 2019. The specified items recorded for fiscal 2019 had a $6 million unfavourable impact on the net income recorded in the Other heading. Net loss excluding specified items stood at $194 million for fiscal 2019 compared to a $170 million net loss in fiscal 2018. Total revenues on a taxable equivalent basis were up, mainly due to the specified items recorded for fiscal 2019, which include a $79 million gain on disposal of Fiera Capital shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss arising from the fair value remeasurement of the Bank’s investment in NSIA. The fiscal 2019 non-interest expenses were also up as a result of the following specified items: $57 million in impairment losses on premises and equipment and on intangible assets, $45 million in provisions for onerous contracts, an $11 million charge related to Maple, and $10 million in severance pay. 42 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis QQuuaarrtteerrllyy FFiinnaanncciiaall IInnffoorrmmaattiioonn Several trends and factors have an impact on the Bank’s quarterly net income, revenues, non-interest expenses and provisions for credit losses. For example, the second quarter of the fiscal year has fewer days than the other quarters, which can result in reductions to total revenues and certain non-interest expense items. The following table presents a summary of results for the past eight quarters. Furthermore, a summary of results for the past 12 quarters is provided in Table 1 on pages 102 and 103. QQuuaarrtteerrllyy RReessuullttss SSuummmmaarryy(1) (millions of Canadian dollars) SSttaatteemmeenntt ooff iinnccoommee ddaattaa Net interest income Non-interest income Total revenues Provisions for credit losses Non-interest expenses Income taxes NNeett iinnccoommee QQ44 QQ33 QQ22 993366 997799 11,,991155 8899 11,,009955 112277 660044 885555 11,,009933 11,,994488 8866 11,,115544 110000 660088 994422 882288 11,,777700 8844 11,,002266 110022 555588 22001199 QQ11 886633 993366 11,,779999 8888 11,,002266 113333 555522 Q4 Q3 Q2 826 988 1,814 73 1,036 139 566 837 955 1,792 76 1,011 136 569 885 869 1,754 91 992 124 547 2018 Q1 834 972 1,806 87 1,024 145 550 (1) For additional information about the 2019 fourth quarter results, visit the Bank’s website at nbc.ca or the SEDAR website at sedar.com to consult the Bank’s Press Release for the Fourth Quarter of 2019, published on December 4, 2019. The above analysis of the past eight quarters reflects the sustained performance of all the business segments and helps readers identify the items that have favourably or unfavourably affected results. Thanks to net income growth across most of the Bank’s main business segments, the net income for each quarter of 2019 was up year over year. However, the year-over-year growth in net income for the first and second quarters of 2019 was tempered somewhat by a slowdown in the activities of the Financial Markets segment. Net interest income posted year-over-year growth in every quarter of 2019. These increases were mainly driven by growth in personal and commercial loan and deposit volumes, net interest income growth at Wealth Management (notably due to loan and deposit growth) and to growth in the net interest income of the ABA Bank subsidiary. The year-over-year increases in net interest income for the first and third quarters of 2019 were tempered somewhat by lower net interest income in the Financial Markets segment. Furthermore, the Credigy subsidiary posted less net interest income in the first, second, and third quarters of 2019 as a result of changes in the loan portfolio mix. The non-interest income results for the first, second and fourth quarters of 2019 were down year over year. Non-interest income in the first and second quarters of 2019 was down year over year given a slowdown in the activities of the Financial Markets segment. The 2019 third-quarter non-interest income included a revision to actuarial reserves and the following specified items: a $79 million gain on disposal of Fiera Capital shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss arising from the remeasurement at fair value of the Bank’s investment in NSIA. The provisions for credit losses posted year-over-year increases in almost every quarter of 2019. Higher credit loss provisions were recorded in the third and fourth quarters of 2019 as a result of provisions on personal loans, credit card receivables, and Financial Markets loans. For the second quarter of 2019, provisions for credit losses saw a year-over-year decrease, mainly due to provisions recorded on loans at the Credigy subsidiary. The non-interest expense results for every quarter of 2019 were up year over year. Explaining these increases were compensation and employee benefits (including the variable compensation associated with revenue growth in the business segments), technology investment expenses made as part of the Bank’s transformation plan and for business development activities, and expenses related to the expansion of ABA Bank’s banking network. In addition, non-interest expenses for the third quarter of 2019 included $57 million in impairment losses on premises and equipment and on intangible assets, $45 million in provisions for onerous contracts, and $10 million in severance pay. For the fourth quarter of 2019, non-interest expenses included an $11 million charge related to Maple. The effective income tax rate for every quarter of 2019 was down year over year. These changes in effective tax rate between the quarters of 2019 and 2018 were created mainly by a realization of capital gains taxed at a lower rate, by higher income from lower tax rate jurisdictions, and by lower tax-exempt dividend income. In addition, the U.S. tax reform had an impact on the effective tax rate of the first quarter of 2019 compared to the first quarter of 2018. National Bank of Canada 43 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis AAnnaallyyssiiss ooff tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett SSuummmmaarryy As at October 31 (millions of Canadian dollars) AAsssseettss Cash and deposits with financial institutions Securities Securities purchased under reverse repurchase agreements and securities borrowed Loans and acceptances, net of allowances Other LLiiaabbiilliittiieess aanndd eeqquuiittyy Deposits Other Subordinated debt Equity attributable to the Bank’s shareholders Non-controlling interests 22001199 2018 %% cchhaannggee 1133,,669988 8822,,222266 1177,,772233 115533,,225511 1144,,556600 228811,,445588 118899,,556666 7755,,998833 777733 1144,,777788 335588 228811,,445588 12,756 69,783 18,159 146,082 15,691 262,471 170,830 76,539 747 13,976 379 262,471 77 1188 ((22)) 55 ((77)) 77 1111 ((11)) 33 66 ((66)) 77 As at October 31, 2019, the Bank’s total assets amounted to $281.5 billion compared to $262.5 billion at year-end 2018, a $19.0 billion or 7% increase owing mainly to a $12.4 billion increase in securities and a $7.2 billion increase in loans and acceptances, net of allowances. CCaasshh aanndd DDeeppoossiittss WWiitthh FFiinnaanncciiaall IInnssttiittuuttiioonnss At $13.7 billion as at October 31, 2019, cash and deposits with financial institutions rose $0.9 billion or 7% since the same date last year, mainly due to deposits with financial institutions made by the ABA Bank subsidiary. The Bank’s liquidity and funding risk management practices are described on pages 82 to 89 of this MD&A. SSeeccuurriittiieess As at October 31, 2019, securities totalled $82.2 billion (29% of total assets). During fiscal 2019, they grew $12.4 billion from $69.8 billion as at October 31, 2018. This growth was partly due to a $6.0 billion increase in securities at fair value through profit or loss attributable to a $13.5 billion increase in equity securities and to a $1.3 billion increase in securities issued or guaranteed by U.S. Treasury, other U.S. agencies and other foreign governments. These increases were tempered by a $4.2 billion decrease in securities issued or guaranteed by the Canadian government and a $3.9 billion decrease in securities issued or guaranteed by Canadian provincial and municipal governments. Securities other than those measured at fair value through profit or loss were up $6.4 billion, essentially due to a $2.1 billion increase in securities issued or guaranteed by the Canadian government, to a $3.5 billion increase in securities issued or guaranteed by U.S. Treasury, other U.S. agencies, and other foreign governments, and to a $0.8 billion increase in other debt securities. Securities purchased under reverse repurchase agreements and securities borrowed totalled $17.7 billion as at October 31, 2019, a 2% decrease since year-end 2018 that is mainly related to activities in the Financial Markets segment. The Bank’s market risk management policies are described on pages 75 to 81 of this MD&A. LLooaannss aanndd AAcccceeppttaanncceess As at October 31, 2019, loans and acceptances, net of allowances for credit losses, totalled $153.3 billion, up $7.2 billion or 5% from October 31, 2018, and accounted for 54% of total assets. Residential mortgage loans outstanding totalled $57.2 billion as at October 31, 2019, rising $3.5 billion or 7% since year-end 2018. This growth was driven by sustained demand for mortgage credit as well as by business growth at the ABA Bank subsidiary. Personal loans totalled $36.9 billion at year-end 2019, declining $0.5 billion from $37.4 billion at year-end 2018 due in part to changes in the loan portfolio mix of the Credigy subsidiary. As for credit card receivables, they totalled $2.3 billion, remaining stable when compared to October 31, 2018. At $57.5 billion as at October 31, 2019, loans and acceptances to businesses and government increased $4.1 billion or 8% since October 31, 2018. This increase was driven mainly by Commercial Banking and Credigy subsidiary activities. Table 9 (page 109) shows gross loans and acceptances by borrower category as at October 31, 2019. At $74.4 billion, residential mortgages (including home equity lines of credit) have posted strong growth since 2015 and account for 48% of total loans and acceptances. This growth in residential mortgages was driven by sustained demand for mortgage credit as well as by growth in business activity at the ABA Bank subsidiary. As for retail loans, they totalled $15.7 billion as at October 31, 2019. With respect to commercial loans, there was year-over-year growth in the agriculture category, utilities category, and manufacturing category. As at October 31, 2019, certain categories posted year-over-year decreases, notably the mining category, the finance and insurance category, and the government category. Furthermore, the Credigy subsidiary’s POCI loans were down from October 31, 2018 due to maturities and repayments in certain portfolios. 44 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Analysis of the Consolidated Balance Sheet IImmppaaiirreedd LLooaannss Impaired loans include loans classified in Stage 3 of the expected credit loss model and the purchased or originated credit-impaired (POCI) loans of the Credigy subsidiary. As at October 31, 2019, gross impaired loans excluding POCI loans stood at $684 million compared to $630 million as at October 31, 2018 (Table 10, page 109). Net impaired loans excluding POCI loans totalled $450 million as at October 31, 2019 compared to $404 million as at October 31, 2018, a $46 million increase related to net impaired loans in the Commercial Banking portfolio and the Financial Markets segment. Gross POCI loans stood at $1,166 million as at October 31, 2019, down from $1,576 million as at October 31, 2018 as a result of maturities and repayments of certain portfolios. A detailed description of the Bank’s credit risk management practices is provided on pages 67 to 74 of this MD&A as well as in Note 7 to the consolidated financial statements. OOtthheerr AAsssseettss As at October 31, 2019, other assets totalled $14.6 billion compared to $15.7 billion as at October 31, 2018. This $1.1 billion decrease in other assets can essentially be traced to a $0.5 billion decrease in derivative financial instruments and to a $0.4 billion decrease in other assets. Investments in associates and joint ventures declined due to the disposal of a portion of the Bank’s interest in Fiera Capital as well as to a conclusion to stop recognizing the equity stake in NSIA as an investment in an associate following a loss of significant influence. Premises and equipment also decreased due to the sale of the land and head office building occupied by the Bank. DDeeppoossiitt LLiiaabbiilliittyy At $189.6 billion as at October 31, 2019, deposits increased by $18.8 billion or 11% since year-end 2018. At $60.1 billion, personal deposits, as presented in Table 12 (page 110), increased $4.4 billion since October 31, 2018 and accounted for 32% of all deposits. This increase was driven by Bank initiatives designed to grow this type of deposit as well as by business growth at the ABA Bank subsidiary. A summary of total personal savings is provided in the table below. As shown in Table 12, business and government deposits totalled $125.3 billion, up $15.0 billion from $110.3 billion at year-end 2018. This increase came from business growth at Commercial Banking and from treasury funding activities, including $3.5 billion in deposits subject to bank recapitalization (bail-in) conversion regulations, from corporate financing activities and from issuances of structured notes. Deposits from deposit-taking institutions were down $0.6 billion from the same date last year. As at October 31, 2019, total personal savings amounted to $233.0 billion, up from $211.5 billion as at October 31, 2018. Overall, off-balance-sheet personal savings stood at $172.9 billion as at October 31, 2019 compared to $155.8 billion a year ago given net inflows in brokerage operations and stronger stock market performance. TToottaall PPeerrssoonnaall SSaavviinnggss As at October 31 (millions of Canadian dollars) BBaallaannccee sshheeeett Deposits OOffff--bbaallaannccee--sshheeeett Brokerage Mutual funds Other TToottaall 22001199 2018 %% cchhaannggee 6600,,006655 55,688 113355,,776688 3366,,881199 331199 117722,,990066 223322,,997711 123,458 31,874 440 155,772 211,460 88 1100 1166 ((2288)) 1111 1100 OOtthheerr LLiiaabbiilliittiieess As at October 31, 2019, other liabilities stood at $76.0 billion, declining $0.5 billion since October 31, 2018, essentially due to a $5.0 billion decrease in obligations related to securities sold short, partly offset by a $1.9 billion increase in obligations related to securities sold under repurchase agreements and securities loaned, a $0.9 billion increase in derivative financial instruments, and a $1.2 billion increase in liabilities related to transferred receivables. SSuubboorrddiinnaatteedd DDeebbtt aanndd OOtthheerr CCoonnttrraaccttuuaall OObblliiggaattiioonnss Subordinated debt has remained relatively stable since October 31, 2018. The contractual obligations are presented in detail in Note 29 to the consolidated financial statements. National Bank of Canada 45 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Analysis of the Consolidated Balance Sheet EEqquuiittyy As at October 31, 2019, equity attributable to the Bank’s shareholders was $14.8 billion, rising $0.8 billion from $14.0 billion since October 31, 2018. This increase came from net income net of dividends, tempered by remeasurements of pension plans and other post-employment benefit plans, by a net change in gains (losses) on cash flow hedges, and by repurchases of common shares for cancellation, factors which themselves were partly offset by issuances of common shares under the Stock Option Plan and the impact of shares purchased or sold for trading. The Consolidated Statements of Changes in Equity on page 118 of this Annual Report present the items of equity. In addition, an analysis of the Bank’s regulatory capital is presented in the Capital Management section of this MD&A. AAccqquuiissiittiioonn On September 27, 2019, the Bank acquired the entire remaining non-controlling interest in the Cambodian subsidiary Advanced Bank of Asia Limited (ABA Bank) for $84 million. Following this transaction, ABA Bank became a wholly owned subsidiary of the Bank. EExxppoossuurreess ttoo CCeerrttaaiinn AAccttiivviittiieess In 2012, the Financial Stability Board (FSB) formed a working group, the Enhanced Disclosure Task Force (EDTF), that was mandated to develop principles for enhancing the risk disclosures of major banks. The EDTF published a report containing 32 recommendations. The risk disclosures required by the EDTF are provided in this Annual Report and in the documents entitled Supplementary Regulatory Capital and Pillar 3 Disclosure and Supplementary Financial Information, which are available on the Bank’s website at nbc.ca. In addition, on page 12 of this Annual Report is a table of contents that readers can use to locate information relative to the 32 recommendations. The FSB recommendations seek to enhance the transparency and measurement of certain exposures, in particular structured entities, subprime and Alt-A exposures, collateralized debt obligations, residential and commercial mortgage-backed securities, and leveraged financing structures. The Bank does not market any specific mortgage financing program to subprime or Alt-A clients. Alt-A loans are granted to borrowers who cannot provide standard proof of income. The Bank’s Alt-A loan volume was $402 million as at October 31, 2019 ($425 million as at October 31, 2018). The Bank does not have any significant direct position in residential and commercial mortgage-backed securities that are not insured by the CMHC. Credit derivative positions are presented in the Supplementary Regulatory Capital and Pillar 3 Disclosure report, which is available on the Bank’s website at nbc.ca. Leveraged finance is commonly employed to achieve a specific objective, for example, to make an acquisition, complete a buy-out or repurchase shares. Leveraged finance risk exposure takes the form of both funded and unfunded commitments. As at October 31, 2019, total commitments for this type of loan stood at $3,559 million ($2,967 million as at October 31, 2018). Details about other exposures are provided in the table concerning structured entities in Note 27 to the consolidated financial statements. 46 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Analysis of the Consolidated Balance Sheet RReellaatteedd PPaarrttyy TTrraannssaaccttiioonnss In the normal course of business, the Bank provides various banking services and enters into contractual agreements and other transactions with associates, joint ventures, directors, key officers and other related parties. These agreements and transactions are entered into under conditions similar to those offered to non-related third parties. In accordance with the Bank Act (Canada), the aggregate of loans granted to key officers of the Bank, excluding mortgage loans granted on their principal residence, cannot exceed twice the officer’s annual salary. Loans to eligible key officers are granted under the same conditions as those granted to any other employee of the Bank. The main conditions are as follows: the employee must meet the same credit requirements as a client;   mortgage loans are offered at the preferential employee rate;     home equity lines of credit bear interest at Canadian prime less 0.5%, but never lower than Canadian prime divided by two; personal loans bear interest at a risk-based regular client rate; credit card advances bear interest at a prescribed fixed rate in accordance with Bank policy; personal lines of credit bear interest at Canadian prime less 0.5%, but never lower than Canadian prime divided by two. The Bank also offers a deferred stock unit plan to directors who are not Bank employees. For additional information, see Note 22 to the consolidated financial statements. Additional information on related parties is presented in Notes 9, 27 and 28 to the consolidated financial statements. IInnccoommee TTaaxxeess In June 2019, the Bank was reassessed by the Canada Revenue Agency (CRA) for additional income tax and interest of approximately $150 million (including estimated provincial tax and interest) in respect of certain Canadian dividends received by the Bank during 2014. In prior fiscal years, the Bank was reassessed for additional income tax and interest of approximately $220 million (including provincial tax and interest) in respect of certain Canadian dividends received by the Bank during the 2013 and 2012 taxation years. The transactions to which the above-mentioned reassessments relate are similar to those prospectively addressed by income tax legislation enacted as a result of the 2015 Canadian federal budget. The CRA may issue reassessments to the Bank for taxation years subsequent to 2014 in regard to activities similar to those that were the subject of the above-mentioned reassessments. The Bank remains confident that its tax position was appropriate and intends to vigorously defend its position. As a result, no amount has been recognized in the consolidated financial statements as at October 31, 2019. EEvveenntt AAfftteerr tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett On November 19, 2019, the Bank paid 7.7 million euros to the German tax authorities in relation to the Maple case. This payment was made upon a final tax claim of the tax authorities against the insolvency administrator that was approved by the Maple GmbH creditor assembly. As at October 31, 2019, a provision of $11 million was recorded to reflect this adjusting event after the Consolidated Balance Sheet date. For additional information, see Note 26 to the consolidated financial statements. National Bank of Canada 47 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis SSeeccuurriittiizzaattiioonn aanndd OOffff--BBaallaannccee--SShheeeett AArrrraannggeemmeennttss In the normal course of business, the Bank is party to various financial arrangements that, under IFRS, are not required to be recorded on the Consolidated Balance Sheet or are recorded under amounts other than their notional or contractual values. These arrangements include, among others, transactions with structured entities, derivative financial instruments, the issuance of guarantees, credit instruments, and financial assets received as collateral. SSttrruuccttuurreedd EEnnttiittiieess The Bank uses structured entities, among other means, to diversify its funding sources and to offer services to clients, in particular to help them securitize their financial assets or provide them with investment opportunities. Under IFRS, a structured entity must be consolidated if the Bank controls the entity. Note 1 to the consolidated financial statements describes the accounting policy and criteria used for consolidating structured entities. Additional information on consolidated and non-consolidated structured entities is provided in Note 27 to the consolidated financial statements. SSeeccuurriittiizzaattiioonn ooff tthhee BBaannkk’’ss FFiinnaanncciiaall AAsssseettss Mortgage Loans The Bank participates in two Canada Mortgage and Housing Corporation (CMHC) securitization programs: the Mortgage-Backed Securities Program under the National Housing Act (Canada) (NHA) and the Canada Mortgage Bond (CMB) Program. Under the first program, the Bank issues NHA securities backed by insured residential mortgage loans and, under the second, the Bank sells NHA securities to Canada Housing Trust (CHT), which finances the purchase through the issuance of mortgage bonds insured by CMHC. Moreover, these mortgage bonds feature an interest rate swap agreement under which a CMHC-certified counterparty pays CHT the interest due to investors and receives the interest on the NHA securities. As at October 31, 2019, the outstanding amount of NHA securities issued by the Bank and sold to CHT was $19.2 billion. The mortgage loans sold consist of fixed- or variable-rate residential loans that are insured against potential losses by a loan insurer. In accordance with the NHA-MBS Program, the Bank advances the funds required to cover late payments and, if necessary, obtains reimbursement from the insurer that insured the loan. The NHA-MBS and CMB programs do not use liquidity guarantee arrangements. The Bank uses these securitization programs mainly to diversify its funding sources. In accordance with IFRS, because the Bank retains substantially all of the risks and rewards of ownership of the mortgage loans transferred to CHT, the derecognition criteria are not met. Therefore, the insured mortgage loans securitized under the CMB Program continue to be recognized in Loans on the Bank’s Consolidated Balance Sheet, and the liabilities for the considerations received from the transfer are recognized in Liabilities related to transferred receivables on the Consolidated Balance Sheet. For additional information, see Note 8 to the consolidated financial statements. Credit Card Receivables In April 2015, the Bank set up Canadian Credit Card Trust II (CCCT II) to continue its program of securitizing credit card receivables on a revolving basis. The Bank uses this entity for capital management and funding purposes. The Bank acts as the servicer of the receivables sold and maintains the client relationship. Furthermore, it administers the securitization program and ensures that all related procedures are stringently followed and that investors are paid according to the provisions of the program. As at October 31, 2019, the credit card receivables portfolio held by CCCT II (net of the Bank Certificate held by the Bank) represented an amount outstanding of $1.6 billion. CCCT II issued investors’ certificates, $0.9 billion of which is held by third parties and $0.7 billion is held by the Bank. New receivables are periodically sold to the structure on a revolving basis to replace the receivables reimbursed by clients. The different series of certificates are rated by the Fitch and DBRS rating agencies. From this portfolio of sold receivables, the Bank retains the excess spread, i.e., the residual net interest income after all the expenses related to this structure have been paid, and thus provides first-loss protection. Furthermore, second- loss protection for issued series is provided by certificates subordinated to the senior notes, representing 5.8% of the total amount of the series issued. The Bank controls CCCT II and thus consolidates it. SSeeccuurriittiizzaattiioonn ooff TThhiirrdd--PPaarrttyy FFiinnaanncciiaall AAsssseettss The Bank administers multi-seller conduits that purchase financial assets from clients and finance those purchases by issuing commercial paper backed by the acquired assets. Clients use these multi-seller conduits to diversify their funding sources and reduce borrowing costs while continuing to service the financial assets and providing some amount of first-loss protection. Notes issued by the conduits and held by third parties provide additional credit loss protection. The Bank acts as a financial agent and provides administrative and transaction structuring services to these conduits. The Bank provides backstop liquidity and credit enhancement facilities under the commercial paper program. These facilities are presented and described in Notes 26 and 27 to the consolidated financial statements. The Bank has concluded derivative financial instrument contracts with these conduits, the fair value of which is presented on the Bank’s Consolidated Balance Sheet. The Bank is not required to consolidate these conduits, as it does not control them. 48 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Securitization and Off-Balance-Sheet Arrangements DDeerriivvaattiivvee FFiinnaanncciiaall IInnssttrruummeennttss The Bank uses various types of derivative financial instruments to meet its clients’ needs, generate trading activity revenues and manage its exposure to interest rate, foreign exchange and credit risk as well as other market risks. All derivative financial instruments are accounted for at fair value on the Consolidated Balance Sheet. Transactions in derivative financial instruments are expressed as notional amounts. These amounts are not presented as assets or liabilities on the Consolidated Balance Sheet. They represent the face amount of the contract to which a rate or price is applied to determine the amount of cash flows to be exchanged. Notes 1 and 16 to the consolidated financial statements provide additional information on the types of derivative financial instruments used by the Bank and their accounting basis. GGuuaarraanntteeeess In the normal course of business, the Bank enters into various guarantee contracts. The principal types of guarantees are letters of guarantee, backstop liquidity and credit enhancement facilities, certain securities lending activities, and certain indemnification agreements. Note 26 to the consolidated financial statements provides detailed information on these guarantees. CCrreeddiitt IInnssttrruummeennttss In the normal course of business, the Bank enters into various off-balance-sheet credit commitments. The credit instruments used to meet the financing needs of its clients represent the maximum amount of additional credit that the Bank could be required to extend if the commitments were fully drawn. For additional information on these off-balance-sheet credit instruments and other items, see Note 26 to the consolidated financial statements. FFiinnaanncciiaall AAsssseettss RReecceeiivveedd aass CCoollllaatteerraall In the normal course of business, the Bank receives financial assets as collateral as a result of transactions involving securities purchased under reverse repurchase agreements, securities borrowing and lending agreements, and derivative financial instrument transactions. For additional information regarding financial assets received as collateral, see Note 26 to the consolidated financial statements. National Bank of Canada 49 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis CCaappiittaall MMaannaaggeemmeenntt Capital management has a dual role of ensuring a competitive return to the Bank’s shareholders while maintaining a solid capital foundation that covers risks inherent to the Bank’s business, supports its business segments, and protects its clients. CCaappiittaall MMaannaaggeemmeenntt FFrraammeewwoorrkk The Bank’s capital management policy defines guiding principles as well as the roles and responsibilities of its internal capital adequacy assessment process. This process aims to determine the capital that the Bank needs to pursue its business activities and accommodate unexpected losses arising from extremely adverse economic and operational conditions. The Bank has implemented a rigorous internal capital adequacy assessment process that comprises the following procedures: conducting an overall risk assessment;   measuring significant risks and the capital requirements related to the Bank’s financial budget for the next fiscal year and current and prospective risk profiles; integrating stress tests across the organization and executing sensitivity analyses to determine the capital buffer above minimum regulatory levels (for additional information on enterprise-wide stress testing, see the Risk Management section of this MD&A); aggregating capital and monitoring the reasonableness of internal capital compared with regulatory capital; comparing projected internal capital with regulatory capital levels, internal operating targets, and competing banks; attesting to the adequacy of the Bank’s capital levels.     Assessing capital adequacy is an integral part of capital planning and strategy. The Bank sets internal capital ratio targets that include a discretionary cushion in excess of the regulatory requirements, which provides a solid financial structure and sufficient capital to meet management’s business needs in accordance with its risk appetite, along with competitive returns to shareholders, under both normal market conditions and a range of severe but plausible stress testing scenarios. The internal capital adequacy assessment process is a key tool in establishing the Bank’s capital strategy and is subject to quarterly reviews and periodic amendments. Risk-adjusted return on capital (RAROC) and shareholder value added (SVA), which are obtained from an assessment of required economic capital, are calculated quarterly for each of the Bank’s business segments. The results are then used to guide management in allocating capital among the different business segments. SSttrruuccttuurree aanndd GGoovveerrnnaannccee Along with its partners from Risk Management, Global Funding and Treasury Group, and Finance, the Capital Management team is responsible for maintaining integrated control methods and processes so that an overall assessment of capital adequacy may be performed. The Board oversees the structure and development of the Bank’s capital management policy and ensures that the Bank maintains sufficient capital in accordance with regulatory requirements and in consideration of market conditions. The Board delegates certain responsibilities to the Risk Management Committee (RMC), which in turn recommends capital management policies and oversees their application. However, the Board, on the recommendation of the RMC, assumes the following responsibilities:       reviewing and approving the capital management policy; reviewing and approving the Bank’s risk appetite, including the main capital and risk targets and the corresponding limits; reviewing and approving the capital plan and strategy on an annual basis, including the Bank’s internal capital adequacy assessment process; reviewing and approving the implementation of significant measures respecting capital, including contingency measures; reviewing significant capital disclosures, including Basel capital adequacy ratios; ensuring the appropriateness of the regulatory capital adequacy assessment. The Office of the President is responsible for defining the Bank’s strategy and plays a key role in guiding measures and decisions regarding capital. The Enterprise-Wide Risk Management Committee oversees capital management, which consists of reviewing the capital plan and strategy and implementing significant measures respecting capital, including contingency measures, and making recommendations with respect to these measures. 50 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Capital Management BBaasseell AAccccoorrdd aanndd RReegguullaattoorryy EEnnvviirroonnmmeenntt BBaasseell AAccccoorrdd The Basel Accord proposes a range of approaches of varying complexity, the choice of which determines the sensitivity of capital to risks. A less complex approach, such as the Standardized Approach, uses regulatory weightings, while a more complex approach uses the Bank’s internal estimates of risk components to establish risk-weighted assets and calculate regulatory capital. As required under Basel, risk-weighted assets (RWA) are calculated for each credit risk, market risk, and operational risk. The Bank uses the Advanced Internal Rating-Based (AIRB) Approach for credit risk to determine minimum regulatory capital requirements for a majority of its portfolios. The credit risk of certain portfolios considered to be less significant is weighted according to the Basel Standardized Approach. The simple risk-weighted method is used to calculate the charge related to banking book equity securities. This method requires proactive management of the capital allocated to portfolios with banking book equity securities since, beyond a certain investment threshold, the cost of regulatory capital becomes prohibitive. As for operational risk, the Bank uses the Standardized Approach. Market risk-weighted assets are primarily determined using the Internal Model-Based Approach, but the Standardized Approach is used to assess interest-rate specific risk. With respect to the risk related to securitization operations, the capital treatment depends on the type of underlying exposures and on the information available about the exposures. The Bank must use the Securitization Internal Rating-Based Approach (SEC-IRBA) if it is able to apply an approved internal ratings-based model and has sufficient information to calculate the capital requirements for all underlying exposures in the securitization pool. Under this approach, the RWA is derived from a combination of supervisory inputs and inputs specific to the securitization exposure such as the implicit capital charge related to the underlying exposures, the credit enhancement level, the effective maturity, the number of exposures, and the weighted average loss given default (LGD). If the Bank cannot use the SEC-IRBA, it must use the Securitization External Rating-Based Approach (SEC-ERBA) for the securitization exposures that are externally rated. This approach assigns risk weights to exposures using external ratings. The Bank uses the ratings assigned by Moody’s, Standard & Poor’s (S&P), Fitch, DBRS or a combination of these ratings. The Bank uses the Internal Assessment Approach (IAA) for unrated securitization exposures relating to the asset-backed commercial paper conduits it sponsors. If the Bank cannot apply the SEC-ERBA or the IAA, it must use the supervisory formula under the Securitization Standardized Approach (SEC-SA). Under this approach, RWA is derived from inputs specific to the securitization exposure such as the implicit capital charge related to the underlying exposures calculated under the standardized credit risk approach as well as credit enhancement and delinquency levels. If none of the above approaches can be used, the securitization exposure must be assigned a risk weight of 1,250%. The Bank can apply a reduced capital charge for securitization exposures that meet the criteria of the Simple, Transparent and Comparable (STC) framework. To mitigate the impact of the revised securitization framework, which took effect on November 1, 2018, OSFI has permitted grandfathering of the current capital treatment for one year through a negative adjustment to RWA that eliminates the initial increase in risk weights. OSFI has also provided transitional arrangements for all securitization transactions completed by December 31, 2018 for a maximum of two years. Capital ratios are calculated by dividing capital by risk-weighted assets. Credit, market, and operational risks are factored into the risk-weighted assets calculation for regulatory purposes. Basel rules apply at the consolidated level of the Bank. Assets of non-consolidated entities for regulatory purposes are therefore excluded from the risk-weighted assets calculation. The definition adopted by the Basel Committee on Banking Supervision (BCBS) distinguishes between three types of capital. Common Equity Tier 1 (CET1) capital consists of common shareholders’ equity less goodwill, intangible assets, and other capital deductions. The Additional Tier 1 instruments comprise eligible non- cumulative preferred shares and the eligible amount of innovative instruments. The sum of CET1 and Additional Tier 1 capital forms what is known as Tier 1 capital. Tier 2 capital consists of eligible subordinated debt and certain allowances for credit losses. Total regulatory capital is the sum of Tier 1 and Tier 2 capital. National Bank of Canada 51 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Capital Management OSFI is responsible for applying the Basel Accord in Canada. As required under the Basel Accord, OSFI requires that regulatory capital instruments other than common equity have a non-viability contingent capital (NVCC) clause to ensure that investors bear losses before taxpayers should the government determine that it is in the public interest to rescue a non-viable financial institution. Instruments issued before January 1, 2013 that would be Basel III compliant if it were not for the absence of the NVCC clause are grandfathered and will be phased out over a period of ten years. The Bank expects to phase out all of its non-NVCC instruments without resorting to any regulatory event redemption. Furthermore, in the regulations of the Canadian Deposit Insurance Corporation (CDIC) Act and the Bank Act (Canada), the Government of Canada has provided detailed information on conversion, issuance, and compensation regimes for bail-in instruments issued by D-SIBs. Pursuant to the CDIC Act, in circumstances where OSFI has determined that the Bank has ceased, or is about to cease, to be viable, the Governor in Council may, upon a Minister of Finance recommendation indicating that he or she believes that it is in the public interest to do so, grant an order directing CDIC to convert all or a portion of certain shares and liabilities of the Bank into common shares of the Bank (a “Bail-In Conversion”). The Bail-in Regulations governing the conversion and issuance of bail-in instruments came into force on September 23, 2018, and those governing compensation for holders of converted instruments came into force on March 27, 2018. Any shares and liabilities issued before the date that the Bail-In Regulations come into force are not subject to a Bail-In Conversion, unless, in the case of a liability, the terms of such liability are, on or after that day, amended to increase its principal amount or to extend its term to maturity, and the liability, as amended, meets the requirements to be subject to a Bail-In Conversion. The Bail-in Regulations did not have a material impact on the Bank’s funding plan. The Bank and all other major Canadian banks have to maintain minimum capital ratios established by OSFI: a CET1 capital ratio of at least 10.0%, a Tier 1 capital ratio of at least 11.5%, and a Total capital ratio of at least 13.5%. All of these ratios are to include a capital conservation buffer of 2.5%, a 1% surcharge applicable solely to D-SIBs, and a 2.0% domestic stability buffer. The domestic stability buffer, which can vary from 0% to 2.5% of risk-weighted assets, consists exclusively of CET1 capital. A D-SIB that fails to meet this buffer requirement will not be subject to automatic constraints to reduce capital distributions but will have to provide a remediation plan to OSFI. The banks also have to meet the capital floor that sets the regulatory capital level according to the Basel II standardized approach. If the capital requirement under Basel III is less than 75% of the capital requirements as calculated under Basel II, the difference is added to risk- weighted assets. OSFI requires Canadian banks to meet a Basel III leverage ratio of at least 3.0%. The leverage ratio is a measure independent of risk that is calculated by dividing the amount of Tier 1 capital by total exposure. Total exposure is defined as the sum of on-balance-sheet assets (including derivative exposures and securities financing transaction exposures) and off-balance-sheet items. The assets deducted from Tier 1 capital are also deducted from total exposure. OSFI’s Total Loss Absorbing Capacity (TLAC) guideline, which applies to all D-SIBs under the federal government’s bail-in regulations, came into effect on September 23, 2018. The purpose of the TLAC guideline is to ensure that a D-SIB has sufficient loss-absorbing capacity to support its recapitalization in the unlikely event it becomes non-viable. OSFI is requiring D-SIBs to maintain a minimum risk-based TLAC ratio of 23.50% (including the domestic stability buffer) of risk-weighted assets and a minimum TLAC leverage ratio of 6.75% by November 1, 2021. During the quarter ended April 30, 2019, the Bank started to issue qualifying bail-in debt and expects its TLAC ratios to improve through the normal refinancing of its maturing unsecured term debt. The Bank does not anticipate any challenges in meeting these TLAC requirements. RReeqquuiirreemmeennttss –– RReegguullaattoorryy RRaattiiooss UUnnddeerr BBaasseell IIIIII CCaappiittaall ccoonnsseerrvvaattiioonn bbuuffffeerr MMiinniimmuumm sseett bbyy BBCCBBSS DD--SSIIBB ssuurrcchhaarrggee MMiinniimmuumm sseett bbyy OOSSFFII((11)) MMiinniimmuumm DDoommeessttiicc ssttaabbiilliittyy bbuuffffeerr(2) AAss aatt OOccttoobbeerr 3311,, 22001199 MMiinniimmuumm sseett bbyy OOSSFFII((11)),, iinncclluuddiinngg tthhee bbuuffffeerr CCaappiittaall rraattiiooss CET1 Tier 1 Total LLeevveerraaggee rraattiioo 44..55 %% 66..00 %% 88..00 %% 33..00 %% 22..55 %% 22..55 %% 22..55 %% nn..aa.. 77..00 %% 88..55 %% 1100..55 %% nn..aa.. 11..00 %% 11..00 %% 11..00 %% nn..aa.. 88..00 %% 99..55 %% 1111..55 %% 33..00 %% 22..00 %% 22..00 %% 22..00 %% nn..aa.. 1100..00 %% 1111..55 %% 1133..55 %% 33..00 %% n.a. Not applicable (1) (2) The capital ratios include the capital conservation buffer and the D-SIB surcharge. For D-SIBs, the buffer level varies between 0% and 2.5% of risk-weighted assets and is set by OSFI. The Bank ensures that its capital levels are always above the minimum capital requirements set by OSFI, including the buffer. By maintaining a strong capital structure, the Bank can cover the risks inherent to its business activities, support its business segments, and protect its clients. Other disclosure requirements pursuant to Pillar 3 of the Basel Accord and a set of recommendations defined by the EDTF are presented in the Supplementary Regulatory Capital and Pillar 3 Disclosure report published quarterly and available on the Bank’s website at nbc.ca. Furthermore, a complete list of capital instruments and their main features is also available on the Bank’s website. 52 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Capital Management RReegguullaattoorryy CCoonntteexxtt The Bank closely monitors regulatory developments and participates actively in various consultative processes. Presented below are brief descriptions of ongoing regulatory projects. As had been planned, the Bank applied several new regulatory requirements in 2019, in particular the SA-CCR (Standardized Approach for Measuring Counterparty Credit Risk) rules and the revised securitization framework (described above). Basel III Reform In December 2017, the Group of Central Bank Governors and Heads of Supervision (GHOS), which oversees the BCBS, endorsed the outstanding Basel III post- crisis regulatory reforms. The purpose of the approved reforms, set out in Basel III: Finalising Post-Crisis Reforms, is to reduce excessive variability in risk- weighted assets and improve comparability and transparency among bank capital ratios. The reforms must be implemented starting in 2022 and include the following: revisions to the standardized approaches for calculating credit risk and operational risk; a constraint on using the internal ratings-based approach for calculating credit risk; and revisions to the leverage ratio, the CVA, and the calculation of the output capital floor. In February 2018, the BCBS issued Pillar 3 Disclosure Requirements – Updated Framework, a consultative document that presents the additional disclosure requirements that will apply when the outstanding Basel III regulatory reforms take effect as of 2022, and these requirements will form a single Pillar 3 disclosure framework. In January 2019, the BCBS also issued a newly revised version of the document entitled Revisions to the Minimum Capital Requirements for Market Risk (initially issued in March 2018), which will have to be applied as of 2022. In July 2018, OSFI issued a discussion paper, Implementation of the Final Basel III Reforms in Canada, which sets out OSFI’s preliminary views on the scope and timelines for implementing the final Basel III reforms in Canada. Other Projects On April 10, 2019, OSFI released the final version of its B-2 guideline, Large Exposure Limits for Domestic Systemically Important Banks. Large exposure limits help to restrict the maximum loss that an institution could face in the event of a sudden failure of a counterparty. This new version of the B-2 guideline tightens the exposure limits applicable to Global Systemically Important Banks (G-SIBs) and to other Canadian D-SIBs. It recognizes eligible credit risk mitigation techniques by measuring exposures on a net basis rather than a gross basis, and it reduces the eligible capital base by replacing Total capital with Tier 1 capital. All D-SIBs are expected to comply with the B-2 guideline for the period beginning November 1, 2019. On May 30, 2019, OSFI released a revised version of its B-12 guideline, Interest Rate Risk Management. This guideline outlines OSFI’s expectations regarding the management of Interest Rate Risk in the Banking Book (IRRBB) in areas such as governance processes, risk measurement, development of stress test scenarios as well as key behavioural and modelling assumptions. D-SIBs will have to apply this revised guideline as of January 1, 2020. On June 26, 2019, the BCBS finalized revisions to the leverage ratio’s treatment of client-cleared derivatives and to disclosure requirements in order to address concerns about balance sheet window-dressing. The treatment of client-cleared derivatives was revised to align the leverage ratio measurement with the measurement determined by the SA-CCR rules as used for risk-based capital requirements. The revision to Revisions to Leverage Ratio Disclosure Requirements aims to alleviate leverage ratio balance sheet window-dressing concerns. Internationally active banks will be required to disclose their leverage ratios based on quarter-end values and on an average of daily values for securities financing transactions. These revisions will come into effect on January 1, 2022. CCaappiittaall MMaannaaggeemmeenntt iinn 22001199 MMaannaaggeemmeenntt AAccttiivviittiieess During the fiscal year ended October 31, 2019, the Bank repurchased 4,547,200 common shares for $281 million, which reduced Common share capital by $40 million and Retained earnings by $241 million. The repurchase of 2,347,200 common shares was part of the normal course issuer bid to repurchase for cancellation program that the Bank had launched on June 6, 2018 and that ended on June 5, 2019; under this program, the Bank repurchased a total of 6,847,200 common shares. On June 10, 2019, the Bank began a new normal course issuer bid to repurchase for cancellation up to 6,000,000 common shares over the 12- month period ending no later than June 9, 2020. During the year ended October 31, 2019, the Bank repurchased 2,200,000 common shares under the new program. As at October 31, 2019, the Bank had 334,172,411 issued and outstanding common shares compared to 335,070,642 a year earlier as well as 98,000,000 issued and outstanding preferred shares, unchanged from October 31, 2018. For additional information on capital instruments, see Notes 15, 18 and 19 to the consolidated financial statements. DDiivviiddeennddss The Bank’s strategy for common share dividends is to aim for a dividend payout ratio of between 40% and 50% of net income attributable to common shareholders excluding specified items, taking into account such factors as financial position, cash needs, regulatory requirements and any other factor deemed relevant by the Board. National Bank of Canada 53 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Capital Management For fiscal 2019, the Bank declared $892 million in dividends to common shareholders, which represents 42% of net income attributable to common shareholders (2018: 41%). The declared dividends are within the target payout range. The Bank has taken a prudent approach to managing regulatory capital and remains confident in its ability to increase earnings going forward. SShhaarreess aanndd SSttoocckk OOppttiioonnss First preferred shares Series 30 Series 32 Series 34 Series 36 Series 38 Series 40 Series 42 Common shares Stock options NNuummbbeerr ooff sshhaarreess $$ mmiilllliioonn AAss aatt OOccttoobbeerr 3311,, 22001199 1144,,000000,,000000 1122,,000000,,000000 1166,,000000,,000000 1166,,000000,,000000 1166,,000000,,000000 1122,,000000,,000000 1122,,000000,,000000 9988,,000000,,000000 333344,,117722,,441111 1122,,110033,,662266 335500 330000 440000 440000 440000 330000 330000 22,,445500 22,,994499 As at November 29, 2019, there were 334,201,015 common shares and 12,076,868 stock options outstanding. NVCC provisions require the conversion of capital instruments into a variable number of common shares should OSFI deem a bank to be non-viable or should the government publicly announce that a bank has accepted or agreed to accept an injection of capital. If an NVCC trigger event were to occur, all of the Bank’s preferred shares and medium-term notes maturing on February 1, 2028, which are NVCC capital instruments, would be converted into common shares of the Bank according to an automatic conversion formula at a conversion price corresponding to the greater of the following amounts: (i) a $5.00 contractual floor price; or (ii) the market price of the Bank’s common shares on the date of the trigger event (10-day weighted average price). Based on a $5.00 floor price and including an estimate for accrued dividends and interest, these NVCC capital instruments would be converted into a maximum of 723 million Bank common shares, which would have a 68.4% dilutive effect based on the number of Bank common shares outstanding as at October 31, 2019. RReegguullaattoorryy CCaappiittaall RRaattiiooss As at October 31, 2019, the Bank’s CET1, Tier 1 and Total capital ratios were, respectively, 11.7%, 15.0% and 16.1%, i.e., above the regulatory requirements, compared to ratios of, respectively, 11.7%, 15.5% and 16.8% as at October 31, 2018. The CET1 capital ratio remained stable. Net income net of dividends, and common share issuances under the Stock Option Plan offset the application of the SA-CCR rules for measuring counterparty credit risk, growth in risk-weighted assets, the common share repurchases during the year ended October 31, 2019, and remeasurements of pension plans and other post-employment benefit plans. The decreases in the Tier 1 capital ratio and the Total capital ratio were essentially due to growth in risk-weighted assets. As at October 31, 2019, the leverage ratio was 4.0%, stable compared to October 31, 2018. The growth in Tier 1 capital was offset by growth in total leverage exposure. RReegguullaattoorryy CCaappiittaall aanndd RRaattiiooss UUnnddeerr BBaasseell IIIIII As at October 31 (millions of Canadian dollars) CCaappiittaall CET1 Tier 1 Total RRiisskk--wweeiigghhtteedd aasssseettss CET1 capital Tier 1 capital Total capital TToottaall eexxppoossuurree CCaappiittaall rraattiiooss CET1 Tier 1 Total LLeevveerraaggee rraattiioo 54 22001199 2018 99,,669922 1122,,449922 1133,,336666 8833,,003399 8833,,003399 8833,,003399 330088,,990022 1111..77 %% 1155..00 %% 1166..11 %% 44..00 %% 8,608 11,410 12,352 73,654 73,670 73,685 284,337 11.7 % 15.5 % 16.8 % 4.0 % National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Capital Management MMoovveemmeenntt iinn RReegguullaattoorryy CCaappiittaall Year ended October 31 (millions of Canadian dollars) CCoommmmoonn EEqquuiittyy TTiieerr 11 ((CCEETT11)) ccaappiittaall Balance at beginning Issuance of common shares (including Stock Option Plan) Impact of shares purchased or sold for trading Repurchase of common shares Other contributed surplus Dividends on preferred and common shares Net income attributable to the Bank’s shareholders Common share capital issued by subsidiaries and held by third parties Removal of own credit spread net of income taxes Impact of adopting IFRS 15 on November 1, 2018 (IFRS 9 on November 1, 2017) Other Movements in accumulated other comprehensive income Translation adjustments Debt securities at fair value through other comprehensive income Impact of adopting IFRS 9 on November 1, 2017 Other Change in goodwill and intangible assets (net of related tax liability) Other, including regulatory adjustments and transitional arrangements Change in defined benefit pension plan asset (net of related tax liability) Change in amount exceeding 15% threshold Deferred tax assets Significant investment in common shares of financial institutions Change in other regulatory adjustments(1) Balance at end AAddddiittiioonnaall TTiieerr 11 ccaappiittaall Balance at beginning New Tier 1 eligible capital issuances Redeemed capital Change in non-qualifying Additional Tier 1 subject to phase-out Other, including regulatory adjustments and transitional arrangements Balance at end TToottaall TTiieerr 11 ccaappiittaall TTiieerr 22 ccaappiittaall Balance at beginning New Tier 2 eligible capital issuances Redeemed capital Change in non-qualifying Tier 2 subject to phase-out Tier 2 instruments issued by subsidiaries and held by third parties Change in certain allowances for credit losses Other, including regulatory adjustments and transitional arrangements Balance at end TToottaall rreegguullaattoorryy ccaappiittaall (1) Represents the change in investments in the Bank’s own CET1. 22001199 2018 88,,660088 110077 4455 ((228811)) 99 ((11,,000088)) 22,,225566 ((1133)) ((88)) ((44)) ((116633)) ((66)) 11 33 113344 33 −− −− 99 99,,669922 22,,880022 −− −− −− ((22)) 22,,880000 7,856 113 (10) (467) 14 (934) 2,145 5 (24) (122) 97 27 (16) (10) 1 (57) (7) − − (3) 8,608 2,601 600 (400) − 1 2,802 1122,,449922 11,410 994422 −− −− −− ((44)) 1100 ((7744)) 887744 204 750 − − 2 (14) − 942 1133,,336666 12,352 National Bank of Canada 55 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Capital Management RRWWAA bbyy KKeeyy RRiisskk DDrriivveerrss CET1 RWA amounted to $83.0 billion as at October 31, 2019, rising $9.4 billion from $73.7 billion as at October 31, 2018. This increase resulted mainly from organic growth in RWA and from a change in the method used to measure counterparty credit risk (SA-CCR). The changes in the Bank’s risk-weighted assets by risk type are presented in the following table. RRiisskk--WWeeiigghhtteedd AAsssseettss MMoovveemmeenntt bbyy KKeeyy DDrriivveerrss Quarter ended (millions of Canadian dollars) CCrreeddiitt rriisskk –– RRiisskk--wweeiigghhtteedd aasssseettss aatt bbeeggiinnnniinngg Book size Book quality Model updates Methodology and policy Acquisitions and disposals Foreign exchange movements CCrreeddiitt rriisskk –– RRiisskk--wweeiigghhtteedd aasssseettss aatt eenndd MMaarrkkeett rriisskk –– RRiisskk--wweeiigghhtteedd aasssseettss aatt bbeeggiinnnniinngg Movement in risk levels(1) Model updates Methodology and policy Acquisitions and disposals MMaarrkkeett rriisskk –– RRiisskk--wweeiigghhtteedd aasssseettss aatt eenndd OOppeerraattiioonnaall rriisskk –– RRiisskk--wweeiigghhtteedd aasssseettss aatt bbeeggiinnnniinngg Movement in risk levels Acquisitions and disposals OOppeerraattiioonnaall rriisskk –– RRiisskk--wweeiigghhtteedd aasssseettss aatt eenndd RRiisskk--wweeiigghhtteedd aasssseettss aatt eenndd OOccttoobbeerr 3311,, 22001199 JJuullyy 3311,, 22001199 AApprriill 3300,, 22001199 JJaannuuaarryy 3311,, 22001199 October 31, 2018 TToottaall TToottaall TToottaall TToottaall Total 6655,,669933 11,,997799 1111 ((4466)) ((336622)) −− ((2211)) 6677,,225544 33,,997722 330044 −− −− −− 44,,227766 1111,,331199 119900 −− 1111,,550099 8833,,003399 6644,,112244 11,,558888 ((115555)) 441166 −− −− ((228800)) 6655,,669933 33,,778888 118844 −− −− −− 33,,997722 1111,,009966 222233 −− 1111,,331199 8800,,998844 6622,,116622 11,,558899 5566 3333 −− −− 228844 6644,,112244 33,,996644 ((117766)) −− −− −− 33,,778888 1100,,991100 118866 −− 1111,,009966 7799,,000088 5599,,447766 11,,227733 ((119988)) −− 11,,663344 −− ((2233)) 6622,,116622 33,,443355 552299 −− −− −− 33,,996644 1100,,774433 116677 −− 1100,,991100 7777,,003366 57,974 1,629 (203) (72) − − 148 59,476 4,755 (406) (914) − − 3,435 10,539 204 − 10,743 73,654 (1) Also includes foreign exchange rate movements that are not considered material. The table above provides the risk-weighted assets movements by key drivers underlying the different risk categories. The “Book size” item reflects organic changes in book size and composition (including new loans and maturing loans). RWA movements attributable to book size include increases or decreases in exposures, measured by exposure at default, assuming a stable risk profile. The “Book quality” item is the Bank’s best estimate of changes in book quality related to experience, such as underlying customer behaviour or demographics, including changes resulting from model recalibrations or realignments and also including risk mitigation factors. The “Model updates” item is used to reflect implementations of new models, changes in model scope, and any other change applied to address model malfunctions. During the quarter ended July 31, 2019, the Bank updated its models for credit card portfolios and energy sector loans. The “Methodology and policy” item presents the impact of changes in calculation methods resulting from changes in regulatory policies as a result, for example, of new regulations. During the quarter ended January 31, 2019, the Bank implemented the SA-CCR rules for measuring counterparty credit risk under the standardized approach, as required by the BCBS. During the quarter ended October 31, 2019, the Bank refined the risk-weight calculation method for derivative financial instruments. 56 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Capital Management AAllllooccaattiioonn ooff EEccoonnoommiicc CCaappiittaall aanndd RReegguullaattoorryy RRWWAA Economic capital is an internal measure that the Bank uses to determine the capital it needs to remain solvent and to pursue its business operations. Economic capital takes into consideration the credit, market, operational, business and other risks to which the Bank is exposed as well as the risk diversification effect among them and among the business segments. Economic capital thus helps the Bank to determine the capital required to protect itself against such risks and ensure its long-term viability. The by-segment allocation of economic capital and regulatory RWA was done on a stand-alone basis before attribution of goodwill and intangible assets. The method used to assess economic capital is reviewed regularly in order to accurately quantify these risks. The Risk Management section of this MD&A provides comprehensive information about the main types of risk. The “Other risks” presented below include risks such as business risk and structural interest rate risk in addition to the benefit of diversification among types of risk. AAllllooccaattiioonn ooff RRiisskkss bbyy BBuussiinneessss SSeeggmmeenntt As at October 31, 2019 (millions of Canadian dollars) NNAATTIIOONNAALL BBAANNKK OOFF CCAANNAADDAA BBuussiinneessss sseeggmmeennttss PPeerrssoonnaall aanndd CCoommmmeerrcciiaall WWeeaalltthh MMaannaaggeemmeenntt FFiinnaanncciiaall MMaarrkkeettss Banking services Credit services Financing Full-service brokerage Private banking Direct brokerage MMaajjoorr aaccttiivviittiieess Investment solutions Investment solutions Insurance Administrative and trade execution services Transaction products for advisors Trust and estate services Equities, Fixed-income, commodities and foreign exchange Corporate banking Investment banking UU..SS.. SSppeecciiaallttyy FFiinnaannccee aanndd IInntteerrnnaattiioonnaall OOtthheerr U.S. Specialty Finance • Credigy International • ABA Bank (Cambodia) • Minority interests in emerging markets Treasury activities Liquidity management Bank funding Asset and liability management Corporate units EEccoonnoommiicc ccaappiittaall bbyy ttyyppee ooff rriisskk RRiisskk--wweeiigghhtteedd aasssseettss Credit Market Operational Other risks TToottaall Credit Market Operational TToottaall 1,708 – 390 217 22,,331155 31,851 – 4,692 3366,,554433 Credit Market Operational Other risks TToottaall Credit Market Operational TToottaall 105 – 242 414 776611 1,811 – 2,917 44,,772288 Credit Market Operational Other risks TToottaall Credit Market Operational TToottaall 2,199 201 308 340 33,,004488 22,783 4,147 3,764 3300,,669944 Credit Market Operational Other risks TToottaall Credit Market Operational TToottaall 521 10 82 42 665555 6,588 – 1,024 77,,661122 Credit Market Operational Other risks TToottaall Credit Market Operational TToottaall 63 (16) (73) (84) ((111100)) 4,221 129 (888) 33,,446622 National Bank of Canada 57 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis RRiisskk MMaannaaggeemmeenntt IInn tthhiiss sseeccttiioonn ooff tthhee MMDD&&AA,, ggrreeyy--sshhaaddeedd tteexxtt aanndd ttaabblleess mmaarrkkeedd wwiitthh aann aasstteerriisskk ((**)) aarree iinntteeggrraall ppaarrttss ooff tthhee ccoonnssoolliiddaatteedd ffiinnaanncciiaall ssttaatteemmeennttss.. TThheeyy rreepprreesseenntt tthhee BBaannkk’’ss oobbjjeeccttiivveess,, tthhee rriisskk mmaannaaggeemmeenntt ppoolliicciieess aanndd pprroocceedduurreess,, aanndd tthhee mmeetthhooddss aapppplliieedd ttoo mmeeaassuurree ccrreeddiitt rriisskk,, mmaarrkkeett rriisskk aass wweellll aass lliiqquuiiddiittyy aanndd ffuunnddiinngg rriisskk,, aass rreeqquuiirreedd bbyy IIFFRRSS 77 –– FFiinnaanncciiaall IInnssttrruummeennttss:: DDiisscclloossuurreess.. Risk-taking is intrinsic to a financial institution’s business. The Bank views risk as an integral part of its development and the diversification of its activities. It advocates a risk management approach consistent with its business strategy. The Bank voluntarily exposes itself to certain risk categories, particularly credit and market risk, in order to generate revenue. It assumes certain risks that are inherent to its activities—to which it does not choose to expose itself—and that do not generate revenue, i.e., mainly operational risks. The purpose of sound and effective risk management is to provide reasonable assurance that incurred risks do not exceed acceptable thresholds, to control the volatility in the Bank's results, and to ensure that risk-taking contributes to the creation of shareholder value. RRiisskk MMaannaaggeemmeenntt FFrraammeewwoorrkk Risk is rigorously managed. Risks are identified, measured and controlled to achieve an appropriate balance between the returns obtained and the risks assumed. Consequently, decision-making is supported by risk assessments and management processes that are consistent with the Bank’s risk appetite and by prudent levels of capital and liquidity. Despite the exercise of stringent risk management and the mitigation measures in place, risk cannot be suppressed entirely, and residual risks may occasionally cause significant losses. The Bank has developed guidelines that support sound and effective risk management: • • • • • risk is everyone’s business: business units, risk management and oversight functions as well as Internal Audit play an important role in ensuring a risk management framework is in place; client-centric: having quality information is key to understanding clients, effectively managing risk, and delivering excellent client service; enterprise-wide: an integrated view of risk is the basis for sound and effective risk management and decision-making by management; human capital: the Bank’s employees are engaged, experienced and have a high level of expertise; their curiosity supports continuous development and their rigour ensures that risk management is built into the corporate culture; fact-based: good risk management relies heavily on common sense and good judgment and on advanced systems and models. RRiisskk AAppppeettiittee Risk appetite represents how much risk an organization is willing to assume to achieve its business strategy. The Bank defines its risk appetite by setting tolerance thresholds, by aligning those thresholds with its business strategy, and by integrating risk management throughout its corporate culture. Risk appetite is built into decision-making processes as well as into strategic, financial and capital planning. The Bank’s risk appetite framework consists of principles, statements, metrics as well as targets and is reinforced by policies and limits. When setting its risk appetite targets, the Bank considers regulatory constraints and the expectations of stakeholders, in particular customers, employees, the community, shareholders, regulatory agencies, governments, and rating agencies. The risk appetite framework is defined by the following principles and statements: The Bank’s brand, reputation and long-term viability are at the centre of our decisions, which demand: • • • • a strong credit rating to be maintained; a strong capital and cash position; rigorous management of regulatory compliance risk, including sales practices; zero tolerance for negligence in information security. The Bank understands the risks taken; they are aligned with our business strategy and translate into: • • • a risk-reward balance; a stable risk profile; a strategic level of concentration aligned with approved targets. The Bank’s transformation and simplification plan is being carried out without compromising rigorous risk management, which is reflected in: • • a low tolerance to operational and reputation risk; operational and information systems stability, both under normal circumstances and in times of crisis. 58 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management The Bank’s management and business units are involved in the process for setting the risk appetite and are responsible for adequately monitoring the chosen risk indicators. These needs are assessed by means of the enterprise strategic planning process. The risk indicators are reported on a regular basis to ensure an effective alignment of the Bank’s risk profile to its risk appetite; otherwise, appropriate actions could be taken. Additional information on the key credit, market and liquidity risk indicators monitored by the Bank’s management is presented on the following pages. EEnntteerrpprriissee--WWiiddee SSttrreessss TTeessttiinngg As part of a more extensive process aimed at ensuring that the Bank maintains adequate capital levels commensurate with its business strategy and risk appetite, an enterprise-wide stress testing program is in place at the Bank. Stress testing can be defined as a risk management method that assesses the potential effects—on the Bank’s financial position, capital and liquidity—of a series of specified changes in risk factors, corresponding to exceptional but plausible events. The program supports management’s decision-making process by identifying potential vulnerabilities for the Bank as a whole that are considered in setting limits as well as in longer term business planning. The scenarios and stress test results are reviewed by a group of stress testing experts, a stress testing oversight group and the Global Risk Committee (GRC) and are approved by the Board. For additional information, see the Stress Testing and Crisis Scenarios sections of this MD&A applicable to credit risk, market risk, and liquidity risk. IInnccoorrppoorraattiioonn ooff RRiisskk MMaannaaggeemmeenntt IInnttoo tthhee CCoorrppoorraattee CCuullttuurree The Bank’s management continually promotes risk management through internal communications. A balanced approach is advocated, whereby business development initiatives are combined with a constant focus on sound and effective risk management. In particular, risk is taken into consideration when preparing the segments’ business plans, when analyzing strategic initiatives and when launching new products. The Bank’s risk management is also strengthened by incentive compensation programs that are structured to reflect the Bank’s risk appetite. In addition, Internal Audit carries out an evaluation of the culture through its mandates. Finally, all employees must complete mandatory annual regulatory compliance training focused on the Bank’s Code of Conduct and Ethics and on anti-money laundering and anti-terrorist financing (AML/ATF) efforts. Risk management training is also offered across all segments of the Bank. Furthermore, to ensure the effectiveness of the existing risk management framework, the Bank has defined clear roles and responsibilities by reinforcing the concept of the three lines of defence. The Governance Structure section presented on the following pages defines this concept as well as the roles and responsibilities at all levels of the organization. FFiirrsstt LLiinnee ooff DDeeffeennccee Risk Owner Business Units SSeeccoonndd LLiinnee ooff DDeeffeennccee Independent Oversight Risk Management and Oversight Functions TThhiirrdd LLiinnee ooff DDeeffeennccee Independent Assurance Internal Audit • Identify, manage, assess and mitigate risks in day-to-day activities. policies and standards. • Oversee risk management by setting • Provide the Board and management with • Ensure activities are in alignment with the Bank’s risk appetite and risk management policies. • Provide independent oversight of management practices and an independent challenge of the first line of defence. • Promote sound risk management at the Bank. • Monitor and report on risk. independent assurance as to the effectiveness and efficiency of the main governance, risk management, and internal control processes and systems. • Provide recommendations and advice to promote the Bank’s long-term financial strength. National Bank of Canada 59 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management GGoovveerrnnaannccee SSttrruuccttuurree** The following diagram shows the Bank’s overall governance architecture and the governance relationships established for risk management. SSHHAARREEHHOOLLDDEERRSS EElleecctt AAppppooiinntt BBOOAARRDD OOFF DDIIRREECCTTOORRSS AAppppooiinnttss aanndd mmaannddaatteess IInnddeeppeennddeenntt AAuuddiittoorr RReeppoorrttss ttoo AAuuddiitt CCoommmmiitttteeee RRiisskk MMaannaaggeemmeenntt CCoommmmiitttteeee HHuummaann RReessoouurrcceess CCoommmmiitttteeee CCoonndduucctt RReevviieeww aanndd CCoorrppoorraattee GGoovveerrnnaannccee CCoommmmiitttteeee RReeppoorrtt ttoo RReeppoorrtt ttoo AAddvviisseess Internal Audit Oversight Function Finance Oversight Function Risk Management Oversight Function RReeppoorrttss ttoo Global Risk Committee Compliance Oversight Function Compensation Risk Oversight Working Group RReeppoorrtt ttoo Financial Markets Risk Committee Operational Risk Management Committee Enterprise- Wide Risk Management Committee AAppppooiinnttss PPrreessiiddeenntt aanndd CCEEOO AAppppooiinnttss OOffffiiccee ooff tthhee PPrreessiiddeenntt RReeppoorrtt ttoo BBuussiinneessss UUnniittss The Board of Directors (Board)(1) The Board examines and approves the Bank’s overall risk philosophy and risk appetite, acknowledges and understands the main risks faced by the Bank, and makes sure appropriate systems are in place to effectively manage and control those risks. In addition, the Board ensures that the Bank operates in accordance with environmental, social and governance (ESG) practices and strategies. It performs its mandate both directly and through its committees, particularly the Audit Committee, the Risk Management Committee, the Human Resources Committee, and the Conduct Review and Corporate Governance Committee. The Audit Committee(1) The Audit Committee oversees the work of the Bank’s internal auditor and independent auditor; ensures the Bank's financial strength; establishes the Bank’s financial reporting framework, analysis processes and internal controls; and reviews any reports of irregularities in accounting, internal controls, and audit. The Risk Management Committee (RMC)(1) The Risk Management Committee examines the risk appetite framework and recommends it to the Board for approval. It approves the main risk management policies and risk tolerance limits. It ensures that appropriate resources, processes and procedures are in place to properly and effectively manage risk on an ongoing basis. Finally, it monitors the risk profile and risk trends of the Bank’s activities and ensures alignment with the risk appetite. The Human Resources Committee(1) The Human Resources Committee examines and approves the Bank’s total compensation policies and programs, taking into consideration the risk management framework, and recommends their approval to the Board. It sets annual objectives and key performance indicators for the President and Chief Executive Officer, recommends that they be approved by the Board, and evaluates the performance and achievements against these objectives and indicators. It recommends to the Board that it approves the compensation of the President and Chief Executive Officer, of the members of the Office of the President, and of the heads of the oversight functions. It also periodically reviews and examines the management succession plan. The Conduct Review and Corporate Governance Committee(1) The Conduct Review and Corporate Governance Committee ensures that the Bank maintains sound practices that comply with legislation and best practices, particularly in the area of ESG responsibilities. It must ensure that the directors are qualified by evaluating the performance and effectiveness of the Board and its members and by planning director succession and the composition of the Board. The Committee ensures that mechanisms are in place to prevent prohibited financial transactions between the Bank and related parties. (1) Additional information about the Bank’s governance architecture can be found in the Management Proxy Circular for the 2020 Annual Meeting of Holders of Common Shares, which will soon be available on the Bank’s website at nbc.ca and on SEDAR’s website at sedar.com. The mandates of the Board and its committees are available in their entirety at nbc.ca. 60 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management The Office of the President and the Bank’s Management Composed of the President and Chief Executive Officer and the officers responsible for the Bank’s main functions and business units, the Office of the President ensures that risk management is effective and aligned with the Bank’s pursuit of its objectives and strategies. The Bank’s management promotes the integration of risk management into its corporate culture and manages the primary risks facing the Bank. The Internal Audit Oversight Function The Internal Audit Oversight Function is the third line of defence in the risk management framework. It is responsible for providing the Bank’s Board and management with objective, independent assurance as well as advice on the effectiveness and efficiency of the main governance, risk management, and internal control processes and systems and for making recommendations and providing advice to promote the Bank’s long-term strength. The Finance Oversight Function The Finance Oversight Function is responsible for optimizing management of financial resources and ensuring sound governance of financial information. It helps the business segments and support functions with their financial performance, ensures compliance with regulatory requirements, and carries out the Bank’s reporting to shareholders and the external reporting of the various units, entities and subsidiaries of the Bank. It is responsible for capital management and actively participates in the activities of the Asset/Liability Management Committee. The Risk Management Oversight Function The Risk Management Oversight Function is responsible for identifying, assessing and monitoring—independently and using an integrated approach—the various risks to which the Bank is exposed and for promoting a risk management culture within the Bank. The Risk Management team helps the Board and management understand and monitor the main risks. The unit also develops, maintains and communicates the risk appetite framework while overseeing the integrity and reliability of risk measures. The Compliance Oversight Function The Compliance Oversight Function is responsible for implementing a Bank-wide regulatory compliance risk management framework by relying on an organizational structure that includes functional links to the main business segments. It also exercises independent oversight and evaluation of the compliance of the Bank and its subsidiaries with standards and policies on regulatory compliance risk. The Compensation Risk Oversight Working Group The working group that monitors compensation-related risks supports the Human Resources Committee in its compensation risk oversight role. It is a three- member group consisting of the Executive Vice-President, Risk Management; the Chief Financial Officer and Executive Vice-President, Finance; and the Executive Vice-President, Employee Experience. The working group helps to ensure that compensation policies and programs do not unduly encourage senior management members, officers, material risk takers or bank employees to take risks beyond the Bank’s risk tolerance thresholds. As part of that role, it ensures that the Bank is adhering to the Corporate Governance Guidelines issued by OSFI and to the Principles for Sound Compensation Practices issued by the Financial Stability Board, for which the Canadian implementation and monitoring is conducted by OSFI. The Board’s Risk Management Committee also reviews the reports presented by the working group to the Human Resources Committee. The Global Risk Committee (GRC) The Global Risk Committee defines the parameters of the policies that determine risk tolerance and the overall risk strategy, for the Bank and its subsidiaries as a whole, and sets limits as well as tolerance and intervention thresholds enabling the Bank to properly manage the main risks to which it is exposed. The committee approves and monitors all large credit facilities. It also recommends for Board approval the Bank’s risk philosophy, risk appetite and risk profile management. The Operational Risk Management Committee, the Financial Markets Risk Committee, and the Enterprise-Wide Risk Management Committee presented in the governance structure diagram are the primary committees reporting to the Global Risk Committee. The Global Risk Committee also carries out its mandate through the Senior Complex Valuation Committee, the Committee on Banks, the Models Oversight Committee and the Product and Activity Review Committees. The Business Units As the first line of defence, the business units manage risks related to their operations within established limits and in accordance with risk management policies by identifying, analyzing and understanding the risks to which they are exposed and implementing risk mitigation mechanisms. The management of these units must ensure that employees are adhering to current policies and limits. National Bank of Canada 61 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Risk Management RRiisskk MMaannaaggeemmeenntt PPoolliicciieess The risk management policies and related standards and procedures set out responsibilities, define and describe the main activity-related risks, specify the requirements that the business units must meet in assessing and managing risk, stipulate the authorization process for risk-taking and set the risk limits to be adhered to. These policies cover the main risks in the Bank, are reviewed regularly to ensure they are still relevant given changes in the markets and in the business plans of the Bank’s business units, and apply to the entire Bank and its subsidiaries. Other policies, standards, and procedures complement the main policies and cover more specific aspects of risk management such as business continuity, the launch of new products, initiatives or activities, or financial instrument measurement. GGoovveerrnnaannccee ooff MMooddeell RRiisskk MMaannaaggeemmeenntt The Bank makes increasing use of models to guide enterprise-wide risk management, financial markets strategy, economic and regulatory capital allocation, global credit risk management, wealth management and profitability measures. Models have in fact become a standard in risk management. This stresses the growing importance of model risk for banks, hence the implementation of a rigorous model risk management process to ensure models can be used appropriately and efficiently to manage risks. The key components of the Bank’s model risk management governance framework are as follows: the model risk management policies and standards, the model vetting group, and the Models Oversight Committee. The policies and standards set the rules and principles applicable to developing and vetting models. The scope of models covered is wide, ranging from market risk pricing models and automated credit decision-making models to the business risk capital model, including models used for regulatory capital and stressed capital purposes, IFRS 9 models, and financial-crime models. The framework also includes more advanced artificial intelligence models. One of the cornerstones of the Bank’s policies is the general principle that all models deemed important for the Bank or used for regulatory capital purposes require heightened lifecycle monitoring and independent vetting. All models used by the Bank are therefore classified in terms of risk level (low, medium, or high). Based on this classification, the Bank applies strict guidelines regarding the requirements for model development and documentation, independent review thereof, performance monitoring thereof, and minimum review frequency. The Bank believes that the best defence against “model risk” is the implementation of a robust development and validation framework. IInnddeeppeennddeenntt OOvveerrssiigghhtt bbyy tthhee CCoommpplliiaannccee SSeerrvviiccee Compliance is an independent oversight function within the Bank. Its Senior Vice-President and Chief Compliance Officer has direct access to the RMC and to the President and Chief Executive Officer and can communicate directly with officers and directors of the Bank and of its subsidiaries and foreign centres. The Senior Vice-President, Chief Compliance Officer and Chief Anti-Money Laundering Officer regularly meets with the Chair of the RMC (with whom she has a direct reporting relationship) in the absence of management, to review matters on the relationship between the Compliance Service and the Bank’s management and on access to the information required. Business unit managers must oversee the implementation of mechanisms for the daily control of regulatory compliance risks arising from the operations under their responsibility. Compliance exercises independent oversight in order to assist managers in effectively managing these risks and to obtain reasonable assurance that the Bank is compliant with the regulatory requirements in effect where it does business, both in Canada and internationally. IInnddeeppeennddeenntt AAsssseessssmmeenntt bbyy IInntteerrnnaall AAuuddiitt Internal Audit is an independent, objective function within the Bank. Through the Audit Committee, it provides assurance to management and the Board as to the Bank’s level of command over its activities, advises on how to improve those activities, and contributes to the creation of added value. It helps the Bank to achieve its objectives by applying a systematic, methodical approach for assessing and improving the effectiveness of the design and operation of its main governance, risk management and internal control processes and systems and formulates recommendations to promote the Bank’s long-term strength. Whenever recommendations are issued, Internal Audit is mandated to independently evaluate the appropriateness of the measures taken by managers to resolve issues and then to ensure rigorous follow-up. The Senior Vice-President, Internal Audit reports to the Chair of the Audit Committee. Her independence is ensured through an administrative relationship with the President and Chief Executive Officer, and she may, at any time, call an unscheduled Audit Committee meeting. Internal Audit has unrestricted access to all business segments, corporate units and subsidiaries of the Bank. 62 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management TToopp aanndd EEmmeerrggiinngg RRiisskkss Top and emerging risks are risks that could have a material adverse effect on the Bank’s financial results, reputation, or long-term business model and strategy. The Bank’s processes are designed to detect and assess these risks as early as possible so that appropriate mitigating strategies can be applied. Managing risk requires a solid understanding of every type of risk found across the Bank. The Bank therefore maintains an inventory of the main risks and the emerging risks to which it is exposed. Doing so makes it easier to identify and effectively manage risks. In the normal course of business, the Bank is primarily exposed to the following risks. Credit risk Market risk Funding and liquidity risk Operational risk Regulatory compliance risk Reputation risk Strategic risk Environmental risk The Bank is also exposed to other significant and emerging risks, as defined below. RRiisskk TTrreenndd DDeessccrriippttiioonn IInnffoorrmmaattiioonn sseeccuurriittyy aanndd ccyybbeerrsseeccuurriittyy Technology, which is now omnipresent in our daily lives, is at the heart of banking services and has become the main driver of innovation in the financial sector. While this digital transformation meets the growing needs of customers while enhancing the operational efficiency of institutions, it nevertheless comes with information security and cybersecurity risks. The personal information and financial data of financial institution customers are prime targets for criminals. These criminals, who are increasingly well organized and employing ever more sophisticated schemes, try to use technology to steal information. Faced with a resurgence of cyberthreats and the sophistication of cybercriminals, the Bank is exposed to the risks associated with data breaches, malicious software, unauthorized access, hacking, phishing, identity theft, intellectual property theft, asset theft, industrial espionage, and possible denial of service due to activities causing network failures and service interruptions. Cyberattacks, as with system breaches or interruptions that support the Bank and its customers, could cause client attrition; financial loss; inability of clients to do their banking; non-compliance with privacy legislation or any other laws in effect; legal disputes; fines; penalties or regulatory action; reputational damage; compliance costs, corrective measures, investigative, or restoration costs; cost hikes to maintain and upgrade technological infrastructures and systems, all of which could affect the Bank’s operating results or financial position. It is also possible for the Bank to be unable to prevent or implement effective preventive measures against every potential cyberthreat, as the tactics used are multiplying, change frequently, come from a wide range of sources and are increasingly sophisticated. Within this context, the Bank works to ensure the integrity and protection of its systems and information. The Bank reaffirms its commitment to continuous improvement in the area of information security, the ultimate goal being to protect its customers and maintain their trust. Along with its partners in the financial sector and with the regulatory authorities, the Bank is committed to making a sustained effort to mitigate technology risks. Measures specifically directed at anticipating this type of threat include the formation of multidisciplinary teams comprising cybersecurity and fraud prevention specialists. The Bank is also pursuing initiatives under its own cybersecurity program aimed at adapting its protection, surveillance, detection and response capabilities in response to changing threats. A governance and accountability structure has also been established to support decision-making based on sound risk management. The RMC is regularly informed of cybersecurity trends and developments and of lessons learned from operational incidents that have occurred in other large organizations in order to gain a better understanding of potential risks, particularly risks related to cybersecurity and the protection of personal information. National Bank of Canada 63 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Risk Management RRiisskk TTrreenndd DDeessccrriippttiioonn The current economic expansion in the United States has become the longest since World War II, and this has many observers wondering whether a recession is imminent. Clearly the power struggle between China and the United States over trade has given cause for concern. The longer that this climate of uncertainty persists, the greater the likelihood that business leaders will delay investment and hiring plans as they wait for more clarity on the new rules of the game. Activity in the global manufacturing sector slowed significantly in 2019 but, fortunately, the service sector continued to perform well. Some emerging countries are particularly vulnerable to rising protectionism, given the important role played by the manufacturing sector in their economies. In addition, in recent years, U.S.-dollar debt levels in certain countries have risen sharply, and an appreciation of the U.S. dollar could compromise the creditworthiness of certain borrowers. In Europe, geopolitical risks are abound, including the possibility that the United Kingdom will leave the European Union without an agreement, political uncertainty in Italy, and a potential resurgence of the yellow vest movement in France. Given the exceptional monetary measures taken by central banks combined with mild economic growth and low inflation, long-term interest rates have remained low for a long time in the advanced economies. Such a situation may have prompted market participants to adopt excessive risk-taking strategies in search of higher returns, which may have adverse effects should the economy falter or interest rates rise. Therefore, the Bank is remaining vigilant and continuing to rely on its strong risk management framework to identify, assess, and mitigate risk and to remain within the risk appetite limits. The Canadian economy is showing encouraging signs in a gloomy global economic environment. The labour market has been resilient despite disappointing economic growth in the fourth quarter of 2018 and in the first quarter of 2019. A strong rebound in the second quarter confirmed that this weakness was only temporary, particularly in the energy sector. In the wake of the sharp drop in oil prices in 2014-2015, producers have adapted to the new environment, but if oil and gas prices were to fall even further, producers would face obstacles that would affect their repayment capacity and credit quality. The fossil fuel-producing provinces continue to idle and their unemployment rates remain high. Sound economic and financial conditions in the three largest provinces (Ontario, Quebec and British Columbia) continue, however, to support a credit environment favourable to the loan portfolios. Still, Canada remains vulnerable to a deteriorating global economic backdrop, which threatens to erode job creation and disposable household income—even more so given high debt levels. While the Vancouver and Toronto real estate markets are showing some stability after a slowdown, they remain vulnerable to a less favourable economic environment due to high prices. An unexpected jump in inflation also represents a risk to the Canadian economy to the extent that it could prompt the U.S. Federal Reserve or the Bank of Canada to scale back its monetary accommodation. Should this occur, real estate assets, among others, would be vulnerable to a price correction. The Bank monitors international developments that may affect the Canadian economy. Even though Canada has reached a trade agreement with its North American partners, American protectionism continues to pose a risk to Canada. For example, the U.S. administration did not hesitate to threaten Mexico with tariffs during the migrant dispute, even though a trade agreement had just been reached. In addition, the current Chinese-American conflict may gradually lead to the development of two quite separate supply chains. Should this occur, Canadian companies that choose to focus on the U.S. market may be denied access to the Chinese market, while those that choose the Chinese market may have more difficulty gaining market share in the United States. These uncertainties may significantly destabilize certain sectors, and the Bank has responded by continuing to monitor market developments and remaining vigilant in line with its risk tolerance policy. EEccoonnoommiicc aanndd ggeeooppoolliittiiccaall rriisskk 64 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management RRiisskk TTrreenndd DDeessccrriippttiioonn RReelliiaannccee oonn tteecchhnnoollooggyy aanndd tthhiirrdd ppaarrttiieess EEnnvviirroonnmmeennttaall,, ssoocciiaall aanndd ggoovveerrnnaannccee ((EESSGG)) aapppprrooaacchh aanndd cclliimmaattee cchhaannggee TTeecchhnnoollooggiiccaall iinnnnoovvaattiioonn aanndd ccoommppeettiittiioonn The Bank is reliant on technology, as clients are seeking greater access to products and services on a variety of platforms that must support substantial data volumes. The fast pace of technological change combined with both client and competitive pressures require significant and sustained investment in technology. Inadequate implementation of technological improvements or new products or services could significantly affect the Bank’s ability to serve and retain clients. Third parties provide essential components of the Bank’s technological infrastructure such as Internet connections and access to network and other communications services. The Bank also relies on the services of third parties to support business processes and to handle certain IT activities. In some cases, these business relationships require the sharing of confidential information. An interruption of these services or a breach of security could have an unfavourable impact on the Bank’s ability to provide products and services to its customers and to conduct business, not to mention the impact it would have on the Bank’s reputation. To mitigate this risk, the Bank has a third-party risk management framework wherein information security, financial health, and performance are validated before any agreements are reached and throughout the life of the agreements. It also includes business continuity plans, which are tested periodically to ensure their effectiveness in times of crisis. Despite these preventive measures and the efforts deployed by the Bank’s teams to manage third parties, there remains a possibility that certain risks will materialize. In such cases, the Bank would then rely on the contingency and mitigation measures established in collaboration with the third parties. The Bank is aware of the significance of third-party-related risks and continues to develop its practices in this regard. In recent years, the environmental, social and governance (ESG) approach has not been a major concern for customers and investors. Today, perceptions have changed, and many stakeholders now agree that these issues have become a current concern and could affect corporate profitability in the near future. The Bank has therefore adopted ESG principles and supported a variety of sustainable development initiatives. The increased focus on ESG issues has not been prompted by any specific laws or regulations requiring greater disclosure but rather by a desire for transparency and a broader understanding of their impact on corporate reputation and finances. Pressures from customers, investors, environmental groups and, more recently, non-financial bodies have also prompted financial institutions to consider the ways in which the ESG approach could affect their operations in terms of reputation risk, strategy, and portfolio management and what they can do to apply principles of responsible citizenship. In recent years there has been a growing emphasis on environmental and climate issues. A financial disclosure framework has been published, as well as various climate change guides for banks, insurers and portfolio managers. Considerable change is occurring in terms of commitment to and implementation of such frameworks and guides. In addition, the Bank of Canada’s annual Financial System Review addressed issues such as the interrelationships between the environment, the economy, and the financial system. This is particularly true in Canada, where resources play a vital role in our economy and where the natural environment is a defining feature of our identity. Although no specific requirements have been published, we will continue to closely monitor developments in this area and all their implications for the Bank. The Bank’s financial performance depends on its ability to develop and market new and innovative products and services, adopt and develop new technologies that help differentiate its products and services and generate cost savings, and market these new products and services at the right time and at competitive prices. Failure to properly review critical changes within the business before and during the implementation and deployment of key technological systems or failure to align client expectations with the Bank’s client commitments and operating capabilities could adversely affect the Bank’s operating results or financial position. In addition, the level of competition in the Bank’s markets has an impact on its performance. Retaining clients hinges on several factors, including the prices of products and services, quality of service, and changes to the products and services offered. National Bank of Canada 65 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Risk Management OOtthheerr FFaaccttoorrss TThhaatt CCaann AAffffeecctt FFuuttuurree RReessuullttss International Risks Through the operations of some of its units (mainly its New York and London offices) and subsidiaries in Canada and abroad (in particular, Credigy Ltd., NBC Global Finance Limited, and Advanced Bank of Asia Limited), the Bank is exposed to risks arising from its presence in international markets and foreign jurisdictions. While these risks do not affect a significant proportion of the Bank’s portfolios, their impact must not be overlooked, especially those that are of a legal or regulatory nature. Such risk can be particularly high when the exposure is in a territory where the enforceability of agreements signed by the Bank is uncertain, in countries and regions facing political or socio-economic disturbances, or in countries that may be subject to international sanctions. Generally speaking, there are many ways in which the Bank may be exposed to the risks posed by other countries, not the least of which being foreign laws and regulations. In all such situations, it is important to consider what is referred to as “country risk.” Country risk affects not only the activities that the Bank carries out abroad but also the business that it conducts with non-resident clients as well as the services it provides to clients doing business abroad, such as electronic funds transfers, international products and transactions from Canada in foreign currencies. As part of its activities, the Bank must adhere to anti-money laundering and anti-terrorist financing (AML/ATF) regulatory requirements in effect in each jurisdiction where it conducts business. It must also comply with the requirements pertaining to current international sanctions in these various jurisdictions. Money laundering and terrorist financing is a financial, regulatory and reputation risk. For additional information, see the Regulatory Compliance Risk Management section. The Bank is exposed to financial risks outside Canada and the United States primarily through its interbank transactions on international financial markets or through international trade finance activities. This geographic exposure represents a moderate proportion of the Bank’s total risk. The geographic exposure of loans is disclosed in the quarterly Supplementary Financial Information report available on the Bank’s website at nbc.ca. To control country risk, the Bank sets credit concentration limits by country and reviews and submits them to the Board for approval upon renewal of the Credit Risk Management Policy. These limits are based on a percentage of the Bank’s regulatory capital, in line with the level of risk represented by each country, particularly emerging countries. The risk is rated using a classification mechanism similar to the one used for credit default risk. In addition to the country limits, authorization caps and limits are established, as a percentage of capital, for the world’s high-risk regions, i.e., essentially all regions except for North America, Western European countries and the developed countries of Asia. Acquisitions The Bank’s ability to successfully complete an acquisition is often conditional on regulatory approval, and the Bank cannot be certain of the timing or conditions of regulatory decisions. Acquisitions could affect future results should the Bank experience difficulty integrating the acquired business. If the Bank does encounter difficulty integrating an acquired business, maintaining an appropriate governance level over the acquired business, or retaining key officers within the acquired business, these factors could prevent the Bank from realizing expected revenue growth, cost savings, market share gains and other projected benefits of the acquisition. Intellectual Property The Bank protects the intellectual property developed by its employees in connection with their duties. However, in some cases, it may have a more limited ability to acquire intellectual property rights. Moreover, the intellectual property rights acquired by the Bank provide no guarantees that they will be effective in deterring or preventing a third party from misappropriating intellectual property or providing a defense against the misappropriation of intellectual property. Moreover, the goods and services developed by the Bank are provided in a competitive market where third parties could hold intellectual property rights prior to those held by the Bank. In such circumstances, there is no guarantee that the Bank will successfully provide a defense against an infringement claim, that it will be able to modify its goods and services to avoid infringing upon third party rights or that it will obtain a licence with commercially acceptable conditions. Ability to Attract and Retain Key Officers The Bank’s future performance depends largely on its ability to attract and retain key officers. There is intense competition for the best people in the financial services industry, and there is no assurance that the Bank, or any entity it acquires, will be able to continue to attract and retain key officers. Judicial and Regulatory Proceedings The Bank takes reasonable measures to comply with the laws and regulations in effect in the jurisdictions where it operates. Should these measures prove ineffective, the Bank could be subject to judicial or regulatory decisions resulting in fines, damages, or other costs or to restrictions likely to adversely affect its operating results or its reputation. The Bank may also be subject to litigation in the normal course of business. Although the Bank establishes provisions for the measures it is subject to under accounting requirements, actual losses resulting from such litigation could differ significantly from the recognized amounts, and unfavourable outcomes in such cases could have a significant adverse effect on the Bank’s operating results. The resulting reputational damage could also affect the Bank’s future business prospects. For additional information, see Note 26 to the consolidated financial statements. 66 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Accounting Policies, Methods and Estimates Used by the Bank The accounting policies and methods used by the Bank determine how the Bank reports its financial position and operating results and require management to make estimates or rely on assumptions about matters that are inherently uncertain. Any changes to these estimates and assumptions may have a significant impact on the Bank’s operating results and financial position. Other Factors Other factors that could affect the Bank’s future results include amendments to tax legislation, unexpected changes in consumer spending and saving habits, the timely development and launch of new products and services, the ability to successfully align its organizational structure, resources and processes, the ability to activate a business continuity plan within a reasonable time, the potential impact of international conflicts or natural catastrophes on the Bank’s activities, and the Bank’s ability to foresee and effectively manage the risks associated with these factors through rigorous risk management. CCrreeddiitt RRiisskk Credit risk is the risk of incurring a financial loss if an obligor does not fully honour its contractual commitments to the Bank. Obligors may be debtors, issuers, counterparties or guarantors. Credit risk is the most significant risk facing the Bank in the normal course of business. The Bank is exposed to credit risk not only through its direct lending activities and transactions but also through commitments to extend credit, letters of guarantee, letters of credit, over-the-counter derivatives trading, debt securities, securities purchased under reverse repurchase agreements, deposits with financial institutions, brokerage activities, and transactions carrying a settlement risk for the Bank such as irrevocable fund transfers to third parties via electronic payment systems. GGoovveerrnnaannccee A policy framework centralizes the governance of activities that generate credit risk for the Bank and is supplemented by a series of subordinate internal policies and standards. These policies and standards address specific management issues such as credit limits, collateral requirements and risk quantification or issues that provide more thorough guidance for given business segments. For example, the institutional activities of the Bank and its subsidiaries on financial markets and international commercial transactions are governed by business unit directives that set out standards adapted to the specific environment of these activities. This also applies to retail brokerage subsidiaries. In isolated cases, a business unit or subsidiary may have its own credit policy, and that policy must always fall within the spirit of the Bank’s policy framework and be reviewed and approved by the management of the Risk Management Group. The Risk Management Group defines the scope of the universe of subsidiaries carrying significant credit risks and the magnitude of the risks incurred. Credit risk is controlled through a rigorous process that comprises the following elements: • • • • • • • • • credit risk rating and assessment; economic capital assessment; stress testing and crisis scenarios; credit granting process; revision and renewal process; risk mitigation; follow-up of monitored accounts and recovery; counterparty risk assessment; settlement risk assessment. Reporting Every quarter, an integrated risk management report is presented to senior management and the RMC. It presents changes in the credit portfolio and highlights on the following matters: • • • • • credit portfolio volume growth by business segment; a breakdown of the credit portfolio according to various criteria for which concentration limits have been set; changes in allowances for credit losses; changes in impaired loans; follow-up of monitored accounts. National Bank of Canada 67 National Bank of Canada2019 Annual ReportManagement’s Discussion and Analysis Risk Management CCrreeddiitt RRiisskk RRaattiinngg aanndd AAsssseessssmmeenntt Before a sound and prudent credit decision can be made, the obligor’s or counterparty’s credit risk must be accurately assessed. This is the first step in processing credit applications. Each application is analyzed and assigned one of 19 grades on a scale of 1 to 10 using a credit rating system developed by the Bank for all portfolios exposed to credit risk. As each grade corresponds to a debtor’s, counterparty’s or third party’s probability of default, the Bank can estimate the credit risk. The credit risk assessment method varies according to portfolio type. There are two main methods for assessing credit risk, i.e., the Advanced Internal Rating-Based (AIRB) Approach and the Standardized Approach, as defined by the Basel Accord to determine minimum regulatory capital requirements for most of its portfolios. The main parameters used to measure the credit risk of loans outstanding and undrawn amounts under the AIRB Approach are as follows: • probability of default (PD), which is the probability of through-the-cycle 12-month default by the obligor, calibrated on a long-run average PD throughout a • full economic cycle; loss given default (LGD), which represents the magnitude of the loss from the obligor’s default that would be expected in an economic downturn and subject to certain regulatory floors, expressed as a percentage of exposure at default; • exposure at default (EAD), which is an estimate of the amount drawn and of the expected use of any undrawn portion prior to default, and cannot be lower than the current balance. The methodology as well as the data and the downturn periods used to estimate LGD are described below. AAIIRRBB AAPPPPRROOAACCHH DDAATTAA DDOOWWNNTTUURRNN PPEERRIIOODD MMEETTHHOODDOOLLOOGGYY FFOORR CCAALLCCUULLAATTIINNGG LLGGDD Retail The Bank’s internal historical data from 1996 to 2016 1996-1998, 2000-2002 October 2008 – December 2009 LGD based on the Bank’s historical internal data on recoveries and losses Corporate The Bank’s internal historical data from 2000 to 2018 2000-2003, 2008-2009 and 2014-2018 LGD based on the Bank’s historical internal data on recoveries and losses Sovereign Moody’s observed default price of bonds, from 1983 to 2015 S&P rating history from 1975 to 2016 1999-2001 and 2008-2012 Based on implied market LGD using observed bond price decreases following the issuer’s default Financial institutions Global Credit Data Consortium historical loss and recovery database from 1998 to 2014 1991-1992, 1994, 1998, 2001-2002 and 2008-2009 Model for predicting LGD based on different issue- and issuer-related risk drivers Personal Credit Portfolios This category comprises portfolios of residential mortgage loans, consumer loans and loans to certain small businesses. To assess credit risk, AIRB models are in place for the main portfolios, particularly mortgage loans, home equity lines of credit, credit cards, budget loans and lines of credit. A risk analysis based on loan grouping in pools of homogeneous obligor and product profiles is used for overall management of personal credit portfolios. This personal credit assessment approach, which has proven particularly effective for estimating credit defaults and losses, takes a number of factors into account, namely: • • • • • behaviour scoring; loan product characteristics; collateral provided; the length of time on the Bank’s balance sheet; loan status (active, delinquent or defaulted). This mechanism provides adequate risk measurement inasmuch as it effectively differentiates risk levels by pool. Therefore, the results are periodically reviewed and, if necessary, adjustments are made to the models. Obligor migrations between pools are among the factors considered in the credit risk assessment. 68 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Loan pools are also established based on PD, LGD, and EAD, which are measured based on the characteristics of the obligor and the transaction itself. The credit risk of these portfolios is estimated using credit scoring models that determine the obligor’s PD. LGD is estimated based on transaction-specific factors such as loan product characteristics (for example, a line of credit versus a term loan), loan-to-value ratio and types of collateral. Under the Bank’s standards applicable to default-risk rating and facility-risk rating and according to its risk review, renewal and quantification standards, default risk ratings must be reviewed annually. Credit scoring models are also used to grant credit. These models use proven statistical methods that measure applicants’ demand characteristics and history based on internal and external historical information to estimate the applicant’s future credit behaviour and assign a probability of default. The underlying data include client information such as current and past employment, historical loan data in the Bank’s management systems and information from external sources such as credit rating agencies. The Bank also uses behaviour scoring models to manage and monitor current commitments. The risk assessment is based on statistical analyses of the past behaviour of obligors with which the Bank has a long-term relationship in an effort to predict their future behaviour. The underlying information includes the obligor’s cash flows and borrowing trends. Information on characteristics that determine behaviour in these models also comes from both internal sources on current commitments and external sources. The table below shows the PD categories along with the associated credit qualities of the personal credit portfolio. Business and Government Credit Portfolios This category comprises business (other than some small businesses that are classified in personal credit portfolios), government and financial institution credit portfolios. These credit portfolios are assigned a risk rating based on a detailed individual analysis of the financial and non-financial aspects of the obligor, including the obligor’s financial strength, sector of economic activity, competitive ability, access to capital and management quality. The Bank has risk-rating tools and models enabling it to specifically assess the risk represented by an obligor in relation to its industry and peers. The models used are adapted to the obligor’s broad sector of activity. Models are in place for ten sectors: business/commercial, large business, financial institutions, sovereigns, investment funds, energy, real estate, agriculture, insurance, and public-private partnership project financing. This risk assessment method assigns a default risk rating to an obligor that reflects its credit quality. To each default credit risk rating corresponds a PD (see the following table). Using this classification of obligor credit risk, the Bank can differentiate appropriately between the various assessments of an obligor’s capacity to meet its contractual obligations. Default risk ratings are assigned according to an assessment of an obligor’s commercial and financial risks based on a solvency review. Various risk quantification models, described below, are used to perform this assessment. The business and government default risk rating scale used by the Bank is similar to the systems used by major external rating agencies. The following table presents a grouping of the ratings by major risk category and compares them with the ratings of two major rating agencies. IInntteerrnnaall DDeeffaauulltt RRiisskk RRaattiinnggss** Description(1) Personal credit portfolios Excellent Good Satisfactory Special mention Substandard Default PD (%) – Retail Ratings 0.000–0.144 0.145–0.506 0.507–2.681 2.682–9.348 9.349–99.999 100 1–2.5 3–4 4.5–6.5 7–7.5 8–8.5 9–10 PD (%) – Corporate and financial institutions 0.000–0.125 0.125–0.451 0.451–4.743 4.743–11.161 11.161–99.999 100 Business and government credit portfolios PD (%) – Sovereign Standard & Poor's 0.000–0.094 0.094–0.454 0.454–6.607 6.607–19.120 19.120–99.999 100 AAA to A- BBB+ to BBB- BB+ to B B- to CCC+ CCC & CCC- CC, C & D Moody's Aaa to A3 Baa1 to Baa3 Ba1 to B2 B3 to Caa1 Caa2 & Caa3 Ca, C & D (1) Additional information is provided in Note 7 – Loans and Allowances for Credit Losses to the audited annual consolidated financial statements for the year ended October 31, 2019. The Bank also uses individual assessment models by industry to assign a risk rating to the credit facility based on the collateral and guarantees the obligor is able to provide and, in some cases, based on other factors. The Bank consequently has a bi-dimensional risk-rating system that, using models and based on internal and external historical data, establishes a default risk rating for each obligor. In addition, the models assign, to each credit facility, an LGD risk rating that is independent of the default risk rating assigned to the obligor. National Bank of Canada 69 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management The Bank’s default risk ratings and LGD risk ratings as well as the related risk parameters contribute directly to informed credit-granting, renewal and monitoring decisions. They are also used to determine and analyze risk-based pricing. In addition, from a credit portfolio management perspective, they are used to establish counterparty credit concentration limits and segment concentration limits and to determine the credit risk appetite of these portfolios. Moreover, they represent an important component in estimating expected and unexpected losses, measuring minimum required economic capital, and measuring the minimum level of capital required, as prescribed by the regulatory authorities. The credit risk of obligors and of their facilities is assessed with the PD and LGD parameters at least once a year or more often if significant changes (triggers) are observed when updating financial information or if another qualitative indicator of a deterioration in the obligor’s solvency or in the collateral associated with the obligor’s facilities is noted. A watchlist also exists that enables the Bank to more actively monitor the financial position of obligors whose default-risk rating is greater than or equal to 7.0. This process seeks to minimize an obligor’s default risk and allows for proactive credit risk management. Validation The Risk Management Group monitors the effectiveness of the risk-rating systems and associated parameters, which are also reviewed regularly in accordance with the Bank’s policies. Backtesting is performed at regular intervals to validate the effectiveness of the models used to estimate PD, LGD, and EAD. For PD in particular, this backtesting takes the form of sequentially applied statistical tests designed to assess the following criteria: the model’s discriminatory power; • • overrides; • model calibration; • the stability of the model’s output. The credit risk quantification models are developed and tested by a team of specialists and their performance is monitored by the applicable business units and related credit risk management services. Models are validated by a unit that is independent of both the specialists who developed the model and the concerned business units. Approvals of new models or changes to existing models are subject to an escalation process established by the model risk management policy. Furthermore, new models or changes to existing models that markedly impact regulatory capital must be approved by the Board before being submitted to the regulatory agencies, and a summary report of all changes to the models is submitted to the RMC once a year. The facility and default risk-rating systems, methods and models are also subject to periodic independent validation as often as required given the inherent risk of the activity. Models that have a significant impact on regulatory capital must be reviewed regularly, thereby further raising the certainty that these quantification mechanisms are working as expected. The key aspects to be validated are factors allowing accurate risk classification by level, adequate quantification of exposure, use of assessment techniques that include external factors such as economic conditions and credit status and, lastly, compliance with internal policies and regulatory provisions. Each year, the Risk Management Group presents a summary report on the validations to the RMC. The Bank’s credit risk assessment and rating systems are overseen by the Models Oversight Committee, the GRC and the RMC, and are an integral part of a comprehensive Bank-wide credit risk oversight framework. Along with the above-mentioned elements, the Bank documents and periodically reviews the policies, definitions of responsibilities, resource allocation and existing processes. AAsssseessssmmeenntt ooff EEccoonnoommiicc CCaappiittaall The assessment of the Bank’s minimum required economic capital is based on the credit risk assessments of debtors. These two activities are therefore interlinked. The different models used to assess the credit risk of a given portfolio type also enable the Bank to determine the default correlation among debtors. This information is a critical component in the evaluation of potential losses for all portfolios carrying credit risk. Estimates of potential losses, whether expected or not, are based on historical loss experience, portfolio monitoring, market data and statistical modelling. Expected and unexpected losses are factors used in assessing the minimum required economic capital for all of the Bank’s credit portfolios. The assessment of economic capital also considers the anticipated potential migrations of obligors’ default risk during the remaining term of their credit commitments. The main risk factors that have an impact on economic capital are as follows: • • • • • • the obligor’s PD; EAD; LGD; the PD correlation among obligors; the residual term of credit commitments; the impact of economic and sector-based cycles on asset quality. 70 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management SSttrreessss TTeessttiinngg aanndd CCrriissiiss SScceennaarriiooss The Bank carries out stress tests to evaluate its sensitivity to crisis situations in certain activity sectors and key portfolios. A global stress test methodology covers most business, government, and personal credit portfolios to provide the Bank with an overview of the situation. By simulating specific scenarios, these tests enable the Bank to measure the level of regulatory capital needed to absorb potential losses and to determine the impact on its solvency. In addition, these tests contribute to portfolio management as they influence the determination of concentration limits by obligor, product or business sector. Mortgage Loan Underwriting To mitigate the impact of an economic slowdown and ensure the long-term quality of its portfolio, the Bank uses sound risk management when granting residential mortgages to confirm: (i) the obligor’s intention to meet its financial obligations, (ii) the obligor’s ability to repay its debts and (iii) the quality of the collateral. In addition, in accordance with the applicable rules, the Bank takes a prudent approach to client qualification by using, for example, a higher interest rate to mitigate the risk of short- or medium-term rate increases. Nonetheless, the risk of economic slowdown could adversely affect the profitability of the mortgage portfolio. In stress test analyses, the Bank considers a variety of scenarios to measure the impact of adverse market conditions. In such circumstances, our analyses show significantly higher credit losses, which would decrease profitability and reduce the Bank’s capital ratios. CCrreeddiitt--GGrraannttiinngg PPrroocceessss Credit-granting decisions are based first and foremost on the results of the risk assessment. Aside from a client’s solvency, credit-granting decisions are also influenced by factors such as available collateral, transaction compliance with policies, standards and procedures, and the Bank’s overall risk-adjusted return objective. Each credit-granting decision is made by authorities within the risk management teams and management who are independent of the business units and are at a reporting level commensurate with the size of the proposed credit transaction and the associated risk. Decision-making authority is determined in compliance with the delegation of authority set out in the Credit Risk Management Policy. A person in a senior position in the organization approves credit facilities that are substantial or carry a higher risk for the Bank. The GRC approves and monitors all substantial credit facilities. Credit applications that exceed management’s latitudes are submitted to the Board for approval. The credit-granting process demands a high level of accountability from managers, who must proactively manage the credit portfolio. RReevviieeww aanndd RReenneewwaall PPrroocceesssseess The Bank periodically reviews credit files. The review process enables the Bank to update information on the quality of the facilities and covers, among other things, risk ratings, compliance with credit conditions, and obligor behaviour. The credit risk of all obligors is reviewed at least once per year. After this periodic review, for on-demand or unused credit, the Bank decides whether to pursue its business relationship with the obligor and, if so, revises the credit conditions. RRiisskk MMiittiiggaattiioonn The Bank also controls credit risk using various risk mitigation techniques. In addition to the standard practice of requiring collateral to guarantee repayment of the credit it grants, the Bank also uses protection mechanisms such as credit derivative financial instruments, syndication and loan assignments as well as an orderly reduction in the amount of credit granted. The most common method used to mitigate credit risk is to obtain quality collateral from obligors. Obtaining collateral cannot replace a rigorous assessment of an obligor’s ability to meet its financial obligations, but, beyond a certain risk threshold, it is an essential complement. Collateral is not required in all cases. It depends upon the level of risk presented by the obligor and the type of loan granted. However, if the level of risk to the Bank is considered high, collateral will likely be required. The legal validity and enforceability of any collateral obtained and the Bank’s ability to correctly and regularly measure the collateral’s value are critical for this mechanism to play its proper role in risk mitigation. The Bank has established specific requirements in its internal policies with respect to the appropriate legal documentation and assessment for the kinds of collateral that business units may require to guarantee the loans granted. The categories of eligible collateral and the lending value of the collateralized assets have also been defined by the Bank. For the most part, they include the following asset categories as well as guarantees (whether secured by collateral or unsecured) and government and bank guarantees: inventories; • accounts receivable; • • machinery and equipment and rolling stock; • • residential and commercial real estate, office buildings and industrial facilities; cash and marketable securities. Portfolio Diversification and Management The Bank is exposed to credit risk, not only through outstanding loans and undrawn amounts of commitments to a particular obligor but also through the sectoral distribution of the outstanding loans and undrawn amounts and through the exposure of its various credit portfolios to geographical, concentration and settlement risks. National Bank of Canada 71 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management The Bank’s approach to controlling these diverse risks begins with a diversification of exposures. Measures designed to maintain a healthy degree of diversification of credit risk in its portfolios are set out in the Bank’s policies, standards and procedures. These instructions are mainly reflected in the application of various exposure limits: credit concentration limits by counterparty and credit concentration limits by business sector, country, region, product, and type of financial instrument. These limits are determined based on the Bank’s credit risk appetite framework and are reviewed periodically. Compliance with these limits, particularly exceptions, is monitored through periodic reports submitted by the Risk Management Group’s officers to the Board. Continuous analyses are performed in order to anticipate problems with a sector or obligor before they materialize as defaulted payments. Other Risk Mitigation Methods Credit risk mitigation measures for transactions in derivative financial instruments, which are regularly used by the Bank, are described in detail in the Counterparty Risk section. Credit Derivative Financial Instruments and Financial Guarantee Contracts The Bank also reduces credit risk by using the protection provided by credit derivative financial instruments such as credit default swaps. When the Bank acquires credit protection, it pays a premium on the swap to the counterparty in exchange for the counterparty’s commitment to pay if the underlying entity defaults or another event involving the underlying entity and covered by the legal agreement occurs. Since, like obligors, providers of credit protection must receive a default risk rating, the Bank’s standards set out all the criteria under which a counterparty may be judged eligible to mitigate the Bank’s credit risk. The Bank may also reduce its credit risk by entering into financial guarantee contracts whereby a guarantor indemnifies the Bank for a loss resulting from an obligor failing to make a payment when due in accordance with the contractual terms of a debt instrument. Loan Syndication The Bank has developed specific instructions on the appropriate objectives, responsibilities and documentation requirements for loan syndication. FFoollllooww--UUpp ooff MMoonniittoorreedd AAccccoouunnttss aanndd RReeccoovveerryy Credit granted and obligors are monitored on an ongoing basis and in a manner commensurate with the related risk. Loan portfolio managers use an array of intervention methods to conduct a particularly rigorous follow-up on files that show a high risk of default. When loans continue to deteriorate and there is an increase in risk to the point where monitoring has to be increased, a group specialized in managing problem accounts steps in to maximize collection of the disbursed amounts and tailor strategies to these accounts. In these cases, loan portfolio managers prepare and submit, to the credit department, a detailed monitoring report (watchlist) each month to track the status of at-risk obligors and the corrective measures undertaken. The management of each department concerned performs follow-ups on the reports, and each quarter a credit monitoring committee meets to review the action plans and monitoring reports of obligors that have commitments of $3 million or more. The authority to approve allowances for credit losses is attributed using limits delegated on the basis of hierarchical level under the Credit Risk Management Policy. Information on the recognition of impaired loans and allowances for credit losses is presented in Notes 1 and 7 to the consolidated financial statements. Forbearance and Restructuring Situations where a business or retail obligor begin showing clear signs of potential insolvency are managed on a case-by-case basis and require the use of judgment. The Loan Work Out Policy sets out the principles applicable in such situations to guide loan restructuring decisions and identify situations where distressed restructuring applies. A distressed restructuring situation occurs when the Bank, for economic or legal reasons related to the obligor’s financial difficulties, grants the obligor a special concession that is contrary to the Bank's policies. Such concessions could include a lower interest rate, waiver of principal and extension of the maturity date. The Bank has established a management framework for commercial and corporate obligors that represent higher-than-normal risk of default. It outlines the roles and responsibilities of loan portfolio managers with respect to managing high-risk accounts and the responsibilities of the Work Out units and other participants in the process. Lastly, the Credit Risk Management Policy and a management framework are used to determine the authorization limits for distressed restructuring situations. During fiscal years 2019 and 2018, the amount of distressed loan restructurings was not significant. CCoouunntteerrppaarrttyy RRiisskk AAsssseessssmmeenntt Counterparty risk is a credit risk that the Bank incurs on various types of transactions involving financial instruments. The most significant risks are those it faces when it trades derivative financial instruments with counterparties on the over-the-counter market or when it purchases securities under reverse repurchase agreements or sells securities under repurchase agreements. Securities lending transactions and securities brokerage activities involving derivative financial instruments are also sources of counterparty risk. Note 16 to the consolidated financial statements provides a complete description of the credit risk for derivative financial instruments by type of traded product. 72 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management The Risk Management Group has developed models by broad category of financial instrument through which it applies an advanced methodology for calculating the Bank’s credit risk exposure and economic capital. The exposures are subject to limits. These two elements are established based on the potential volatility of the underlying assets until expiration of the contract. Counterparty obligations related to the trading of contracts on derivative financial instruments, securities lending transactions and reverse repurchase agreements are frequently subject to credit risk mitigation measures. The mitigation techniques are somewhat different from those used for loans and advances and depend on the nature of the instrument or the type of contract traded. The most widely used measure is the signing of master agreements: the International Swaps & Derivatives Association, Inc. (ISDA) master agreement, the Global Master Repurchase Agreement (GMRA) and the Global Master Securities Lending Agreement (GMSLA). These agreements make it possible, in the event of default, insolvency or bankruptcy of one of the contracting parties, to apply full netting of the gross amounts of the market values for each of the transactions covered by the agreement in force at the time of default. The amount of the final settlement is therefore the net balance of gains and losses on each transaction, which reduces exposure when a counterparty defaults. The Bank’s policies require that an ISDA, GMRA, or GMSLA agreement be signed with most trading counterparties to derivatives, foreign exchange forward contracts, securities lending transactions and reverse repurchase agreements. Another mechanism for reducing credit risk on derivatives and foreign exchange forward contracts complements the ISDA master agreement in many cases and provides the Bank and its counterparty (or either of the parties, if need be) with the right to request collateral from the counterparty when the net balance of gains and losses on each transaction exceeds a threshold defined in the agreement. These agreements, also known as Credit Support Annexes (CSAs), are common between financial institutions active in international financial markets since they limit credit risk while providing traders with additional flexibility to continue trading with the counterparty. The Bank often uses this type of legal documentation in transactions with financial institutions and governments. For business transactions, the Bank prefers to use internal mechanisms set out in the credit agreements. The Bank’s internal policies set the conditions governing the implementation of such mitigation methods. Requiring collateral as part of a securities lending transaction or reverse repurchase agreement is not solely the result of an internal credit decision. In fact, it is a mandatory market practice imposed by self-regulating organizations in the financial services sector such as the Investment Industry Regulatory Organization of Canada. The Bank also has policies and guidelines governing its own collateral pledged to counterparties, given the potential impact of such asset transfers on its liquidity. In accordance with its Liquidity, Funding & Pledging Policy, the Bank conducts simulations of potential counterparty collateral claims under the CSAs in effect in the event of a Bank downgrade or other unlikely occurrences. The simulations are based on various Bank downgrading scenarios or market value fluctuations of transactions covered by CSAs. The Bank has identified circumstances in which it is likely to be exposed to wrong-way risk, which is generally associated with exposure to counterparty risk and characterized by higher risk for the Bank if a counterparty’s PD increases (unfavourable positive correlation). A common wrong-way risk arises from the trading of derivatives contracts with counterparties where the underlying assets may include equity securities issued by those counterparties. AAsssseessssmmeenntt ooff SSeettttlleemmeenntt RRiisskk Settlement risk potentially arises from transactions that feature reciprocal delivery of cash or securities between the Bank and a counterparty. Foreign exchange contracts are an example of transactions that can generate significant levels of settlement risk. However, the implementation of multilateral settlement systems that allow settlement netting among participating institutions has contributed greatly to reducing the risks associated with the settlement of foreign exchange transactions among banks. The Bank also uses financial intermediaries to gain access to established clearing houses in order to minimize settlement risk for certain financial derivative transactions. In some cases, the Bank may have direct access to established clearing houses for settling financial transactions such as repurchase agreements or reverse repurchase agreements. In addition, certain derivative financial instruments traded over the counter are settled directly or indirectly by central counterparties. For additional information, see the table that presents notional amounts in Note 16 to the consolidated financial statements. There are several other types of transactions that may generate settlement risk, in particular the use of certain electronic fund transfer services. This risk refers to the possibility that the Bank may make a payment or settlement on a transaction without receiving the amount owed by the counterparty, and with no opportunity to recover the funds delivered (irrevocable settlement). The ultimate means for completely eliminating such a risk is for the Bank to complete no payments or settlements before receiving the funds due from the counterparty. Such an approach cannot, however, be used systematically. For several electronic payment services, the Bank is able to implement mechanisms that allow it to make its transfers revocable or to debit the counterparty in the amount of the settlements before it makes its own transfer. On the other hand, the nature of transactions in financial instruments makes it impossible for such practices to be widely used. For example, on foreign exchange transactions involving a currency other than the U.S. dollar, time zone differentials impose strict payment schedules on the parties. The Bank cannot unduly postpone a settlement without facing significant penalties, due to the large size of amounts involved. The most effective way for the Bank to control settlement risks, both for financial market transactions and irrevocable transfers, is to impose internal risk limits based on the counterparty’s ability to pay. National Bank of Canada 73 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management The amounts shown in the following tables represent the Bank’s maximum exposure to credit risk as at the financial reporting date without taking into account any collateral held or any other credit enhancements. These amounts do not take into account allowances for credit losses nor amounts pledged as collateral. The tables also exclude equity securities. MMaaxxiimmuumm CCrreeddiitt RRiisskk EExxppoossuurree UUnnddeerr tthhee BBaasseell AAsssseett CCaatteeggoorriieess** (millions of Canadian dollars) AAss aatt OOccttoobbeerr 3311,, 22001199 RReettaaiill Residential mortgage Qualifying revolving retail Other retail NNoonn--rreettaaiill Corporate Sovereign Financial institutions TTrraaddiinngg ppoorrttffoolliioo SSeeccuurriittiizzaattiioonn TToottaall –– GGrroossss ccrreeddiitt rriisskk SSttaannddaarrddiizzeedd AApppprrooaacchh AAIIRRBB AApppprrooaacchh TToottaall –– GGrroossss ccrreeddiitt rriisskk (millions of Canadian dollars) RReettaaiill Residential mortgage Qualifying revolving retail Other retail NNoonn--rreettaaiill Corporate Sovereign Financial institutions TTrraaddiinngg ppoorrttffoolliioo SSeeccuurriittiizzaattiioonn TToottaall –– GGrroossss ccrreeddiitt rriisskk SSttaannddaarrddiizzeedd AApppprrooaacchh AAIIRRBB AApppprrooaacchh TToottaall –– GGrroossss ccrreeddiitt rriisskk DDrraawwnn UUnnddrraawwnn ccoommmmiittmmeennttss RReeppoo--ssttyyllee ttrraannssaaccttiioonnss(1) DDeerriivvaattiivvee ffiinnaanncciiaall iinnssttrruummeennttss(2) OOtthheerr ooffff--bbaallaannccee-- sshheeeett iitteemmss(3) 5500,,332288 22,,554400 1144,,225588 6677,,112266 5566,,000022 3311,,330088 55,,220000 9922,,551100 −− 11,,116666 116600,,880022 1177,,116666 114433,,663366 116600,,880022 88,,881122 33,,004466 11,,991111 1133,,776699 2200,,552277 55,,222222 442255 2266,,117744 −− −− 3399,,994433 660011 3399,,334422 3399,,994433 −− −− −− −− 2211,,552244 3366,,220088 9977,,442233 115555,,115555 −− −− 115555,,115555 2288,,557711 112266,,558844 115555,,115555 −− −− −− −− 11 119900 11,,996666 22,,115577 1122,,001155 −− 1144,,117722 11,,995511 1122,,222211 1144,,117722 −− −− 2200 2200 44,,110033 114488 662299 44,,888800 −− 33,,559988 88,,449988 111199 88,,337799 88,,449988 TToottaall 5599,,114400 55,,558866 1166,,118899 8800,,991155 110022,,115577 7733,,007766 110055,,664433 228800,,887766 1122,,001155 44,,776644 337788,,557700 4488,,440088 333300,,116622 337788,,557700 As at October 31, 2018 Drawn Undrawn commitments Repo-style transactions(1) Derivative financial instruments(2) Other off-balance- sheet items(3) 45,926 2,829 15,461 64,216 50,750 27,131 4,107 81,988 − 1,474 147,678 13,152 134,526 147,678 8,287 3,447 1,589 13,323 17,588 5,234 303 23,125 − − 36,448 253 36,195 36,448 − − − − 16,657 41,364 75,839 133,860 − − 133,860 14,577 119,283 133,860 − − − − 29 47 4,122 4,198 9,620 − 13,818 3,965 9,853 13,818 − − 14 14 3,503 139 738 4,380 − 3,272 7,666 356 7,310 7,666 Total 54,213 6,276 17,064 77,553 88,527 73,915 85,109 247,551 9,620 4,746 339,470 32,303 307,167 339,470 (1) (2) (3) Securities purchased under reverse repurchase agreements and sold under repurchase agreements as well as securities loaned and borrowed. Exposure presented using the SA-CCR method since the first quarter of 2019. Letters of guarantee, documentary letters of credit and securitized assets that represent the Bank’s commitment to make payments in the event that a client cannot meet its financial obligations to third parties. 74 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management MMaarrkkeett RRiisskk Market risk is the risk of losses arising from movements in market prices. Market risk comes from a number of factors, particularly changes to market variables such as interest rates, exchange rates, equity prices, commodity prices and implied volatilities. The Bank is exposed to market risk through its participation in trading, investment and asset/liability management activities. Trading activities involve taking positions, particularly on various instruments such as bonds, shares, currencies, commodities or derivative financial instruments. The Bank is exposed to non-trading market risk through its asset/liability management and investment portfolios. The trading portfolios include positions in financial instruments and commodities held either with trading intent or to hedge other elements of the trading book. Positions held with trading intent are those held for short-term resale and/or with the intent of taking advantage of actual or expected short-term price movements or to lock in arbitrage profits. These portfolios target one of the following objectives: market making, liquidating positions for clients or selling financial products to clients. Non-trading portfolios include financial instruments intended to be held to maturity as well as those held for daily cash management or for the purpose of maintaining targeted returns or ensuring asset and liability management. GGoovveerrnnaannccee A market risk management policy governs global market risk management across the Bank’s units and subsidiaries that are exposed to this type of risk. It is approved by the GRC. The policy sets out the framework and principles for managing market risk; defines risk measures, control and monitoring activities; sets limits; and reports on breaches. The Financial Markets Risk Committee oversees all Financial Markets segment risks that could adversely affect the Bank's results, liquidity, or capital. This committee also oversees the Financial Markets segment’s risk framework to ensure that controls are in place to contain risk in accordance with the Bank's risk appetite framework. Market risk limits ensure the link and coherence between the Bank’s market risk appetite targets and the day-to-day market risk management by all parties involved, notably senior management, business lines and market risk sector in its independent control function. The Bank's monitoring and reporting process consists of comparing market risk exposure to alert levels and market risk limits determined for all limit authorization and approval levels. AAsssseessssiinngg MMaarrkkeett RRiisskk The Risk Management Group uses a variety of risk measures to estimate the size of potential losses under more or less severe scenarios, and using both short- term and long-term time horizons. For short-term horizons, the Bank’s risk measures include Value-at-Risk (VaR), Stressed VaR (SVaR), and sensitivity metrics. For long-term horizons or sudden significant market moves, including those due to a lack of market liquidity, the risk measures include stress testing across an extensive range of scenarios. VaR and SVaR Models VaR is a statistical measure of risk that is used to quantify market risks by product and by risk type as well as aggregate risk by portfolio, for the Bank as a whole. VaR is defined as the maximum loss at a specific confidence level over a certain horizon under normal market conditions. The VaR method has the advantage of providing a uniform measurement of financial instrument-related market risks based on a single statistical confidence level and time horizon. For VaR, the Bank uses a historical price distribution to compute the probable loss levels at the 99% confidence level, using a two-year history of daily time series of risk factor changes. VaR is the maximum daily loss the Bank could incur, in 99 cases out of 100, in a given portfolio. In other words, the loss could exceed that amount in only one out of 100 cases. The trading VaR is measured by assuming a holding period of one day for ongoing market risk management and a 10-day holding period for regulatory capital purposes. VaR is calculated on a daily basis both for major classes of financial instruments (including derivative financial instruments) and all trading portfolios in the Financial Markets segment and the Bank's Global Funding and Treasury Group. In addition to the one-day trading VaR, the Bank calculates a trading SVaR, which is a statistical measure of risk that replicates the VaR calculation method but uses, instead of a two-year history of risk factor changes, a 12-month data period corresponding to a continuous period of significant financial stress that is relevant in terms of the Bank’s portfolios. National Bank of Canada 75 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management VaR methodology techniques are well suited to measure risks under normal market conditions. VaR metrics are most appropriate as a risk measure for trading positions in liquid financial markets. However, there are limitations in measuring risks with this method when extreme and sudden market risk events occur, since they are likely to underestimate the Bank’s market risk. VaR methodology limitations include the following:  past changes in market risk factors may not always produce accurate predictions of the distribution and correlations of future market movements;   a VaR with a daily time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day; the market risk factor historical database used for VaR calculation may not reflect potential losses that could occur under unusual market conditions (e.g., periods of extreme illiquidity) relative to the historical period used for VaR estimates; the use of a 99% VaR confidence level does not reflect the extent of potential losses beyond that percentile.  Given the limitations of VaR, for the Bank it represents only one component in its risk management oversight, which also incorporates, among other measures, stress testing, sensitivity analysis, concentration and liquidity limits and analysis. The Bank also conducts backtesting of the VaR model. It consists of comparing the profits and losses to the statistical VaR measure. Backtesting is essential to verifying the VaR model’s capacity to adequately forecast the maximum risk of market losses and thus validate, retroactively, the quality and accuracy of the results obtained using the model. If the backtesting results present material discrepancies, the VaR model could be revised in accordance with the Bank’s model risk management framework. CCoonnttrroolllliinngg MMaarrkkeett RRiisskk Outstanding VaR exposure is monitored daily in relation to established limits for each type of market risk, portfolio and business unit. The RMC reviews VaR results and other risk measure results each quarter, including any breaches of the limits set out in the policy. The Bank also uses economic capital for market risk as an indicator for risk appetite and limits setting. This indicator measures the amount of capital that is required to absorb unexpected losses due to market risk events over a one-year horizon and with a determined confidence level. For additional information on economic capital, see the Capital Management section of this MD&A. 76 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management The following tables provide a breakdown of the Bank’s Consolidated Balance Sheet into assets and liabilities by those that carry market risk and those that do not carry market risk, distinguishing between trading positions whose main risk measures are VaR and SVaR and non-trading positions that use other risk measures. RReeccoonncciilliiaattiioonn ooff MMaarrkkeett RRiisskk WWiitthh CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett IItteemmss (millions of Canadian dollars) AAss aatt OOccttoobbeerr 3311,, 22001199 BBaallaannccee sshheeeett TTrraaddiinngg(1) NNoonn--TTrraaddiinngg(2) NNoott ssuubbjjeecctt ttoo mmaarrkkeett rriisskk NNoonn--ttrraaddeedd rriisskk pprriimmaarryy rriisskk sseennssiittiivviittyy MMaarrkkeett rriisskk mmeeaassuurreess AAsssseettss Cash and deposits with financial institutions Securities At fair value through profit or loss At fair value through other comprehensive income At amortized cost Securities purchased under reverse repurchase agreements and securities borrowed Loans and acceptances, net of allowances Derivative financial instruments Defined benefit asset Other LLiiaabbiilliittiieess Deposits Acceptances Obligations related to securities sold short Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments Liabilities related to transferred receivables Defined benefit liability Other Subordinated debt 1133,,669988 6611,,882233 1100,,664488 99,,775555 1177,,772233 115533,,225511 88,,112299 3388 66,,339933 228811,,445588 118899,,556666 66,,889933 1122,,884499 2211,,990000 66,,885522 2211,,331122 337744 55,,880033 777733 226666,,332222 557799 1122,,660099 551100 IInntteerreesstt rraattee(3) 5588,,117700 −− −− −− 66,,006600 77,,113344 −− −− 7711,,994433 99,,886699 −− 1122,,884499 −− 66,,112233 55,,116655 −− 2244 −− 3344,,003300 33,,665533 1100,,664488 99,,775555 1177,,772233 114477,,119911 999955 3388 −− 220022,,661122 117799,,669977 66,,889933 −− 2211,,990000 772299 1166,,114477 337744 991111 777733 222277,,442244 IInntteerreesstt rraattee(3) aanndd eeqquuiittyy(4) IInntteerreesstt rraattee(3) aanndd eeqquuiittyy(5) IInntteerreesstt rraattee(3) IInntteerreesstt rraattee(3)(6) IInntteerreesstt rraattee(3) IInntteerreesstt rraattee(7) aanndd eexxcchhaannggee rraattee(7) OOtthheerr(8) IInntteerreesstt rraattee(3) IInntteerreesstt rraattee(3) IInntteerreesstt rraattee(3)(6) IInntteerreesstt rraattee(7) aanndd eexxcchhaannggee rraattee(7) IInntteerreesstt rraattee(3) OOtthheerr(8) IInntteerreesstt rraattee(3) IInntteerreesstt rraattee(3) −− −− −− −− −− −− −− 66,,339933 66,,990033 −− −− −− −− −− −− −− 44,,886688 −− 44,,886688 (1) (2) (3) (4) (5) (6) (7) (8) Trading positions whose risk measures are VaR and SVaR. For additional information, see the tables on the following pages that show the VaR and SVaR distributions of the trading portfolios by risk category as well as their correlation effect. Non-trading positions that use other risk measures. For additional information, see the tables on the following pages that show the VaR and SVaR distributions of the trading portfolios by risk category and their correlation effect as well as the interest rate sensitivity tables. For additional information, see Note 6 to the consolidated financial statements. The fair value of equity securities designated at fair value through other comprehensive income is presented in Notes 3 and 6 to the consolidated financial statements. These instruments are recorded at amortized cost and are subject to credit risk for capital management purposes. For trading-related transactions with maturities of more than one day, interest rate risk is included in the VaR and SVaR measures. For additional information, see Notes 16 and 17 to the consolidated financial statements. For additional information, see Note 23 to the consolidated financial statements. National Bank of Canada 77 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management (millions of Canadian dollars) AAsssseettss Cash and deposits with financial institutions Securities At fair value through profit or loss At fair value through other comprehensive income At amortized cost Securities purchased under reverse repurchase agreements and securities borrowed Loans and acceptances, net of allowances Derivative financial instruments Defined benefit asset Other LLiiaabbiilliittiieess Deposits Acceptances Obligations related to securities sold short Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments Liabilities related to transferred receivables Defined benefit liability Other Subordinated debt Balance sheet Trading(1) Non-trading(2) Not subject to market risk Non-traded risk primary risk sensitivity Market risk measures As at October 31, 2018 12,756 55,817 5,668 8,298 18,159 146,082 8,608 64 7,019 262,471 170,830 6,801 17,780 19,998 6,036 20,100 186 5,638 747 248,116 226 12,269 261 Interest rate(3) 51,575 − − − 5,417 7,625 − − 64,843 7,187 − 17,780 − 4,807 3,733 − 21 − 33,528 4,242 5,668 8,298 18,159 140,665 983 64 − 190,348 163,643 6,801 − 19,998 1,229 16,367 186 910 747 209,881 Interest rate(3) and equity(4) Interest rate(3) and equity(5) Interest rate(3) Interest rate(3)(6) Interest rate(3) Interest rate(7) and exchange rate(7) Other(8) Interest rate(3) Interest rate(3) Interest rate(3)(6) Interest rate(7) and exchange rate(7) Interest rate(3) Other(8) Interest rate(3) Interest rate(3) − − − − − − − 7,019 7,280 − − − − − − − 4,707 − 4,707 (1) (2) (3) (4) (5) (6) (7) (8) Trading positions whose risk measures are VaR and SVaR. For additional information, see the tables on the following pages that show the VaR and SVaR distributions of the trading portfolios by risk category as well as their correlation effect. Non-trading positions that use other risk measures. For additional information, see the tables on the following pages that show the VaR and SVaR distributions of the trading portfolios by risk category and their correlation effect as well as the interest rate sensitivity tables. For additional information, see Notes 6 to the consolidated financial statements. The fair value of equity securities designated at fair value through other comprehensive income is presented in Notes 3 and 6 to the consolidated financial statements. These instruments are recorded at amortized cost and are subject to credit risk for capital management purposes. For trading-related transactions with maturities of more than one day, interest rate risk is included in the VaR and SVaR measures. For additional information, see Notes 16 and 17 to the consolidated financial statements. For additional information, see Note 23 to the consolidated financial statements. TTrraaddiinngg AAccttiivviittiieess The first table below shows the VaR distribution of trading portfolios by risk category as well as their correlation effect. The second table on the next page shows the SVaR distribution, i.e., the VaR of the Bank’s current portfolios obtained following the calibration of risk factors over a 12-month stress period. VVaaRR ooff TTrraaddiinngg PPoorrttffoolliiooss bbyy RRiisskk CCaatteeggoorryy(1)** Year ended October 31 (millions of Canadian dollars) Interest rate Foreign exchange Equity Commodity Correlation effect(2) TToottaall ttrraaddiinngg VVaaRR LLooww ((44..00)) ((00..44)) ((22..88)) ((00..55)) nn..mm.. ((33..88)) HHiigghh AAvveerraaggee 22001199 PPeerriioodd eenndd ((77..11)) ((11..88)) ((66..00)) ((11..55)) nn..mm.. ((88..99)) ((55..33)) ((00..88)) ((33..88)) ((11..00)) 44..88 ((66..11)) ((44..44)) ((11..33)) ((33..88)) ((11..22)) 44..44 ((66..33)) Low (3.0) (0.5) (1.6) (0.5) n.m. (3.1) High (5.9) (2.7) (5.8) (1.7) n.m. (7.4) Average 2018 Period end (4.1) (1.2) (3.5) (1.0) 4.6 (5.2) (5.9) (1.4) (4.7) (0.9) 7.0 (5.9) n.m. Computation of a correlation effect for the high and low is not meaningful, as highs and lows may occur on different days and be attributable to different types of risk. (1) (2) Amounts are presented on a pre-tax basis and represent one-day VaR using a 99% confidence level. The total trading VaR is less than the sum of the individual risk factor VaR results due to the correlation effect. 78 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management SSVVaaRR ooff TTrraaddiinngg PPoorrttffoolliiooss bbyy RRiisskk CCaatteeggoorryy(1)** Year ended October 31 (millions of Canadian dollars) Interest rate Foreign exchange Equity Commodity Correlation effect(2) TToottaall ttrraaddiinngg SSVVaaRR LLooww ((1111..88)) ((00..66)) ((44..55)) ((11..11)) nn..mm.. ((99..00)) HHiigghh AAvveerraaggee 22001199 PPeerriioodd eenndd ((2266..66)) ((44..11)) ((1144..44)) ((44..00)) nn..mm.. ((1177..88)) ((1166..44)) ((11..44)) ((77..33)) ((22..11)) 1144..22 ((1133..00)) ((1155..11)) ((22..00)) ((88..99)) ((22..77)) 1133..44 ((1155..33)) Low (7.5) (0.5) (1.2) (0.4) n.m. (4.0) High Average 2018 Period end (15.7) (4.1) (9.3) (2.9) n.m. (17.8) (11.8) (1.5) (3.5) (1.8) 8.9 (9.7) (13.6) (2.4) (9.3) (2.2) 17.7 (9.8) n.m. Computation of a correlation effect for the high and low is not meaningful, as highs and lows may occur on different days and be attributable to different types of risk. (1) (2) Amounts are presented on a pre-tax basis and represent one-day SVaR using a 99% confidence level. The total trading SVaR is less than the sum of the individual risk factor SVaR results due to the correlation effect. The average total trading VaR stood at $6.1 million for fiscal 2019, up from $5.2 million in fiscal 2018. The average total trading SVaR was also up, rising from $9.7 million in fiscal 2018 to $13.0 million in fiscal 2019. These increases were essentially due to higher interest rate risk and higher equity risk. The revenues generated by trading activities are compared with VaR as a backtesting assessment of the appropriateness of this risk measure as well as the financial performance of trading activities relative to the risk undertaken. The table below shows daily trading and underwriting revenues and VaR. Daily trading and underwriting revenues were positive on 97% of the days for the year ended October 31, 2019. Daily trading and underwriting losses in excess of $1 million were recorded on 4 days. None of these losses exceeded the VaR. DDaaiillyy TTrraaddiinngg aanndd UUnnddeerrwwrriittiinngg RReevveennuueess (millions of Canadian dollars) 25 20 15 10 5 0 (5) (10) (15) 8 1 . v o N 8 1 . c e D 9 1 . n a J 9 1 . b e F 9 1 . r a M 9 1 . r p A 9 1 y a M 9 1 e n u J 9 1 y l u J 9 1 . g u A 9 1 . t p e S 9 1 . t c O Daily trading and underwriting revenues VaR National Bank of Canada 79 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management CCrriissiiss SScceennaarriiooss A crisis scenario is a risk management technique that consists of estimating potential losses under abnormal market conditions and risk factor movements. This technique enhances transparency by exploring a range of serious but plausible events. These crises scenarios simulate the results that the portfolios would generate if the extreme scenarios in question were to occur. The Bank’s stress testing framework, which is to all positions generating market risk currently comprises the following range of different stress test scenarios:    sharp parallel increases/decreases in interest rates; non-parallel movements (flattening and steepening) and increases/decreases in credit spreads; sharp stock market crash coupled with a significant increase in volatility; increase in stock prices associated with less volatility; increase in the volatility of the term structure coupled with a decrease in stock prices; significant increases/decreases in commodity prices coupled with increases/decreases in volatility; short-term and long-term increases/decreases in commodity prices;  depreciation/appreciation of the U.S. dollar and of other currencies relative to the Canadian dollar. SSttrruuccttuurraall IInntteerreesstt RRaattee RRiisskk As part of its core banking activities, such as lending and deposit taking, the Bank is exposed to interest rate risk. Interest rate risk is the potential negative impact of interest rate fluctuations on the Bank’s annual net interest income and economic value of equity. Activities related to hedging, investments and term funding are also exposed to structural interest rate risk. The Bank’s main exposure to interest rate risk stems from a variety of sources: yield curve risk, which refers to changes in the level, slope and shape of the yield curve; repricing risk, which arises from timing differences in the maturity and repricing of on- and off-balance-sheet items;    options risk, either implicit (e.g., prepayment of mortgage loans) or explicit (e.g., capped mortgages and rate guarantees) in balance sheet products;  basis risk that is caused by imperfect correlation between different yield curves. The Bank’s exposure to structural interest rate risk is assessed and controlled mostly through the impact of stress scenarios and market shocks on the economic value of the Bank’s equity and on 12-month net interest income projections. These metrics are based on cash flow projections prepared using a number of assumptions. Specifically, the Bank has developed key assumptions on loan prepayment levels, deposit redemptions, and the behaviour of customers that were granted rate guarantees. These specific assumptions were developed based on historical analyses and are reviewed frequently. Funds transfer pricing is a process by which the Bank’s business units are charged or paid according to their use or supply of funding. Through this mechanism, all funding activities as well as the interest rate risk and liquidity risk associated with those activities are centralized in the Global Funding and Treasury Group. Active management of structural interest rate risk can significantly enhance the Bank’s profitability and add to shareholder value. The Bank’s goal is to maximize its economic value of equity and annual net interest income considering the Bank’s risk appetite. This has to be accomplished within prescribed risk limits and is done primarily by implementing a policy framework approved by the Board, which establishes a risk tolerance threshold, monitoring structures controlled by the various committees, risk indicators, reporting procedures, delegation of responsibilities and segregation of duties. The Bank also prepares an annual funding plan that incorporates the expected growth of assets and liabilities. Regulatory Context On May 30, 2019, OSFI released a revised version of its B-12 guideline, Interest Rate Risk Management. The guideline outlines OSFI’s expectations regarding the management of Interest Rate Risk in the Banking Book (IRRBB) in areas such as governance processes, risk measurement, development of stress test scenarios as well as key behavioural and modelling assumptions. D-SIBs will have to apply this revised guideline as of January 1, 2020. Governance Management of the Bank’s structural interest rate risk is mandated to the Global Funding and Treasury Group. In this role, the executives and personnel of this group are responsible for the day-to-day management of the risks inherent to structural interest rate risk hedging decisions and operations. They act as the primary effective challenge function with respect to the execution of these activities. The Office of the President approves and endorses the structural interest rate exposure and strategies on the recommendation of the Global Funding and Treasury Group. The Risk Management Group is responsible for assessing structural interest rate risk, monitoring activities, and ensuring compliance with the structural interest rate risk policy. The Risk Management Group ensures that an appropriate risk management framework is in place and ensures compliance with the risk appetite framework and policy. Structural interest rate risk supervision is mainly provided by the Financial Markets Risk Committee. This committee reviews exposure to structural interest rate risk, the use of limits, and changes made to assumptions. 80 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Stress Testing and Crisis Scenarios Stress tests are performed on a regular basis to assess the impact of various scenarios on annual net interest income and on the economic value of equity in order to guide the management of structural interest rate risk. Crisis scenarios are performed where the yield curve level, slope and shape are shocked. Yield curve basis and volatility scenarios are also performed. All risk factors mentioned above are covered by specific scenarios and have Board-approved or GRC- approved risk limits. Dynamic simulation is also used to project the Bank’s future net interest income, future economic value and future structural interest rate risk exposure. These simulations project cash flows of assets, liabilities and off-balance-sheet products over a given investment horizon. Given their dynamic nature, they encompass assumptions pertaining to changes in volume, client term preference, prepayments of deposits and loans, and the yield curve. The following tables present the potential before-tax impact of an immediate and sustained 100-basis-point increase or decrease in interest rates on the economic value of equity and on the net interest income of the non-trading portfolios for the next 12 months, assuming no further hedging is undertaken. IInntteerreesstt RRaattee SSeennssiittiivviittyy –– NNoonn--TTrraaddiinngg AAccttiivviittiieess ((BBeeffoorree TTaaxx))** As at October 31 (millions of Canadian dollars) IImmppaacctt oonn eeqquuiittyy 100-basis-point increase in the interest rate 100-basis-point decrease in the interest rate IImmppaacctt oonn nneett iinntteerreesstt iinnccoommee 100-basis-point increase in the interest rate 100-basis-point decrease in the interest rate CCaannaaddiiaann ddoollllaarr OOtthheerr ccuurrrreenncciieess ((117788)) 119999 ((2266)) 7733 4400 ((44)) 4422 ((44)) 22001199 TToottaall ((113388)) 119955 1166 6699 Canadian dollar Other currencies (140) 154 10 34 9 17 19 8 2018 Total (131) 171 29 42 IInnvveessttmmeenntt GGoovveerrnnaannccee The Bank has created securities portfolios in liquid and less liquid securities for strategic, long-term investment and liquidity management purposes. These investments carry market risk, credit risk, liquidity risk and concentration risk. The investment governance sets out the guiding principles and general management standards that must be followed by all those who manage portfolios of these securities included in the portfolios of the Bank and its subsidiaries. Under this investment governance, business units that are active in managing these types of portfolios must adopt internal investment policies that set, among other things, targets and limits for the allocation of assets in the portfolios concerned and internal approval mechanisms. The primary objective is to reduce concentration risk by industry, issuer, country, type of financial instrument and credit quality. Overall limits in value and in proportion to the Bank’s equity are set on the outstanding amount of liquid preferred shares, liquid equity securities excluding preferred shares, and instruments classified as illiquid securities in the securities portfolios. The overall exposure to common shares with respect to an individual issuer and the total outstanding amount invested in private equity funds, for investment banking services, are also subject to limits. Restrictions are also set on investments defined as special. Lastly, the Bank has a specific strategic investment policy, approved by the Board, which defines strategic investments as purchases of business assets or acquisitions of significant interests in an entity for purposes of acquiring control or creating a long-term relationship. SSttrruuccttuurraall FFoorreeiiggnn EExxcchhaannggee RRiisskk The Bank’s structural foreign exchange risk arises from investments in foreign operations denominated in currencies other than the Canadian dollar. This risk, predominantly in U.S. dollars, is measured by assessing the impact of currency fluctuations on net interest income and shareholders’ equity. The Bank uses financial instruments (derivative and non-derivative) to hedge some of this risk. An adverse change in foreign exchange rates can also impact the Bank’s capital ratios due to the amount of RWA denominated in a foreign currency. When the Canadian dollar depreciates relative to other currencies, unrealized translation gains on the Bank’s net investments in foreign operations, net of related hedges, are reported in other comprehensive income in shareholders’ equity. In addition, the Canadian-dollar equivalent of U.S.-dollar-denominated RWA and regulatory capital deductions increases. The reverse is true when the Canadian dollar appreciates relative to the U.S. dollar. The structural foreign exchange risk exposure is managed to ensure that the potential impacts on the capital ratios and net income are within tolerable limits set by risk policies. National Bank of Canada 81 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management LLiiqquuiiddiittyy aanndd FFuunnddiinngg RRiisskk Liquidity and funding risk is the risk that the Bank will be unable to honour daily cash and financial obligations without resorting to costly and untimely measures. Liquidity and funding risk arises when sources of funds become insufficient to meet scheduled payments under the Bank’s commitments. Liquidity risk stems from mismatched cash flows related to assets and liabilities as well as the characteristics of certain products such as credit commitments and non-fixed-term deposits. The Bank’s primary objective as a financial institution is to manage liquidity such that it supports the Bank’s business strategy and allows it to honour its commitments when they come due, even in extreme conditions. This is done primarily by implementing a policy framework approved by the Board, which establishes a risk appetite, monitoring structures controlled by various committees, risk indicators, reporting procedures, delegation of responsibilities and segregation of duties. The Bank also prepares an annual funding plan that incorporates the expected growth of assets and liabilities. Regulatory Environment The Bank works closely with national and international regulators to implement regulatory liquidity standards. The Bank adapts its processes and policies to reflect the Bank’s liquidity risk appetite towards these new requirements. The Liquidity Adequacy Requirements are reviewed annually to reflect domestic and international regulatory changes. They constitute OSFI's proposed liquidity framework and include six chapters:  overview; liquidity coverage ratio (LCR);   net stable funding ratio (NSFR);  net cumulative cash flow (NCCF);   liquidity monitoring tools; intraday liquidity monitoring tools. The LCR is used to ensure that banks can overcome severe short-term stress, while the NSFR is a structural ratio over a one-year horizon. The NCCF metric is defined as a monitoring tool that calculates a survival period. It is based on the assumptions of a stress scenario prescribed by OSFI that aims to represent a combined systemic and bank-specific crisis. The Bank publishes the LCR on a quarterly basis. It is currently monitoring the NSFR ratio and will be compliant therewith as of the effective date of January 1, 2021, with OSFI having published the final version of the Net Stable Funding Ratio Disclosure Requirements guideline on April 11, 2019, which sets out NSFR ratio disclosure requirements for D-SIBs. These requirements will be applicable as of January 1, 2020, but since OSFI has introduced an additional year to implement the disclosure framework, they will take effect on January 1, 2021. On April 11, 2019, OSFI also issued a new version of its Liquidity Adequacy Requirements guideline, which will come into effect on January 1, 2020. This version differs from the previous one and seeks to ensure that liquidity risk measuring and monitoring standards reflect current sound practices. On May 23, 2019, OSFI updated the covered bond limit calculation. Effective August 1, 2019, total assets pledged by a deposit-taking institution for covered bonds must not, at any time, represent more than 5.5% of the issuer’s on-balance-sheet assets. On July 18, 2019, OSFI published proposed changes to guideline B-6 – Liquidity Principles for public consultation. The current version was last updated in 2012, and the proposed changes aim to ensure that the guideline remains current, relevant, and appropriate to the scale and complexity of institutions. OSFI is targeting an implementation date of January 1, 2020. GGoovveerrnnaannccee The Global Funding and Treasury Group is responsible for managing liquidity and funding risk. Although the day-to-day and strategic management of risks associated with liquidity, funding and pledging activities is assumed by the Global Funding and Treasury Group, the Risk Management Group is responsible for assessing liquidity risk and overseeing compliance with the resulting policy. The Risk Management Group ensures that an appropriate risk management framework is in place and ensures compliance with the risk appetite framework. This structure provides an independent oversight and effective challenge for the liquidity, funding and pledging decisions, strategy, and exposure. The Bank’s Liquidity, Funding and Pledging Governance policy requires review and approval by the RMC, based on recommendations from the GRC. The Bank has established two levels of limits. The first level of limits encompasses the Bank’s overall liquidity position and is Board approved, while the second level of limits is more focused on specific elements of liquidity risk and is approved by the GRC. The Board not only approves the supervision of day-to-day risk management and governance but also backup plans in anticipation of emergency and liquidity crisis situations. If a limit has to be revised, the Risk Management Group with the support of the Global Funding and Treasury Group, submits the proposed revision to the GRC. If the latter approves the request, it is presented to the Board for approval only if a level-one limit is concerned. Oversight of liquidity risk is entrusted mainly to the Financial Markets Risk Committee, whose members include representatives of the Financial Markets segment, the Global Funding and Treasury Group, the Risk Management Group, and Internal Audit. 82 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Through the Financial Markets Risk Committee, the Risk Management Group regularly reports changes in liquidity, funding and pledging indicators and compliance with regulatory, Board and GRC approved limits. If control reports indicate non-compliance with the limits and, generally, deterioration of liquidity indicators, the Global Funding and Treasury Group takes remedial action. According to the escalation process, problematic situations are reported to management and to the GRC and the RMC. An executive report on the Bank’s liquidity and funding risk management, which describes the Bank’s liquidity position and informs the Board of non-compliance with the limits and other rules observed during the reference period as well as remedial action taken, is submitted quarterly to the RMC. LLiiqquuiiddiittyy MMaannaaggeemmeenntt The Bank performs liquidity management, funding and pledging operations not only from its head office and regional offices in Canada, but also through certain foreign centres. Although the volume of such operations abroad represents a sizable portion of global liquidity management, the Bank’s liquidity management is centralized. By organizing liquidity management, funding and pledging activities within the Global Funding and Treasury Group, the Bank can better coordinate enterprise-wide funding and risk monitoring activities. All internal funding transactions between Bank entities are controlled by the Global Funding and Treasury Group. This centralized structure streamlines the allocation and control of liquidity management, funding and pledging limits. Nonetheless, the Liquidity, Funding and Pledging Governance policy contains special provisions for the financial centres that are most active in terms of institutional funding and sets limits and monitoring thresholds for secured and unsecured short-term funding, both in absolute value and materiality. The Bank’s funds transfer pricing system prices liquidity by allocating the cost or income to the various business segments. Liquidity costs are allocated to liquidity-intensive activities, mainly long-term loans, and commitments to extend credit and less liquid securities as well as strategic investments. The liquidity compensation is credited to the suppliers of funds, primarily funding in the form of stable deposits from the Bank’s distribution network. Short-term day-to-day funding decisions are based on a daily cumulative net cash position, which is controlled using liquidity ratio limits. Among these ratios and metrics, the Bank pays particular attention to the funds obtained on the wholesale market and to cumulative cash flows over various time horizons. Moreover, the Bank’s collateral pledging activities are monitored in relation to the different limits set by the Bank and are subject to monthly stress tests using simulations. In particular, the Bank uses various scenarios to estimate the potential amounts of additional collateral that would be required in the event of a downgrade to the Bank’s credit rating. Liquidity risk can be assessed in many different ways using different liquidity indicators. One of the key monitoring tools of liquidity risk is the Bank’s survival period based on contractual maturity and behavioural assumptions applied to balance sheet items as well as off-balance-sheet commitments. Stress Testing and Crisis Scenarios Using various simulations, survival period measures the number of months it would take to completely utilize the Bank’s liquid assets if the Bank were to lose deposits prematurely or if funds from wholesale markets were not renewed at maturity. It is measured monthly using three scenarios, which were developed to assess sensitivity to a Bank-specific and/or systemic crisis. Deposit loss simulations are carried out based on their degree of stability, while the value of certain assets is encumbered by an amount reflecting their readiness for liquidation in a crisis. Appropriate scenarios and limits are included in the Bank's liquidity, funding and pledging governance policy. The Bank maintains an up-to-date, comprehensive financial contingency and crisis recovery plan that describes the measures to be taken in the event of a critical liquidity situation. This plan is reviewed and approved annually by the Board as part of business continuity and recovery planning. For additional information, see the Regulatory Compliance Risk Management section of this MD&A. Liquidity Risk Appetite The Bank monitors and manages its risk appetite through liquidity limits, ratios and stress tests. The Bank’s liquidity risk appetite is based on the following principles:    ensure the Bank has a sufficient amount of unencumbered liquid assets to cover its financial requirements, in both normal and stressed conditions; ensure the Bank keeps a liquidity buffer above the minimum regulatory requirement; ensure the Bank maintains diversified and stable sources of funding. Liquid Assets To protect depositors and creditors from unexpected crisis situations, the Bank holds a portfolio of unencumbered liquid assets that can be readily liquidated to meet financial obligations. The majority of unencumbered liquid assets are held in Canadian or U.S. dollars. Moreover, all assets that can be quickly monetized are considered liquid assets. The Bank’s liquidity reserves do not factor in the availability of the central bank’s emergency liquidity facilities. The following tables provide information on the Bank’s encumbered and unencumbered assets. National Bank of Canada 83 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management LLiiqquuiidd AAsssseett PPoorrttffoolliioo As at October 31 (millions of Canadian dollars) CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss SSeeccuurriittiieess Issued or guaranteed by the Canadian government, U.S. Treasury, other U.S. agencies and other foreign governments Issued or guaranteed by Canadian provincial and municipal governments Other debt securities Equity securities LLooaannss Securities backed by insured residential mortgages AAss aatt OOccttoobbeerr 3311,, 22001199 As at October 31, 2018 As at October 31 (millions of Canadian dollars) UUnneennccuummbbeerreedd lliiqquuiidd aasssseettss bbyy eennttiittyy National Bank (parent) Domestic subsidiaries Foreign subsidiaries and branches As at October 31 (millions of Canadian dollars) UUnneennccuummbbeerreedd lliiqquuiidd aasssseettss bbyy ccuurrrreennccyy Canadian dollar U.S. dollar Other currencies LLiiqquuiidd AAsssseett PPoorrttffoolliioo –– AAvveerraaggee(4) Year ended October 31 (millions of Canadian dollars) CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss SSeeccuurriittiieess Issued or guaranteed by the Canadian government, U.S. Treasury, other U.S. agencies and other foreign governments Issued or guaranteed by Canadian provincial and municipal governments Other debt securities Equity securities LLooaannss Securities backed by insured residential mortgages AAss aatt OOccttoobbeerr 3311,, 22001199 As at October 31, 2018 BBaannkk--oowwnneedd lliiqquuiidd aasssseettss(1) LLiiqquuiidd aasssseettss rreecceeiivveedd(2) TToottaall lliiqquuiidd aasssseettss EEnnccuummbbeerreedd lliiqquuiidd aasssseettss(3) 22001199 UUnneennccuummbbeerreedd lliiqquuiidd aasssseettss 2018 Unencumbered liquid assets 1133,,669988 −− 1133,,669988 44,,110022 99,,559966 10,287 2255,,664488 1188,,776600 4444,,440088 1100,,222244 55,,664477 4400,,770077 77,,442222 110033,,334466 91,640 55,,440044 22,,221122 2288,,993344 −− 5555,,331100 57,483 1155,,662288 77,,885599 6699,,664411 77,,442222 115588,,665566 149,123 2200,,995533 99,,448833 22,,227788 4422,,667733 44,,449966 8833,,998855 86,176 2233,,445555 20,825 66,,114455 55,,558811 2266,,996688 22,,992266 7744,,667711 6,540 5,398 16,611 3,286 62,947 22001199 2018 3300,,338800 1144,,881155 2299,,447766 7744,,667711 30,205 11,543 21,199 62,947 22001199 2018 3399,,117722 1199,,335566 1166,,114433 7744,,667711 35,838 22,663 4,446 62,947 BBaannkk--oowwnneedd lliiqquuiidd aasssseettss(1) LLiiqquuiidd aasssseettss rreecceeiivveedd(2) TToottaall lliiqquuiidd aasssseettss EEnnccuummbbeerreedd lliiqquuiidd aasssseettss(3) 22001199 UUnneennccuummbbeerreedd lliiqquuiidd aasssseettss 2018 Unencumbered liquid assets 1111,,883300 −− 1111,,883300 33,,333399 88,,449911 9,098 2288,,115522 2233,,334499 5511,,550011 1111,,332200 55,,441100 3388,,441166 77,,668888 110022,,881166 96,513 66,,776611 22,,447744 2299,,885500 −− 6622,,443344 63,347 1188,,008811 77,,888844 6688,,226666 77,,668888 116655,,225500 159,860 2288,,550066 1133,,663399 22,,999999 4411,,990066 44,,553388 9944,,992277 96,591 2222,,999955 19,180 44,,444422 44,,888855 2266,,336600 33,,115500 7700,,332233 4,652 4,041 22,001 4,297 63,269 Bank-owned liquid assets include assets for which there are no legal or geographic restrictions. Securities received as collateral with respect to securities financing and derivative transactions and securities purchased under reverse repurchase agreements and securities borrowed. In the normal course of its funding activities, the Bank pledges assets as collateral in accordance with standard terms. Encumbered liquid assets include assets used to cover short sales, obligations related to securities sold under repurchase agreements and securities loaned, guarantees related to security-backed loans and borrowings, collateral related to derivative financial instrument transactions, asset-backed securities and liquid assets legally restricted from transfers. The average is based on the sum of the end-of-period balances of the 12 months of the year divided by 12. (1) (2) (3) (4) 84 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management SSuummmmaarryy ooff EEnnccuummbbeerreedd aanndd UUnneennccuummbbeerreedd AAsssseettss (millions of Canadian dollars) Cash and deposits with financial institutions Securities Securities purchased under reverse repurchase agreements and securities borrowed Loans and acceptances, net of allowances Derivative financial instruments Investments in associates and joint ventures Premises and equipment Goodwill Intangible assets Other assets (millions of Canadian dollars) Cash and deposits with financial institutions Securities Securities purchased under reverse repurchase agreements and securities borrowed Loans and acceptances, net of allowances Derivative financial instruments Investments in associates and joint ventures Premises and equipment Goodwill Intangible assets Other assets EEnnccuummbbeerreedd aasssseettss(1) UUnneennccuummbbeerreedd aasssseettss AAss aatt OOccttoobbeerr 3311,, 22001199 EEnnccuummbbeerreedd aasssseettss aass %% ooff ttoottaall aasssseettss TToottaall OOtthheerr(2) 33,,995599 −− 1122,,885500 −− −− −− −− −− −− −− 1166,,880099 AAvvaaiillaabbllee aass ccoollllaatteerraall 99,,559966 5577,,227766 44,,887733 22,,992266 −− −− −− −− −− −− 7744,,667711 OOtthheerr(3) −− −− −− 111188,,449900 88,,112299 338855 449900 11,,441122 11,,440066 22,,773388 113333,,005500 1133,,669988 8822,,222266 1177,,772233 115533,,225511 88,,112299 338855 449900 11,,441122 11,,440066 22,,773388 228811,,445588 11..44 88..99 44..66 1111..33 −− −− −− −− −− −− 2266..22 Encumbered assets(1) Unencumbered assets As at October 31, 2018 Encumbered assets as % of total assets Total Other(2) 2,382 − 17,781 − − − − − − − 20,163 Available as collateral 10,287 48,996 378 3,286 − − − − − − 62,947 Other(3) − − − 114,126 8,608 645 601 1,412 1,314 3,111 129,817 12,756 69,783 18,159 146,082 8,608 645 601 1,412 1,314 3,111 262,471 0.9 7.9 6.8 10.9 − − − − − − 26.5 PPlleeddggeedd aass ccoollllaatteerraall 114433 2244,,995500 −− 3311,,883355 −− −− −− −− −− −− 5566,,992288 Pledged as collateral 87 20,787 − 28,670 − − − − − − 49,544 (1) In the normal course of its funding activities, the Bank pledges assets as collateral in accordance with standard terms. Encumbered assets include assets used to cover short sales, obligations related to securities sold under repurchase agreements and securities loaned, guarantees related to security-backed loans and borrowings, collateral related to derivative financial instrument transactions, asset-backed securities, residential mortgage loans securitized and transferred under the Canada Mortgage Bond program, assets held in consolidated trusts supporting the Bank’s funding activities and mortgage loans transferred under covered bond programs. (2) Other encumbered assets include assets for which there are restrictions and therefore cannot be used for collateral or funding purposes as well as assets used to cover short sales. (3) Other unencumbered assets are assets that cannot be used for collateral or funding purposes in their current form. This category includes assets that are potentially eligible as funding program collateral (e.g., Canada Mortgage and Housing Corporation insured mortgages that can be securitized into mortgage-backed securities under the National Housing Act (Canada)). National Bank of Canada 85 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Liquidity Coverage Ratio (LCR) The LCR was introduced primarily to ensure banks maintain sufficient liquidity to withstand periods of severe short-term stress. OSFI has been requiring Canadian banks to maintain a minimum LCR of 100%. An LCR above 100% ensures that banks are holding sufficient high-quality liquid assets (HQLA) to cover net cash outflows given a severe, 30-day liquidity crisis. The assumptions underlying the LCR scenario were established by the BCBS and OSFI. The following table provides average LCR data calculated using the daily figures in the quarter. For the quarter ended October 31, 2019, the Bank’s average LCR was 146%, well above the 100% regulatory requirement and demonstrating the Bank’s solid liquidity position. LLCCRR DDiisscclloossuurree RReeqquuiirreemmeennttss(1) (millions of Canadian dollars) HHiigghh--qquuaalliittyy lliiqquuiidd aasssseettss ((HHQQLLAA)) 1 Total HQLA CCaasshh oouuttfflloowwss 2 Retail deposits and deposits from small business customers, of which: 3 Stable deposits 4 Less stable deposits 5 Unsecured wholesale funding, of which: 6 Operational deposits (all counterparties) 7 Non-operational deposits (all counterparties) 8 Unsecured debt 9 Secured wholesale funding 10 Additional requirements, of which: 11 Outflows related to derivative exposures and other collateral requirements 12 Outflows related to loss of funding on secured debt securities 13 Backstop liquidity and credit enhancement facilities and commitments to extend credit 14 Other contractual commitments to extend credit 15 Other contingent commitments to extend credit 16 Total cash outflows CCaasshh iinnfflloowwss 17 Secured lending (e.g., reverse repos) 18 Inflows from fully performing exposures 19 Other cash inflows 20 Total cash inflows 21 Total HQLA 22 Total net cash outflows 23 Liquidity coverage ratio (%)(5) TToottaall uunnwweeiigghhtteedd vvaalluuee(2) ((aavveerraaggee)) OOccttoobbeerr 3311,, 22001199 TToottaall wweeiigghhtteedd vvaalluuee(3) ((aavveerraaggee)) For the quarter ended July 31, 2019 Total weighted value(3) (average) nn..aa.. 4455,,889911 4433,,993333 1199,,335500 2244,,558833 7766,,557799 1133,,006655 5544,,114433 99,,337711 nn..aa.. 3366,,009933 99,,223333 883399 2266,,002211 11,,997700 9922,,665500 nn..aa.. 111166,,229999 1100,,449966 1166,,007700 114422,,886655 33,,003399 558811 22,,445588 4422,,447799 33,,114433 2299,,996655 99,,337711 1155,,995522 1100,,119999 55,,229911 883399 44,,006699 557766 11,,444477 7733,,669922 1199,,550000 66,,445555 1166,,007700 4422,,002255 46,194 2,893 588 2,305 39,240 2,780 28,888 7,572 16,440 9,031 4,113 858 4,060 415 1,442 69,461 19,765 6,094 13,531 39,390 TToottaall aaddjjuusstteedd vvaalluuee(4) Total adjusted value(4) nn..aa.. nn..aa.. nn..aa.. 4455,,889911 3311,,666677 114466 %% 46,194 30,071 154 % Unweighted values are calculated as outstanding balances maturing or callable within 30 days (for inflows and outflows). n.a. Not applicable (1) OSFI prescribed a table format in order to standardize disclosure throughout the banking industry. (2) (3) Weighted values are calculated after the application of respective haircuts (for HQLA) or inflow and outflow rates. (4) (5) Total adjusted values are calculated after the application of both haircuts and inflow and outflow rates and any applicable caps. The data in this table has been calculated using averages of the daily figures in the quarter. As at October 31, 2019, Level 1 liquid assets represented 79% of the Bank’s HQLA, which includes cash, central bank deposits, and bonds issued or guaranteed by the Canadian government and Canadian provincial governments. Cash outflows arise from the application of OSFI-prescribed assumptions on deposits, debt, secured funding, commitments and additional collateral requirements. The cash outflows are partly offset by cash inflows, which come mainly from secured loans and performing loans. The Bank expects some quarter- over-quarter variation between reported LCRs, and such variation may not be indicative of a trend. The variation between the quarter ended October 31, 2019 and the previous quarter was a result of normal business activities. The Bank’s liquid asset buffer is well in excess of its total net cash outflows. The LCR assumptions differ from the assumptions used for the liquidity disclosures presented in the tables on the previous pages or those used for internal liquidity management rules. While the liquidity disclosure framework was prescribed by the EDTF, the Bank’s internal liquidity metrics use assumptions that are calibrated according to its business model and experience. 86 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Intraday Liquidity The Bank manages its intraday liquidity in such a way that the amount of available liquidity exceeds its maximum intraday liquidity requirements. The Bank monitors its intraday liquidity on an hourly basis and the evolution is presented monthly to the Financial Markets Risk Committee. FFuunnddiinngg RRiisskk Funding risk is defined as the risk to the Bank’s ongoing ability to raise sufficient funds to finance actual or proposed business activities on an unsecured or secured basis at an acceptable price. The Bank maintains a good balance of its funding through appropriate diversification of its unsecured funding vehicles, securitization programs and secured funding. The Bank also diversifies its funding by currency, geography and maturity. The funding management priority is to achieve an optimal balance between deposits, securitization, secured funding and unsecured funding. This brings optimal stability to the funding and reduces vulnerability to unpredictable events. Funding and liquidity levels remained sound and robust over the year and the Bank does not foresee any event, commitment or demand that might have a significant impact on its funding and liquidity risk position. For additional information, see the table entitled Residual Contractual Maturities of Balance Sheet Items and Off-Balance-Sheet Commitments in Note 29 to the consolidated financial statements. Credit Ratings The credit ratings assigned by ratings agencies represent their assessment of the Bank’s credit quality based on qualitative and quantitative information provided to them. Credit ratings may be revised at any time based on various factors, including macro-economic factors, methodologies used by ratings agencies, or the current and projected financial condition of the Bank. Credit ratings are one of the main factors that influence the Bank’s ability to access financial markets at a reasonable cost. A downgrade in the Bank’s credit ratings could adversely affect the cost, size and term of future funding and could also result in increased requirement to pledge collateral or decreased capacity to engage in certain collateralized business activities at a reasonable cost, including hedging and derivatives transactions. Funding and liquidity levels remained sound and robust, and the Bank continues to enjoy excellent access to the market for its funding needs. The Bank received favourable credit ratings from all the agencies, reflecting the high quality of its debt instruments, and the Bank's objective is to maintain these high ratings. On July 29, 2019, DBRS Limited (DBRS) changed the trend on all the Bank’s ratings and its related entities from "Stable" to "Positive" to reflect improvements in its assessment of the Bank's funding and liquidity levels. For Moody's, S&P, and Fitch, the outlook remains unchanged at "Stable." The following table presents the Bank’s credit ratings according to four rating agencies as at October 31, 2019. TThhee BBaannkk’’ss CCrreeddiitt RRaattiinnggss Short-term senior debt Canadian commercial paper Long-term deposits Long-term non-bail-inable senior debt(1) Senior debt(2) NVCC subordinated debt NVCC preferred shares Counterparty risk(3) Covered bonds program Rating outlook MMooooddyy’’ss SS&&PP AAss aatt OOccttoobbeerr 3311,, 22001199 FFiittcchh DDBBRRSS P-1 Aa3 Aa3 A3 Baa2 (hyb) Ba1 (hyb) Aa3/P-1 Aaa Stable A-1 A-1 (mid) A BBB+ BBB P-3 (high) Stable R-1 (mid) AA (low) AA (low) A (high) BBB (high) Pfd-2 (low) AAA Positive F1 A+ A+ A+ A+ AAA Stable Includes senior debt issued prior to September 23, 2018 and senior debt issued on or after September 23, 2018 which is excluded from the Bank Recapitalization (Bail-in) Regime. Subject to conversion under the Bank Recapitalization (Bail-in) Regime. (1) (2) (3) Moody’s uses the term Counterparty Risk Rating while Fitch uses the term Derivative Counterparty Rating. National Bank of Canada 87 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Guarantees As part of a comprehensive liquidity management framework, the Bank regularly reviews its contracts that stipulate that additional collateral could be required in the event of a downgrade of the Bank’s credit rating. The Bank’s liquidity position management already incorporates additional collateral requirements in the event of a one-notch to three-notch downgrade. The table below presents the additional collateral requirements in the event of a one-notch or three-notch credit rating downgrade. (millions of Canadian dollars) Derivatives(1) OOnnee--nnoottcchh ddoowwnnggrraaddee AAss aatt OOccttoobbeerr 3311,, 22001199 TThhrreeee--nnoottcchh ddoowwnnggrraaddee 2266 3355 (1) Contractual requirements related to agreements known as Credit Support Annexes. Funding Strategy The main objective of the funding strategy is to support the Bank's organic growth while also enabling it to survive potentially severe and prolonged crises and to meet its regulatory obligations and financial targets. The Bank’s funding framework is summarized as follows:  pursue a diversified deposit strategy to fund core banking activities through stable deposits coming from the networks of each of the Bank’s major business  segments; incorporate the regulatory framework into day-to-day liquidity management and into the long-term funding plan by leveraging a strong risk management culture and centralized expertise;  maintain active access to various markets to ensure a diversification of institutional funding in terms of source, geographic location, currency, instrument and maturity, whether or not funding is secured. The funding strategy is implemented in accordance with the overall objectives of strengthening the Bank's franchise among market participants and consolidating its excellent reputation. The Bank continuously monitors and analyzes the possibilities for accessing less expensive and more flexible funding. The deposit strategy remains a priority for the Bank, which continues to prefer deposits to institutional funding. The Bank actively monitors and controls liquidity risk exposures and funding needs within and across entities, business segments, and currencies. The process involves evaluating the liquidity position of individual business segments in addition to that of the Bank as a whole as well as the liquidity risk from raising unsecured and secured funding in foreign currencies. The funding strategy is implemented through the funding plan and deposit strategy, which are monitored, updated to reflect actual results and regularly evaluated. 88 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Diversified Funding Sources The primary purpose of diversification by source, geographic location, currency, instrument, maturity and depositor is to mitigate liquidity and funding risk by ensuring that the Bank maintains alternative sources of funds that strengthen its capacity to withstand a variety of severe yet plausible institution-specific and market-wide shocks. To meet this objective, the Bank: sets limits on funding concentration; takes funding diversification into account in the business planning process;   maintains a variety of funding programs to access different markets;   maintains strong relationships with fund providers;   is active in various funding markets of all tenors and for various instruments; identifies and monitors the main factors that affect the ability to raise funds. The Bank is active in the following funding and securitization platforms:  Canadian dollar Senior Unsecured Debt;  U.S. dollar Senior Unsecured Debt programs;  Canadian Medium-Term Note Shelf;  U.S. dollar Commercial Paper programs;  U.S. dollar Certificates of Deposit; Euro Medium-Term Note program;   Canada Mortgage and Housing Corporation securitization programs;  Canadian Credit Card Trust II;  Legislative Covered Bond program. The table below presents the residual contractual maturities of the Bank’s wholesale funding. The information has been presented in accordance with the categories recommended by the EDTF for comparison purposes with other banks. RReessiidduuaall CCoonnttrraaccttuuaall MMaattuurriittiieess ooff WWhhoolleessaallee FFuunnddiinngg(1) (millions of Canadian dollars) AAss aatt OOccttoobbeerr 3311,, 22001199 Deposits from banks(2) Certificates of deposit and commercial paper(3) Senior unsecured medium-term notes(4) Senior unsecured structured notes Covered bonds and asset-backed securities Mortgage securitization Covered bonds Securitization of credit card receivables Subordinated liabilities(5) Secured funding Unsecured funding As at October 31, 2018 11 mmoonntthh oorr lleessss OOvveerr 11 mmoonntthh ttoo 33 mmoonntthhss OOvveerr 33 mmoonntthhss ttoo 66 mmoonntthhss OOvveerr 66 mmoonntthhss ttoo 1122 mmoonntthhss 660055 11,,991144 1144 665544 −− −− −− −− 33,,118877 −− 33,,118877 33,,118877 1,944 1133 44,,119999 339955 −− 11,,449911 −− −− −− 66,,009988 11,,449911 44,,660077 66,,009988 7,261 77 33,,223388 22,,110033 −− 999955 −− 887744 −− 77,,221177 11,,886699 55,,334488 77,,221177 4,339 −− 22,,664444 22,,777711 225544 11,,225566 −− −− −− 66,,992255 11,,225566 55,,666699 66,,992255 5,143 SSuubbttoottaall 11 yyeeaarr oorr lleessss 662255 1111,,999955 55,,228833 990088 33,,774422 −− 887744 −− 2233,,442277 44,,661166 1188,,881111 2233,,442277 18,687 OOvveerr 11 yyeeaarr ttoo 22 yyeeaarrss −− −− 33,,443322 −− 33,,664400 22,,229900 −− −− 99,,336622 55,,993300 33,,443322 99,,336622 9,856 OOvveerr 22 yyeeaarrss −− −− 44,,773300 44,,110088 1133,,993300 77,,116688 3377 777733 3300,,774466 2211,,113355 99,,661111 3300,,774466 28,950 TToottaall 662255 1111,,999955 1133,,444455 55,,001166 2211,,331122 99,,445588 991111 777733 6633,,553355 3311,,668811 3311,,885544 6633,,553355 57,493 (1) (2) (3) (4) (5) Bankers’ acceptances are not included in this table. Deposits from banks include all non-negotiable term deposits from banks. Includes bearer deposit notes. Certificates of deposit denominated in euros are included in senior unsecured medium-term notes. Subordinated debt is presented in this table but the Bank does not consider it as part of its wholesale funding. National Bank of Canada 89 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management OOppeerraattiioonnaall RRiisskk Operational risk is the risk of loss resulting from an inadequacy or a failure ascribable to human resources, equipment, processes, technology or external events. Operational risk exists for every Bank activity. Theft, fraud, cyberattacks, unauthorized transactions, system errors, human error, amendments to or misinterpretation of laws and regulations, litigation or disputes with clients, inappropriate sales practice behaviour or property damage are just a few examples of events likely to cause financial loss, harm the Bank’s reputation or lead to punitive damages or regulatory penalties or sanctions. Although operational risk cannot be eliminated entirely, it can be managed in a thorough and transparent manner to keep it at an acceptable level. The Bank’s operational risk management framework is built on the concept of three lines of defence and provides a clear allocation of responsibilities to all levels of the organization, as mentioned below. OOppeerraattiioonnaall RRiisskk MMaannaaggeemmeenntt FFrraammeewwoorrkk The operational risk management framework is described in the Operational Risk Management Policy, which is derived from the Risk Management Policy. The operational risk management framework is aligned with the Bank's risk appetite and is made up of policies, standards, and procedures specific to each operational risk, which fall under the responsibility of specialized groups. The segments use several operational risk management tools and methods to identify, assess, and monitor their operational risks and control measures. With these tools and methods, the segments can: recognize and understand the inherent and residual risks to which their activities and operations are exposed; identify how to mitigate the identified risks and monitor them to keep them at an acceptable level;    proactively and continuously manage risks. OOppeerraattiioonnaall RRiisskk MMaannaaggeemmeenntt TToooollss aanndd MMeetthhooddss Collection and Analysis of Data on Operational Losses Incurred by the Bank The Operational Risk Unit applies a process, across the Bank and its subsidiaries, for collecting and compiling data on internal operational losses. This data is entered into a centralized database and includes the amount of each loss, the type of risk involved, a description of the event that caused the loss, and the date of the loss, making it possible to better understand the fundamental causes of this type of loss and develop mitigation strategies. During fiscal years 2019 and 2018, there were no material losses resulting from an operational risk event. Analysis and Lessons Learned From Operational Events Observed in Other Large Businesses By collecting and analyzing media-reported information about significant operational events, in particular events related to information security and theft of personal information experienced by other financial institutions, the Bank can assess the effectiveness of its own operational risk management practices and reinforce them, if necessary. Operational Risk Self-Assessment Program The operational risk self-assessment program gives each business unit and corporate unit the means to proactively identify and assess new or major operational risks to which they are exposed, evaluate the effectiveness of mitigating controls, and develop action plans to keep such risks at acceptable levels. Key Risk Indicators The business units and corporate units define key indicators associated with their main operational risks. The key indicators are used to monitor operational risk profiles and are related to critical thresholds that, once reached, result in action by management. Using key risk indicators, the business units can track risks and proactively detect any adverse change in risk exposure. Scenario Analysis Scenario analysis, which is part of a Bank-wide stress testing program, is an important and useful tool for assessing the potential impacts arising from major operational events. It helps the Bank define its risk appetite, set its exposure limits, and engage in strategic planning. More specifically, it helps senior management to better understand the risks facing the Bank and to make appropriate management decisions to mitigate potential operational risks. Insurance Program In order to protect itself against any material losses related to its exposure to unforeseeable operational risks, the Bank also has adequate insurance, the nature and amount of which meet its coverage requirements. OOppeerraattiioonnaall RRiisskk RReeppoorrttss aanndd DDiisscclloossuurreess Operational events for which the financial impact exceeds the tolerance thresholds or that have a significant regulatory or reputation impact are submitted to the decision-making levels concerned. Management is obligated to report on its management process and to remain alert to current and future issues. Reports on the Bank’s risk profile, highlights, and emerging risks are periodically submitted, on a timely basis, to the Operational Risk Management Committee, the GRC and the RMC. This reporting enhances the transparency and proactive management of the main operational risk factors. 90 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management RReegguullaattoorryy CCoommpplliiaannccee RRiisskk Regulatory compliance risk is the risk of the Bank or its employees failing to comply with the regulatory requirements in effect where the Bank does business, both in Canada and internationally. Regulatory compliance risk is present in all of the daily operations of each Bank segment. A situation of regulatory non- compliance can adversely affect the Bank’s reputation and result in penalties, fines and sanctions or increased oversight by regulators. OOrrggaanniizzaattiioonnaall SSttrruuccttuurree ooff CCoommpplliiaannccee Compliance is an independent oversight function within the Bank. The Senior Vice-President, Chief Compliance Officer and Chief Anti-Money Laundering Officer serves as both chief compliance officer (CCO) and chief anti-money laundering and anti-terrorist financing officer (CAMLATFO). She is responsible for implementing and updating the Bank’s compliance program and the AML/ATF program across all Bank segments. Having a reporting relationship with the Chair of the RMC, the CCO and CAMLATFO meets with him on at least once every quarter. With him, she goes over matters on the relationship between the Compliance Service and the Bank’s management and on access to the information required. The CCO and CAMLATFO can also communicate directly with officers and directors of the Bank and of its subsidiaries and foreign centres. RReegguullaattoorryy CCoommpplliiaannccee FFrraammeewwoorrkk The Bank operates in a highly regulated industry. To ensure sound management of regulatory compliance, the Bank favours proactive approaches and incorporates regulatory requirements into its day-to-day operations. Regulatory compliance risk management ensures that events stemming from regulatory non-compliance are proactively identified and understood and that mitigating strategies are implemented. Such proactive management also provides reasonable assurance that the Bank is in compliance, in all material respects, with the regulatory requirements in effect where it does business, both in Canada and internationally. The implementation of a regulatory compliance risk management framework across the Bank is entrusted to the Compliance Service, which has the following mandate:  make sure that policies and standards that ensure compliance with the regulations are in effect, including regulations related to AML/ATF, to international sanctions, and to corruption;  develop compliance and AML/ATF training programs for Bank employees, officers, and directors;  exercise independent oversight and monitor the programs, policies, and procedures implemented by the Bank, its subsidiaries, and foreign centres to ensure that the control mechanisms are sufficient, respected, and effective; report relevant compliance and AML/ATF matters to the Bank’s Board and inform it of any changes in the effectiveness of the Bank’s risk management framework.  The Bank holds itself to high regulatory compliance risk management standards in order to earn the trust of its clients, its shareholders, the market and the general public. Described below are the main regulatory developments that have been monitored over the past year. Consumer Protection Last year saw several regulatory changes. Notably, several amendments to the Quebec Consumer Protection Act came into force, and the industry adopted a voluntary code of conduct to protect seniors. In addition, Bill C-86 was adopted by the Government of Canada and will substantially amend the Bank Act (Canada). The purpose of these regulatory changes is to ensure consumer protection by fostering transparency and informed decision-making. Furthermore, the Bank constantly monitors the consumer protection landscape such that it can change its business practices if necessary. The Bank also makes sure its practices are aligned with industry practices by taking part in a variety of events that bring together players from the financial services ecosystem. Anti-Money Laundering and Anti-Terrorist Financing (AML/ATF) Activities On July 10, 2019, the Government of Canada published amendments to the regulations under the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (2019), which will come into force in three stages. Amendments regarding identification methods may be applied once the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) publishes its guideline on the topic, and the other amendments will come into force in June 2020 and June 2021. Regarding the five-year review of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act, Canadian banks are still awaiting the introduction of the bill. Privacy and Data Protection Due to changes in technologies and in society at large, privacy and data protection is a topical issue in Canada. In Europe, the new General Data Protection Regulation (GDPR) has been in force since May 2018, and several companies have received substantial penalties for contravening this regulation. In the United States, California has also adopted a stringent privacy protection act, which will come into force in January 2020. Changes in legislation related to the protection of personal information could accelerate in several jurisdictions, including Canada. This acceleration could be reflected in the granting of greater powers to the regulators responsible for privacy protection, such as the power to impose penalties. We are monitoring the relevant legislative developments. National Bank of Canada 91 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Canada Deposit Insurance Corporation (CDIC) Changes in the Government of Canada’s deposit insurance framework have been announced concerning information on co-owned accounts and accounts held in trust as well as on the insurability of certain deposits. As of April 30, 2020, coverage will be extended to insurable deposits in foreign currencies and to term deposits with maturities exceeding five years. In addition, as of April 30, 2021, separate coverage will be granted for Registered Education Savings Plans and Registered Disability Savings Plans. New requirements will also be established for the coverage of deposits in trust, particularly nominee-brokered deposits. Recovery and Resolution Planning As part of the regulatory measures used to manage systemic risks, D-SIBs are required to have in place recovery and resolution plans. A recovery plan is essentially a road map that guides the recovery of a bank in the event of severe financial stress; conversely, a resolution plan guides its orderly wind-down in the event of failure when recovery is no longer an option. The Bank improves and periodically updates its recovery and resolution plans to prepare for these high- risk, but low-probability events. These plans are presented to its domestic regulatory authorities. In addition, the Bank and other D-SIBs continue to work with the CDIC to develop a comprehensive settlement plan that would ensure orderly winding down of the Bank’s operations. Section 871(m) – Dividend Equivalent Payments Section 871(m) of the U.S. Internal Revenue Code aims to ensure that non-U.S. persons pay tax on payments that can be considered dividends on U.S. shares, when these payments are made on certain derivative instruments. The derivative instruments for which the underlyings are U.S. shares or “non-qualified indices” concluded as of January 1, 2017 are subject to the withholding and reporting requirements. The effective date for certain components of this regulation has been deferred from January 1, 2019 to January 1, 2021. Some of the obligations of a qualified derivatives dealer, established under subsection 871(m) of the IRC and the qualified intermediary agreement have also been deferred to January 1, 2021. Good Practice in the Foreign Exchange Market The FX Global Code is a voluntary code of good practice that applies to all participants in the wholesale foreign exchange market in all of the world’s financial centres. The code is the result of nearly two years of collaborative effort among central banks, including the Bank of Canada, and market participants from the world’s leading financial centres. The code defines the good practices to be followed by market participants to guarantee a robust, fair and transparent foreign exchange market. It covers such areas as ethics, governance, execution of orders (confirmation and settlement), information sharing, and risk management. The Bank completed implementation of the code of good practice and published a declaration of compliance with the FX Global Code on its website. Reform of Benchmark Interest Rates The reform of benchmark interest rates is a global initiative coordinated and led by central banks and public authorities around the world, including in Canada. The objective is to improve benchmarks by ensuring that they satisfy robust international standards. The initiative will introduce other benchmarks as potential successors to benchmark interest rates such as the Interbank Offered Rates (IBOR), which are the benchmark rates used by the major international banks for short-term loans on the interbank market. These rates, particularly LIBOR (London Interbank Offered Rate), are widely used as benchmark rates around the world for derivative financial instruments, bonds and other floating-rate instruments. The gradual elimination of the IBOR rates will have an impact on over-the-counter derivative transactions, and the Bank expects that a standardized solution for the industry will be adopted, probably in the form of an ISDA protocol. For some other types of contracts, contractual amendments are anticipated by the end of 2021, when some of the current rates are expected to be eliminated. RReeppuuttaattiioonn RRiisskk Reputation risk is the risk that the Bank’s operations or practices will be judged negatively by the public, whether that judgment is with or without basis, thereby adversely affecting the perception, image or trademarks of the Bank, potentially resulting in costly litigation or loss of income. Reputation risk generally arises from a deficiency in managing another risk. The Bank’s reputation may, for example, be adversely affected by non-compliance with laws and regulations or by process failures. All risks must therefore be managed effectively in order to protect the Bank’s reputation. The Bank seeks to ensure that its employees are constantly aware of the potential repercussions of their actions on the Bank’s reputation and image. In addition to the previously discussed operational risk management initiatives, a variety of mechanisms are in place to support sound reputation risk management, including codes of professional conduct applicable to all employees, policies regarding ethics and corporate governance and appropriate training programs. The Bank also has a reputation risk policy, approved by the RMC of the Board, that covers all of the Bank’s practices and transactions, including those of the third parties with which it establishes business relationships. The policy sets the reputation risk management principles and rules. The policy is complemented by the special provisions of the new products and activities policy, which determines the approvals required by the various committees that assess risk whenever new products or activities are introduced within the business units. These provisions are intended, among other things, to provide oversight for the management of reputation risk, which may be material for such products or activities. The new products and activities policy requires that any new product or activity for which reputation risk is determined to be high be submitted to the GRC for approval. The activities of the Compliance Service, Legal Affairs Department, Public Relations Department and Investor Relations Department complete the reputation risk management framework. 92 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management SSttrraatteeggiicc RRiisskk Strategic risk is the risk of a loss arising from inappropriate strategic orientations, improper execution or ineffective response to economic, financial, or regulatory changes. The corporate strategic plan is developed by the Office of the President, in alignment with the Bank’s overall risk appetite, and approved by the Board. Once approved, the initiatives of the strategic plan are monitored regularly to ensure that they are progressing. If not, strategies could be reviewed or adjusted if deemed appropriate. In addition, the Bank has a specific Board-approved policy for strategic investments, which are defined as purchases of business assets or acquisitions of significant interests in an entity for the purposes of acquiring control or creating a long-term relationship. As such, acquisition projects and other strategic investments are analyzed through a due diligence process to ensure that these investments are aligned with the corporate strategic plan and the Bank’s risk appetite. EEnnvviirroonnmmeennttaall RRiisskk Environmental risk is the risk of an environmental issue leading to a loss in financial or operating value or harming the Bank’s reputation or having an impact on its stakeholders. Consequently, physical risks resulting from the impacts of increases in the number and intensity of extreme weather events, as well as transition risks resulting from a shift to a low-carbon economy, require particular attention to reduce the Bank’s exposure to these negative externalities and, at the same time, seize new growth opportunities. The Bank, aware that it has a mobilizing role to play in environmental matters, announced its support for the Financial Stability Board’s Task Force on Climate- Related Financial Disclosures (TCFD) and will disclose, in addition to its performance reports, the information recommended by the task force. The TCFD has structured its recommendations around four pillars that represent an organization’s operating fundamentals: governance, strategy, risk management, and metrics and targets. These four major classes of recommendations are intended to provide a framework for the publication of climate-related financial information such that institutional investors can make informed choices about their exposure to climate-related risks and opportunities. GGoovveerrnnaannccee Oversight by the Board of Directors (Board) The Board identifies environmental, social, and governance (ESG) issues, including the impacts that climate change could have on the organization as a whole, and monitors the evolution of those issues. The Risk Management Committee, Audit Committee, and Conduct Review and Corporate Governance Committee are responsible for periodically examining the efforts made by the Bank to ensure that it is operating in accordance with high standards of corporate responsibility, including in environmental issues. This year, their respective mandates were expanded in this regard. Each year, the Board also reviews the Bank’s Social Responsibility Report, which notably provides details about its contribution to environmental protection. To further clarify the Bank’s commitment to exercising effective governance with regard to mechanisms to oversee risks and opportunities related specifically to the climate, the Risk Management Committee has a specific responsibility to ensure that the risk management framework takes ESG risks into account such that they are appropriately identified and monitored and integrated into the existing risk management processes. Management’s Role The Bank oversees climate-related risks through the risk management framework and various executive committees. The Enterprise-Wide Risk Management Committee (co-chaired by the Executive Vice-President, Risk Management and the Chief Financial Officer and Executive Vice-President, Finance) is regularly informed of developments and issues to facilitate monitoring and discussion such that issues can be effectively resolved when necessary. SSttrraatteeggyy The Bank has committed, through its mission, to make a positive impact on its stakeholders. It works to ensure that its commitments are reflected throughout its practices, including the transition to a low-carbon economy. An identification of environment-related risks and opportunities has helped the Bank to evolve and incorporate climate matters into its internal decision-making. There are many opportunities to limit environmental risks—including climate-related risks—and their impacts on the community. With this in mind, the Bank plans on offering more solutions whereby clients can increase their presence in low-carbon activities such as renewable energies and responsible investment. For example, a program that allows for the issuance of sustainability bonds will enable various organizations, including the Bank itself, to issue debt securities to finance projects that meet certain environmental and social criteria. The Bank also provides financial support to environmental organizations whose mission is to promote sustainable development and protect biodiversity and natural environments. National Bank of Canada 93 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Risk Management Over the past year, the Bank has completed a classification of the physical risks and transition-related risks based on each of the industries that make up its credit portfolios. In addition, in response to the TCFD’s recommendations, the Bank assessed the proportion of its carbon-related exposures to better understand the impacts of climate-related risks and opportunities on its credit portfolios. The results of these assessments will allow the Bank to start by examining its investment and asset growth strategy in more detail. They will also help guide the Bank’s climate scenario analyses of these industries in the years to come. The Bank will communicate the results of these analyses in an open and transparent manner. The Bank continues to work with its peers to find solutions for more accurate and consistent analyses and assessments of climate-related risks and opportunities. It is also a member of several strategic working groups, helping it to stay abreast of developments related to ESG risks, particularly climate risks. RRiisskk MMaannaaggeemmeenntt Risk Identification, Assessment and Management The Bank recognizes the importance of identifying, assessing, and managing climate-related risks. To this end, it proactively monitors all risks as well as its segments’ risk exposures in relation to its risk appetite and established limits. Top and emerging risks are risks that could have a material adverse effect on the Bank’s financial results, reputation, or long-term business model and strategy. These risks include credit, market, liquidity, operational, and ESG risks as well as climate-related risks. In addition, rapidly changing economic, regulatory, technological and business environments may have an impact on certain activities or on the Bank as a whole. Based on the TCFD's recommendations, the Bank has identified two types of relevant climate-related risks to include in its monitoring activities: physical risks and transition-related risks. It defines physical risks as the potential impacts on its physical assets and financial assets arising from more frequent and more intense extreme weather events, food insecurity, and energy and resource supply problems related to climate change. The Bank defines transition-related risks as the impacts arising from the move toward a low-emission economy. Such impacts include technological changes or public policy directions that could lead to a revaluation of the company's assets and result in new costs or new opportunities. The Bank’s definition of transition-related risk also includes market risk and reputational risk. The Bank ensures that it has processes in place to proactively identify and measure these risks so that it can implement appropriate mitigation strategies. To this end, the Bank has implemented an environmental policy that applies to activities and decisions across the Bank as well as in all its business segments. This policy clearly sets out the established principles for identifying and limiting environmental risk as well as the impacts on the community and its business segments. Incorporation of Risk Given that environmental risk is associated with credit risk and operational risk, the Bank recognizes the importance of incorporating several additional control measures into its existing risk management processes. To this end, risks are regularly reported to the Enterprise-Wide Risk Management Committee. The Bank's current approach to controlling risks includes regularly identifying and prioritizing the impacts of physical risks and transitional risks. This applies to all industries affected by the Bank's assets. In the interests of proactively ensuring the strategic positioning of its entire portfolio, the Bank has expressed its desire to support the energy transition toward a lower-carbon economy. Through its credit adjudication process, it seeks to develop and implement a process for assessing and quantifying the impacts of climate change on its strategy and results. IInnddiiccaattoorrss aanndd OObbjjeeccttiivveess Measures Used to Assess Climate-Related Risks and Opportunities To date, the Bank has implemented several measures to manage climate-related risks and opportunities related to its investment, funding, and operational strategies. Among other things, the Bank calculates its own annual greenhouse gas (GHG) emissions, and it performs a calculation and analysis of the proportion of its carbon-related investments that serves as a guide to discussions about strategic alignment and risk appetite. GHG Emissions The Bank has carried out a voluntary annual inventory of its GHG emissions since 2008. It reports the information to the Carbon Disclosure Project, which compiles several types of climate data. Objectives for Managing Climate-Related Risks and Opportunities The Bank is committed to reducing its environmental footprint by implementing, on a voluntary basis, various eco-responsible measures aimed at calculating and reducing its GHG emissions. This includes significant improvements made to the energy efficiency of its facilities over the past 15 years. The Bank has implemented an innovative system for managing the energy consumption of 300 branches that uses a web-based interface. As a result, the Bank can monitor its facilities in real time with a view to managing its energy consumption more effectively. OOuuttllooookk aanndd NNeexxtt SStteeppss For the coming year, the Bank will focus its efforts on:  growing the proportion of its renewable-energy-related funding assets at a faster pace than those related to fossil fuels;  offering to support customers in their energy transitions;  developing indicators for effectively monitoring its sustainable development performance;  strengthening its partnerships with the industry's main change agents in order to meet its commitments. 94 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis CCrriittiiccaall AAccccoouunnttiinngg EEssttiimmaatteess A summary of the significant accounting policies used by the Bank is presented in Note 1 to the consolidated financial statements of this Annual Report. Some of these accounting policies are considered critical given their importance to the presentation of the Bank’s financial position and operating results and require subjective and complex judgments and estimates on matters that are inherently uncertain. Any change in these judgments and estimates could have a significant impact on the Bank’s consolidated financial statements. The critical accounting estimates are as follows. CCllaassssiiffiiccaattiioonn ooff FFiinnaanncciiaall IInnssttrruummeennttss At initial recognition, all financial instruments are recorded at fair value on the Consolidated Balance Sheet. At initial recognition, financial assets must be classified as subsequently measured at fair value through other comprehensive income, at amortized cost, or at fair value through profit or loss. The Bank determines the classification based on the contractual cash flow characteristics of the financial assets and on the business model it uses to manage these financial assets. For the purpose of classifying a financial asset, the Bank must determine whether the contractual cash flows associated with the financial asset are solely payments of principal and interest on the principal amount outstanding. The principal is generally the fair value of the financial asset at initial recognition. The interest consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period, and for other basic lending risks and costs as well as of a profit margin. If the Bank determines that the contractual cash flows associated with a financial asset are not solely payments of principal and interest, the financial assets must be classified as measured at fair value through profit or loss. When classifying financial assets, the Bank determines the business model used for each portfolio of financial assets that are managed together to achieve a same business objective. The business model reflects how the Bank manages its financial assets and the extent to which the financial asset cash flows are generated by the collection of the contractual cash flows, the sale of the financial assets, or both. The Bank determines the business model using scenarios that it reasonably expects to occur. Consequently, the business model determination is a matter of fact and requires the use of judgment and consideration of all the relevant evidence available at the date of determination. A financial asset portfolio falls within a “hold to collect” business model when the Bank’s primary objective is to hold these financial assets in order to collect contractual cash flows from them and not to sell them. When the Bank’s objective is achieved both by collecting contractual cash flows and by selling the financial assets, the financial asset portfolio falls within a “hold to collect and sell” business model. In this type of business model, collecting contractual cash flows and selling financial assets are both integral components to achieving the Bank’s objective for this financial asset portfolio. Financial assets are mandatorily measured at fair value through profit or loss if they do not fall within either a “hold to collect” business model or a “hold to collect and sell” business model. FFaaiirr VVaalluuee ooff FFiinnaanncciiaall IInnssttrruummeennttss The fair value of a financial instrument is the price that would be received to sell a financial asset or paid to transfer a financial liability in an orderly transaction in the principal market at the measurement date under current market conditions (i.e., an exit price). Unadjusted quoted prices in active markets, based on bid prices for financial assets and offered prices for financial liabilities, provide the best evidence of fair value. A financial instrument is considered quoted in an active market when prices in exchange, dealer, broker or principal-to-principal markets are accessible at the measurement date. An active market is one where transactions occur with sufficient frequency and volume to provide quoted prices on an ongoing basis. When there is no quoted price in an active market, the Bank uses another valuation technique that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The chosen valuation technique incorporates all the factors that market participants would consider when pricing a transaction. Judgment is required when applying a large number of acceptable valuation techniques and estimates to determine fair value. The estimated fair value reflects market conditions on the valuation date and, consequently, may not be indicative of future fair value. The best evidence of the fair value of a financial instrument at initial recognition is the transaction price, i.e., the fair value of the consideration received or paid. If there is a difference between the fair value at initial recognition and the transaction price, and the fair value is determined using a valuation technique based on observable market inputs or, in the case of a derivative, if the risks are fully offset by other contracts entered into with third parties, this difference is recognized in the Consolidated Statement of Income. In other cases, the difference between the fair value at initial recognition and the transaction price is deferred on the Consolidated Balance Sheet. The amount of the deferred gain or loss is recognized over the term of the financial instrument. The unamortized balance is immediately recognized in net income when (i) observable market inputs can be obtained and support the fair value of the transaction, (ii) the risks associated with the initial contract are substantially offset by other contracts entered into with third parties, (iii) the gain or loss is realized through a cash receipt or payment, or (iv) the transaction matures or is cancelled before maturity. National Bank of Canada 95 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Critical Accounting Estimates In certain cases, measurement adjustments are recognized to address factors that market participants would use at the measurement date to determine fair value but that are not included in the measurement technique due to system limitations or uncertainty surrounding the measure. These factors include, but are not limited to, the unobservable nature of inputs used in the valuation model, assumptions about risk such as market risk, credit risk, or risk related to the valuation model and future administration costs. The Bank may also consider market liquidity risk when determining the fair value of financial instruments when it believes these instruments could be disposed of for a consideration below the fair value otherwise determined due to a lack of market liquidity or an insufficient volume of transactions in a given market. The measurement adjustments also include the funding valuation adjustment applied to derivative financial instruments to reflect the market implied cost or benefits of funding collateral for uncollateralized or partly collateralized transactions. IFRS establishes a fair value hierarchy that classifies the inputs used in financial instrument fair value measurement techniques according to three levels. The fair value hierarchy has the following levels: Level 1 Inputs corresponding to unadjusted quoted prices in active markets for identical assets and liabilities and accessible to the Bank at the measurement date. These instruments consist primarily of equity securities, derivative financial instruments traded in active markets, and certain highly liquid debt securities actively traded in over-the-counter markets. Level 2 Valuation techniques based on inputs, other than the quoted prices included in Level 1 inputs, that are directly or indirectly observable in the market for the asset or liability. These inputs are quoted prices of similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; inputs other than quoted prices used in a valuation model that are observable for that instrument; and inputs that are derived principally from or corroborated by observable market inputs by correlation or other means. These instruments consist primarily of certain loans, certain deposits, derivative financial instruments traded in over-the-counter markets, certain debt securities, certain equity securities whose value is not directly observable in an active market, liabilities related to transferred receivables as well as certain other liabilities. Level 3 Valuation techniques based on one or more significant inputs that are not observable in the market for the asset or liability. The Bank classifies financial instruments in Level 3 when the valuation technique is based on at least one significant input that is not observable in the markets. The valuation technique may also be partly based on observable market inputs. Financial instruments whose fair values are classified in Level 3 consist of investments in hedge funds, certain derivative financial instruments, equity and debt securities of private companies, certain loans, and certain deposits (structured deposit notes). Establishing fair value is an accounting estimate and has an impact on Securities at fair value through profit or loss, certain Loans, Securities at fair value through other comprehensive income, Obligations related to securities sold short, Derivative financial instruments, financial instruments designated at fair value through profit or loss, and financial instruments designated at fair value through other comprehensive income on the Consolidated Balance Sheet. This estimate also has an impact on Non-interest income in the Consolidated Statement of Income of the Financial Markets segment and of the Other heading. Lastly, this estimate has an impact on Other comprehensive income in the Consolidated Statement of Comprehensive Income. For additional information on the fair value determination of financial instruments, see Notes 3 and 6 to the consolidated financial statements. IImmppaaiirrmmeenntt ooff FFiinnaanncciiaall AAsssseettss At the end of each reporting period, the Bank applies a three-stage impairment approach to measure the expected credit losses (ECL) on all debt instruments measured at amortized cost or at fair value through other comprehensive income and on loan commitments and financial guarantees that are not measured at fair value. ECLs are a probability-weighted estimate of credit losses over the remaining expected life of the financial instrument. The ECL model is forward looking. Measurement of ECLs at each reporting period reflects reasonable and supportable information about past events, current conditions, and forecasts of future events and economic conditions. Judgment is required in making assumptions and estimates, determining movements between the three stages, and applying forward-looking information. Any changes in assumptions and estimates, as well as the use of different, but equally reasonable, estimates and assumptions, could have an impact on the allowances for credit losses and the provisions for credit losses for the year. All business segments are affected by this accounting estimate. For additional information, see Note 7 to the consolidated financial statements. 96 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Critical Accounting Estimates DDeetteerrmmiinniinngg tthhee SSttaaggee The ECL three-stage impairment approach is based on the change in the credit quality of financial assets since initial recognition. If, at the reporting date, the credit risk of non-impaired financial instruments has not increased significantly since initial recognition, these financial instruments are classified in Stage 1, and an allowance for credit losses that is measured, at each reporting date, in an amount equal to 12-month expected credit losses is recorded. When there is a significant increase in credit risk since initial recognition, these non-impaired financial instruments are migrated to Stage 2, and an allowance for credit losses that is measured, at each reporting date, in an amount equal to lifetime expected credit losses is recorded. In subsequent reporting periods, if the credit risk of the financial instrument improves such that there is no longer a significant increase in credit risk since initial recognition, the ECL model requires reverting to Stage 1, i.e., recognition of 12-month expected credit losses. When one or more events that have a detrimental impact on the estimated future cash flows of a financial asset have occurred, the financial asset is considered credit-impaired and is migrated to Stage 3, and an allowance for credit losses equal to lifetime expected losses continues to be recorded or the financial asset is written off. Interest income is calculated on the gross carrying amount for financial assets in Stages 1 and 2 and on the net carrying amount for financial assets in Stage 3. AAsssseessssmmeenntt ooff SSiiggnniiffiiccaanntt IInnccrreeaassee iinn CCrreeddiitt RRiisskk In determining whether credit risk has increased significantly, the Bank uses an internal credit risk grading system, external risk ratings, and forward-looking information to assess deterioration in credit quality of a financial instrument. To assess whether or not the credit risk of a financial instrument has increased significantly, the Bank compares the probability of default (PD) occurring over its expected life as at the reporting date with the PD occurring over its expected life on the date of initial recognition and considers reasonable and supportable information indicative of a significant increase in credit risk since initial recognition. The Bank includes relative and absolute thresholds in the definition of significant increase in credit risk and a backstop of 30 days past due. All financial instruments that are 30 days past due are migrated to Stage 2 even if other metrics do not indicate that a significant increase in credit risk has occurred. The assessment of a significant increase in credit risk requires significant judgment. MMeeaassuurreemmeenntt ooff EExxppeecctteedd CCrreeddiitt LLoosssseess ECLs are measured as the probability-weighted present value of all expected cash shortfalls over the remaining expected life of the financial instrument, and reasonable and supportable information about past events, current conditions and forecasts of future events and economic conditions is considered. The estimation and application of forward-looking information requires significant judgment. The cash shortfall is the difference between all contractual cash flows owed to the Bank and all the cash flows that the Bank expects to receive. The measurement of ECLs is primarily based on the product of the financial instrument’s probability of default (PD), loss given default (LGD) and exposure at default (EAD). Forward-looking macroeconomic factors such as unemployment rates, housing price indices, interest rates, and gross domestic product (GDP) are incorporated into the risk parameters. The estimate of expected credit losses reflects an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes. The Bank incorporates three forward-looking macroeconomic scenarios in its ECL calculation process: a base scenario, an upside scenario and a downside scenario. Probability weights are attributed to each scenario. The scenarios and probability weights are reassessed quarterly and are subject to management review. The Bank applies experienced credit judgment to adjust the modelled ECL results when it becomes evident that known or expected risk factors and information were not considered in the credit risk rating and modelling process. ECLs for all financial instruments are recognized in Provisions for credit losses in the Consolidated Statement of Income. In the case of debt instruments measured at fair value through other comprehensive income, ECLs are recognized in Provisions for credit losses in the Consolidated Statement of Income, and a corresponding amount is recognized in Other comprehensive income with no reduction in the carrying amount of the asset on the Consolidated Balance Sheet. As for debt instruments measured at amortized cost, they are presented net of the related allowance for credit losses on the Consolidated Balance Sheet. Allowances for credit losses for off-balance-sheet credit exposures that are not measured at fair value are included in Other liabilities on the Consolidated Balance Sheet. National Bank of Canada 97 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Critical Accounting Estimates PPuurrcchhaasseedd oorr OOrriiggiinnaatteedd CCrreeddiitt--IImmppaaiirreedd FFiinnaanncciiaall AAsssseettss On initial recognition of a financial asset, the Bank determines whether the asset is credit-impaired. For financial assets that are credit-impaired upon purchase or origination, the lifetime expected credit losses are reflected in the initial fair value. In subsequent reporting periods, the Bank recognizes only the cumulative changes in these lifetime ECLs since initial recognition as an allowance for credit losses. The Bank recognizes changes in ECLs in Provisions for credit losses in the Consolidated Statement of Income, even if the lifetime ECLs are less than ECLs that were included in the estimated cash flows on initial recognition. DDeeffiinniittiioonn ooff DDeeffaauulltt The definition of default used by the Bank to measure ECLs and transfer financial instruments between stages is consistent with the definition of default used for internal credit risk management purposes. The Bank considers a financial asset, other than a credit card receivable, to be credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of the financial asset have occurred or when contractual payments are 90 days past due. Credit card receivables are considered credit-impaired and are fully written off at the earlier of the following: when a notice of bankruptcy is received, a settlement proposal is made, or contractual payments are 180 days past due. WWrriittee--OOffffss A financial asset and its related allowance for credit losses are normally written off in whole or in part when the Bank considers the probability of recovery to be non-existent and when all guarantees and other remedies available to the Bank have been exhausted or if the borrower is bankrupt or winding up and balances owing are not likely to be recovered. IImmppaaiirrmmeenntt ooff NNoonn--FFiinnaanncciiaall AAsssseettss Premises and equipment and intangible assets with finite useful lives are tested for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. At the end of each reporting period, the Bank determines whether there is an indication that premises and equipment or intangible assets with finite useful lives may be impaired. Goodwill and intangible assets that are not yet available for use or that have indefinite useful lives are tested for impairment annually or more frequently if there is an indication that the asset might be impaired. An asset is tested for impairment by comparing its carrying amount with its recoverable amount. The recoverable amount must be estimated for the individual asset. Where it is not possible to estimate the recoverable amount of an individual asset, the recoverable amount of the cash-generating unit (CGU) to which the asset belongs will be determined. Goodwill is always tested for impairment at the level of a CGU or a group of CGUs. A CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. The Bank uses judgment to identify CGUs. An asset’s recoverable amount is the higher of fair value less costs to sell and the value in use of the asset or CGU. Value in use is the present value of expected future cash flows from the asset or CGU. The recoverable amount of the CGU is determined using valuation models that consider various factors such as projected future cash flows, discount rates and growth rates. The use of different estimates and assumptions in applying the impairment tests could have a significant impact on income. If the recoverable amount of an asset or a CGU is less than its carrying amount, the carrying amount is reduced to its recoverable amount and an impairment loss is recognized in Non-interest expenses in the Consolidated Statement of Income. Management exercises judgment when determining whether there is objective evidence that premises and equipment or intangible assets with finite useful lives may be impaired. It also uses judgment in determining to which CGU or group of CGUs an asset or goodwill is to be allocated. Moreover, for impairment assessment purposes, management must make estimates and assumptions regarding the recoverable amount of non-financial assets, CGUs or a group of CGUs. For additional information on the estimates and assumptions used to calculate the recoverable amount of an asset or CGU, see Note 11 to the consolidated financial statements. Any changes to these estimates and assumptions may have an impact on the recoverable amount of a non-financial asset and, consequently, on impairment testing results. These accounting estimates have an impact on Premises and equipment, Intangible assets and Goodwill reported on the Consolidated Balance Sheet. The aggregate impairment loss, if any, is recognized as a non-interest expense for the corresponding segment and presented in the Other item. EEmmppllooyyeeee BBeenneeffiittss –– PPeennssiioonn PPllaannss aanndd OOtthheerr PPoosstt--EEmmppllooyymmeenntt BBeenneeffiittss Pension plan and other post-employment plan expenses and obligations are actuarially determined using the projected benefit method prorated on service. The calculations incorporate management’s best estimates of various actuarial assumptions such as discount rates, rates of compensation increase, health care cost trend rates, mortality rates and retirement age. Remeasurements of these plans result in actuarial gains and losses related to the defined benefit obligation and the actual return on plan assets, excluding the net interest determined by applying a discount rate to the net asset or liability of the plans. Remeasurements are immediately recognized in Other comprehensive income and will not be subsequently reclassified to net income; these cumulative gains and losses are reclassified to Retained earnings. 98 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Critical Accounting Estimates The use of different assumptions could have a significant impact on the defined benefit asset (liability) presented in Other assets (Other liabilities) on the Consolidated Balance Sheet, on the pension plan and other post-employment benefit plan expenses presented in Compensation and employee benefits in the Consolidated Statement of Income, as well as on Remeasurements of pension plans and other post-employment benefit plans presented in Other comprehensive income. All business segments are affected by this accounting estimate. For additional information, including the significant assumptions used to determine the Bank’s pension plan and other post-employment benefit plan expenses and the sensitivity analysis for significant plan assumptions, see Note 23 to the consolidated financial statements. IInnccoommee TTaaxxeess The Bank makes assumptions to estimate income taxes as well as deferred tax assets and liabilities. This process includes estimating the actual amount of income taxes payable and evaluating tax loss carryforwards and temporary differences arising from differences between the values of the items reported for accounting and for income tax purposes. Deferred tax assets and liabilities, presented in Other assets and Other liabilities on the Consolidated Balance Sheet, are calculated according to the tax rates to be applied in future periods. Previously recorded deferred tax assets and liabilities must be adjusted when the date of the future event is revised based on current information. The Bank periodically evaluates deferred tax assets to assess recoverability. In the Bank’s opinion, based on the information at its disposal, it is probable that all deferred tax assets will be realized prior to their expiration. This accounting estimate affects Income taxes in the Consolidated Statement of Income for all business segments. For additional information on income taxes, see Notes 1 and 24 to the consolidated financial statements. CCoonnttiinnggeenntt LLiiaabbiilliittiieess MMaappllee FFiinnaanncciiaall GGrroouupp IInncc.. The Bank has a 24.9% equity interest in Maple Financial Group Inc. (Maple), a privately owned Canadian company that operated through direct and indirect wholly owned subsidiaries in Canada, Germany, the United Kingdom and the United States. Maple Bank GmbH (Maple GmbH), an indirect wholly owned subsidiary of Maple, has been the subject of an investigation into alleged tax irregularities by German prosecutors since September 2015 and, to the Bank’s knowledge, that investigation is ongoing. The Bank understands that the investigation is focusing on selected trading activities by Maple GmbH and some of its former employees, primarily during taxation years 2006 to 2010. The German authorities have alleged that these trading activities, often referred to as “cum/ex trading,” violated German tax laws. Neither the Bank nor its employees were involved in these trading activities and, to the Bank’s knowledge, are not the subject of this investigation. At that time, the Bank announced that if it were determined that portions of the dividends it received from Maple could be reasonably attributed to tax fraud by Maple GmbH, arrangements would be made to repay those amounts to the relevant authority. On February 6, 2016, the German Federal Financial Supervisory Authority, BaFin, placed a moratorium on the business activities of Maple GmbH preventing it from carrying out its normal business activities. In August 2016, Maple filed for bankruptcy under applicable Canadian laws, and a trustee was appointed to administer the company. Similar proceedings were initiated for each of Maple’s other material subsidiaries in their home jurisdictions. In light of the situation, the Bank wrote off the carrying value of its equity interest in Maple in an amount of $164 million ($145 million net of income taxes) during the first quarter of 2016. The $164 million write-off of the equity interest in this associate was recognized in the Non-interest income – Other item of the Consolidated Statement of Income for the year ended October 31, 2016 and was reported in the Financial Markets segment. While there has not yet been a determination of tax fraud on the part of Maple GmbH or its employees, in the insolvency proceedings of Maple GmbH the German finance office issued a declaration about the result of the tax audit at Maple GmbH and about the relevant tax consequences of the cum/ex trading and concluded a final tax claim of the tax authorities against the insolvency administrator. This claim was approved by the Maple GmbH creditor assembly. The Bank has been in contact with the German prosecutors, who have confirmed that, in their view based upon the evidence they have considered since the occurrence of the insolvency, the Bank was not involved in any respect with the alleged tax fraud undertaken by Maple GmbH nor was it negligent in failing to identify that alleged fraud. Further to discussions between the Bank and the German prosecutors concerning the amounts deemed attributable to the alleged tax fraud, the Bank paid 7.7 million euros to the German tax authorities on November 19, 2019. The Bank has been engaging in discussions with the bankruptcy and insolvency administrators of relevant Maple entities regarding potential claims they may assert against Maple’s former shareholders in relation to the insolvency of Maple and its subsidiaries. The Bank does not see a legal basis for any such liability but is nevertheless continuing discussions at this time. If any payments are required, they are not expected to be material to the Bank’s financial position. National Bank of Canada 99 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Critical Accounting Estimates LLiittiiggaattiioonn In the normal course of business, the Bank and its subsidiaries are involved in various claims relating, among other matters, to loan portfolios, investment portfolios and supplier agreements, including court proceedings, investigations or claims of a regulatory nature, class actions or other legal remedies of varied natures. More specifically, the Bank is involved as a defendant in class actions instituted by consumers contesting, inter alia, certain transaction fees or who wish to avail themselves of certain legislative provisions relating to consumer protection. The recent developments in the main legal proceedings involving the Bank are as follows: WWaattssoonn In 2011, a class action was filed in the Supreme Court of British Columbia against Visa Corporation Canada (Visa) and MasterCard International Incorporated (MasterCard) (the Networks) as well as National Bank and a number of other Canadian financial institutions. A similar action was also initiated in Quebec, Ontario, Alberta and Saskatchewan. In each of the actions, the Networks and financial institutions are alleged to have been involved in a price-fixing system to maintain and increase the fees paid by merchants on transactions executed using the credit cards of the Networks. In so doing, they would notably be in breach of the Competition Act. An unspecified amount of compensatory and punitive damages is being claimed. In 2017, a settlement was reached with the plaintiffs; in 2018 it was approved by the trial courts in each of the five jurisdictions where the action was initiated. The rulings approving the settlement are now the subject of appeal proceedings in multiple jurisdictions. DDeeffrraannccee On January 21, 2019, the Quebec Superior Court authorized a class action against the Bank and several other Canadian financial institutions. The originating application was served to the Bank on April 23, 2019. The class action was initiated on behalf of consumers residing in Quebec. The plaintiffs allege that non- sufficient funds charges, billed by all of the defendants when a payment order is refused due to non-sufficient funds, are illegal and prohibited by the Consumer Protection Act. The plaintiffs are claiming, in the form of damages, the repayment of these charges as well as punitive damages. It is impossible to determine the outcome of the claims instituted or which may be instituted against the Bank and its subsidiaries. The Bank estimates, based on the information at its disposal, that while the amount of contingent liabilities pertaining to these claims, taken individually or in the aggregate, could have a material impact on the Bank’s consolidated results of operation for a particular period, it would not have a material adverse impact on the Bank’s consolidated financial position. Provisions are liabilities of uncertain timing and amount. A provision is recognized when the Bank has a present obligation (legal or constructive) arising from a past event, when it is probable that an outflow of economic resources will be required to settle the obligation and when the amount of the obligation can be reliably estimated. Provisions are based on the Bank’s best estimates of the economic resources required to settle the present obligation, given all relevant risks and uncertainties, and, when it is significant, the effect of the time value of money. The recognition of a litigation provision requires the Bank’s management to assess the probability of loss and estimate any potential monetary impact. The Bank examines each litigation provision individually by considering the development of each case, its past experience in similar transactions and the opinion of its legal counsel. Each new piece of information can alter the Bank’s assessment as to the probability and estimated amount of the loss and the extent to which it adjusts the recorded provision. Moreover, the actual settlement cost of these litigations can be significantly higher or lower than the amounts recognized. SSttrruuccttuurreedd EEnnttiittiieess In the normal course of business, the Bank enters into arrangements and transactions with structured entities. Structured entities are entities designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when voting rights relate solely to administrative tasks and the relevant activities are directed by means of contractual arrangements. A structured entity is consolidated when the Bank concludes, after evaluating the substance of the relationship and its right or exposure to variable returns, that it controls that entity. Management must exercise judgment in determining whether the Bank controls an entity. Additional information is provided in the Securitization and Off-Balance-Sheet Arrangements section of this MD&A and in Note 27 to the consolidated financial statements. 100 100 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis FFuuttuurree AAccccoouunnttiinngg PPoolliiccyy CChhaannggeess The IASB issues revisions and amendments to a number of standards, some of which have already had an impact on the Bank and others that could have an impact in the future. The Bank is currently assessing the impact that adoption of the following standards will have on its consolidated financial statements. A summary of these amendments and the effective dates applicable to the Bank are presented below. EEffffeeccttiivvee DDaattee –– NNoovveemmbbeerr 11,, 22001199 IFRS 16 – Leases In January 2016, the IASB issued IFRS 16 – Leases. The new standard replaces the previous lease accounting standard, IAS 17 – Leases, and related interpretations. Under IAS 17, lessees and lessors were required to classify their leases as either finance leases or operating leases and to account for these two types of leases differently. IFRS 16 provides a single accounting model for lessees, requiring lessees to recognize a right-of-use asset as well as a liability that reflects the present value of future lease payments. Lessees will also recognize depreciation expense on the right-of-use asset and interest expense on the lease liability in the Consolidated Statement of Income. As for lessors, IFRS 16 substantially carries forward the lessor accounting in IAS 17, with the distinction between finance and operating leases being retained. The Bank has elected to apply IFRS 16 using the modified retrospective basis by adjusting the Consolidated Balance Sheet as at November 1, 2019, the date of initial application, with no restatement of comparative periods. The most significant impact to the Bank will be related to real estate leases, which are currently classified as operating leases. On transition, the Bank will apply, on a lease-by-lease basis, certain practical expedients. More specifically, it will measure the right-of-use assets at an amount equal to the lease liability, it will rely on the Bank’s assessment about whether leases are onerous as at October 31, 2019 as an alternative to performing an impairment test as at November 1, 2019, and it will exclude initial direct costs from the measurement of the right-of-use assets as at November 1, 2019. Furthermore, on transition and thereafter, the Bank will exclude leases for which the underlying asset is of low value, will exclude short-term leases and, for real estate leases, will elect not to separate non-lease components from lease components. As at October 31, 2019, the Bank’s best estimate of the impact of adopting IFRS 16 is an increase in total assets of approximately $653 million representing leased premises, an increase in total liabilities of approximately $653 million primarily representing lease liabilities, and a decrease of approximately 9 basis points in the Common Equity Tier 1 (CET 1) capital ratio as at November 1, 2019. IFRIC Interpretation 23 – Uncertainty Over Income Tax Treatments In June 2017, the IASB issued IFRIC Interpretation 23, which addresses how to reflect tax treatment uncertainty in accounting for income taxes. This interpretation will not have an impact on the Bank’s Consolidated Balance Sheet as at November 1, 2019. EEffffeeccttiivvee DDaattee –– NNoovveemmbbeerr 11,, 22002200 Conceptual Framework for Financial Reporting On March 29, 2018, the IASB published Conceptual Framework for Financial Reporting to replace its 2010 conceptual framework. For the IASB, the revised conceptual framework has been in effect since its publication date. Early application is permitted. Reform to Benchmark Interest Rates (Amendments to IFRS 9, IAS 39 and IFRS 7) In September 2019, in response to uncertainty arising from the phasing-out of benchmark interest rates such as interbank offered rates (IBORs), the IASB issued amendments to its new and former financial instrument standards, IFRS 9 – Financial Instruments and IAS 39 – Financial Instruments: Recognition and Measurement as well as to the related standard on disclosures, IFRS 7 – Financial Instruments: Disclosures. The amendments modify certain hedge accounting requirements in IFRS 9 and IAS 39 to provide relief from the potential effects of the uncertainty caused by the IBOR reform. In addition, the amendments to IFRS 7 require additional disclosure about hedging relationships directly affected by this uncertainty. When the Bank adopted IFRS 9 on November 1, 2017, it made an accounting policy choice to continue applying the IAS 39 hedge accounting requirements. For the Bank, the effective date of these amendments is November 1, 2020. However, early adoption is permitted. EEffffeeccttiivvee DDaattee –– NNoovveemmbbeerr 11,, 22002211 IFRS 17 – Insurance Contracts In May 2017, the IASB issued IFRS 17 – Insurance Contracts, a new standard that replaces IFRS 4, the current insurance contract accounting standard. IFRS 17 introduces a new accounting framework that will improve the comparability and quality of financial information. At its meeting on November 14, 2018, the IASB tentatively decided to defer the IFRS 17 effective date to fiscal years beginning on or after January 1, 2022. National Bank of Canada 101 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information Table 1 – Quarterly Results (millions of Canadian dollars, except per share amounts) SSttaatteemmeenntt ooff iinnccoommee ddaattaa Net interest income Non-interest income(1) TToottaall rreevveennuueess Provisions for credit losses Non-interest expenses(2) Income taxes NNeett iinnccoommee Non-controlling interests NNeett iinnccoommee aattttrriibbuuttaabbllee ttoo tthhee BBaannkk’’ss sshhaarreehhoollddeerrss EEaarrnniinnggss ppeerr ccoommmmoonn sshhaarree Basic Diluted DDiivviiddeennddss (per share) Common Preferred Series 28 Series 30 Series 32 Series 34 Series 36 Series 38 Series 40 Series 42 TToottaall QQ44 QQ33 QQ22 33,,559966 33,,883366 77,,443322 334477 44,,330011 446622 22,,332222 6666 22,,225566 993366 997799 11,,991155 8899 11,,009955 112277 660044 1144 559900 885555 11,,009933 11,,994488 8866 11,,115544 110000 660088 1177 559911 994422 882288 11,,777700 8844 11,,002266 110022 555588 1199 553399 22001199 QQ11 886633 993366 11,,779999 8888 11,,002266 113333 555522 1166 553366 $$ $$ 66..3399 66..3344 $$ 11..6688 11..6677 11..6688 $$ 11..6666 $$ 11..5522 11..5511 11..5511 11..5500 $$ 22..6666 $$ 00..6688 $$ 00..6688 $$ 00..6655 $$ 00..6655 −− 11..00115566 00..99775500 11..44000000 11..33550000 11..11112255 11..11550000 11..22337755 −− 00..22551155 00..22443377 00..33550000 00..33337755 00..22778811 00..22887755 00..33009944 −− 00..22551166 00..22443388 00..33550000 00..33337755 00..22778811 00..22887755 00..33009933 −− 00..22556622 00..22443377 00..33550000 00..33337755 00..22778822 00..22887755 00..33009944 −− 00..22556633 00..22443388 00..33550000 00..33337755 00..22778811 00..22887755 00..33009944 RReettuurrnn oonn ccoommmmoonn sshhaarreehhoollddeerrss’’ eeqquuiittyy 1188..00 %% 1188..22 %% 1188..77 %% 1177..88 %% 1177..22 %% TToottaall aasssseettss LLoonngg--tteerrmm ffiinnaanncciiaall lliiaabbiilliittiieess(3) NNeett iimmppaaiirreedd llooaannss(4) uunnddeerr IIFFRRSS 99 NNeett iimmppaaiirreedd llooaannss uunnddeerr IIAASS 3399 NNuummbbeerr ooff ccoommmmoonn sshhaarreess oouuttssttaannddiinngg (thousands) Average – Basic Average – Diluted End of period PPeerr ccoommmmoonn sshhaarree Book value Share price High Low NNuummbbeerr ooff eemmppllooyyeeeess – WWoorrllddwwiiddee NNuummbbeerr ooff bbrraanncchheess iinn CCaannaaddaa 228811,,445588 227766,,331122 226699,,110066 226633,,335555 777733 445500 777733 442200 777722 337799 776644 337733 333355,,110044 333377,,663300 333344,,339933 333366,,990000 333344,,117722 333344,,884433 333377,,776688 333344,,221100 333355,,447788 333388,,551155 333355,,111166 333355,,771166 333388,,558855 333355,,550000 $$ 3366..8899 $$ 3366..1122 $$ 3355..4499 $$ 3344..8855 $$ 6688..0022 5544..9977 6688..0022 6600..3388 2255,,448877 442222 6644..1166 6600..7711 2244,,888811 442299 6633..8822 6600..3311 2244,,113377 442288 6611..8800 5544..9977 2233,,996600 442288 (1) (2) (3) (4) For fiscal 2019, the Non-interest income item includes a $79 million gain on disposal of Fiera Capital Corporation shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss resulting from the fair value measurement of an investment. For fiscal 2019, the Non-interest expenses item includes $57 million in impairment losses on premises and equipment and on intangible assets, $45 million in provisions for onerous contracts, an $11 million charge related to Maple, and $10 million in severance pay. Subordinated debt. Given the adoption of IFRS 9, all loans classified in Stage 3 of the expected credit loss model are impaired loans; the net impaired loans presented in this table exclude POCI loans. Under IAS 39, loans were considered impaired according to different criteria. Net impaired loans are presented net of allowances for credit losses on Stage 3 loan amounts drawn. 102 102 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information Total Q4 Q3 Q2 3,382 3,784 7,166 327 4,063 544 2,232 87 2,145 826 988 1,814 73 1,036 139 566 16 550 837 955 1,792 76 1,011 136 569 23 546 885 869 1,754 91 992 124 547 25 522 2018 Q1 834 972 1,806 87 1,024 145 550 23 527 Total Q4 Q3 Q2 3,436 3,173 6,609 244 3,857 484 2,024 84 1,940 881 823 1,704 70 976 133 525 19 506 887 788 1,675 58 971 128 518 24 494 815 782 1,597 56 941 116 484 22 462 2017 Q1 853 780 1,633 60 969 107 497 19 478 $ 6.01 $ 5.94 1.53 $ 1.52 1.54 $ 1.52 $ 1.46 1.44 1.48 1.46 $ 2.44 $ 0.62 $ 0.62 $ 0.60 $ 0.60 – 1.0250 0.9750 1.4000 1.3500 1.1125 0.9310 0.5323 – 0.2562 0.2437 0.3500 0.3375 0.2781 0.2875 0.5323 – 0.2563 0.2438 0.3500 0.3375 0.2781 0.2875 – – 0.2562 0.2437 0.3500 0.3375 0.2782 0.3560 – – 0.2563 0.2438 0.3500 0.3375 0.2781 – – $ $ $ 5.44 5.38 $ 1.40 1.39 1.39 $ 1.37 $ 1.30 1.28 1.35 1.34 2.28 $ 0.58 $ 0.58 $ 0.56 $ 0.56 0.9500 1.0250 0.9750 1.4000 1.3500 0.4724 – – 0.2375 0.2562 0.2437 0.3500 0.3375 0.4724 – – 0.2375 0.2563 0.2438 0.3500 0.3375 – – – 0.2375 0.2562 0.2437 0.3500 0.3375 – – – 0.2375 0.2563 0.2438 0.3500 0.3375 – – – 18.4 % 17.8 % 18.4 % 18.6 % 18.7 % 18.1 % 17.8 % 18.2 % 17.9 % 18.4 % 262,471 257,637 256,259 251,065 245,827 240,072 239,020 234,119 747 404 753 413 755 382 8 371 9 9 10 1,009 206 240 213 226 339,372 343,240 337,508 341,395 335,071 339,160 343,280 337,441 339,885 343,900 339,348 340,950 345,458 340,390 340,809 344,771 341,108 345,507 339,592 341,555 345,353 341,580 341,107 345,416 341,524 339,476 343,270 340,810 $ 34.40 $ 33.91 $ 32.64 $ 31.75 $ 31.51 $ 30.84 $ 29.97 $ 29.51 $ 65.63 58.69 65.63 58.93 23,450 428 64.29 61.26 23,029 428 64.08 58.69 22,359 428 65.35 62.33 21,868 429 $ 62.74 46.83 62.74 55.29 21,635 429 56.44 51.77 21,526 443 58.75 52.94 21,290 445 56.60 46.83 21,295 448 National Bank of Canada 103 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information TTaabbllee 22 –– OOvveerrvviieeww ooff RReessuullttss Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) Net interest income on a taxable equivalent basis Non-interest income on a taxable equivalent basis(2) Total revenues on a taxable equivalent basis Non-interest expenses(3) Contribution on a taxable equivalent basis Provisions for credit losses Income before income taxes on a taxable equivalent basis Income taxes on a taxable equivalent basis Net income Non-controlling interests Net income attributable to the Bank’s shareholders Average assets 22001199 2018 2017 2016 2015 33,,779911 33,,997711 77,,776622 44,,330011 33,,446611 334477 33,,111144 779922 22,,332222 6666 3,526 3,885 7,411 4,063 3,348 327 3,021 789 2,232 87 3,645 3,208 6,853 3,857 2,996 244 2,752 728 2,024 84 3,436 2,639 6,075 3,875 2,200 484 1,716 460 1,256 75 3,240 2,817 6,057 3,665 2,392 228 2,164 545 1,619 70 22,,225566 228866,,116622 2,145 265,940 1,940 248,351 1,181 235,913 1,549 222,929 (1) (2) (3) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. For fiscal 2019, the Non-interest income item includes a $79 million gain on disposal of Fiera Capital Corporation shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss resulting from the fair value measurement of an investment. For fiscal 2019, the Non-interest expenses item includes $57 million in impairment losses on premises and equipment and on intangible assets, $45 million in provisions for onerous contracts, an $11 million charge related to Maple, and $10 million in severance pay. TTaabbllee 33 –– CChhaannggeess iinn NNeett IInntteerreesstt IInnccoommee(1) Year ended October 31 (taxable equivalent basis)(2) (millions of Canadian dollars) PPeerrssoonnaall aanndd CCoommmmeerrcciiaall(1) Net interest income Average assets Average interest-bearing assets Net interest margin(3) WWeeaalltthh MMaannaaggeemmeenntt(1) Net interest income on a taxable equivalent basis Average assets FFiinnaanncciiaall MMaarrkkeettss Net interest income on a taxable equivalent basis Average assets UUSSSSFF&&II Net interest income Average assets OOtthheerr Net interest income on a taxable equivalent basis Average assets TToottaall Net interest income on a taxable equivalent basis Average assets 22001199 2018 2017 2016 2015 22,,338833 111122,,779988 110066,,999955 2,276 106,857 101,446 2,127 102,139 97,339 2,011 97,741 92,660 1,917 92,090 86,543 22..2233 %% 2.24 % 2.19 % 2.17 % 2.22 % 447700 66,,221199 446 6,167 447744 111122,,449933 409 100,721 665566 1100,,998855 ((119922)) 4433,,666677 584 9,270 (189) 42,925 373 5,947 772 94,991 466 7,519 (93) 37,755 316 5,612 266 5,275 938 87,491 1,001 86,466 284 5,319 205 2,275 (113) 39,750 (149) 36,823 33,,779911 228866,,116622 3,526 265,940 3,645 248,351 3,436 235,913 3,240 222,929 (1) (2) (3) For fiscal years prior to 2019, certain amounts have been reclassified, mainly amounts related to advisor banking service activities, which have been transferred from the Wealth Management segment to the Personal and Commercial segment. See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. Net interest margin is calculated by dividing net interest income by average interest-bearing assets. 104 104 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information TTaabbllee 44 –– NNoonn--IInntteerreesstt IInnccoommee Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) Underwriting and advisory fees Securities brokerage commissions Mutual fund revenues Trust service revenues Credit fees Revenues from acceptances, letters of credit and guarantee Card revenues Deposit and payment service charges Trading revenues (losses) on a taxable equivalent basis Gains (losses) on available-for-sale securities, net Gains (losses) on non-trading securities, net Insurance revenues, net Foreign exchange revenues, other than trading Share in the net income of associates and joint ventures Other(2) Canada United States Other countries Non-interest income on a taxable equivalent basis as a % of total revenues on a taxable equivalent basis(1) Non-interest income on a taxable equivalent basis and excluding specified items as a % of total revenues on a taxable equivalent basis and excluding specified items(1) 22001199 331144 117788 444499 660099 113344 228833 117755 227711 996644 7777 113366 9966 3344 225511 33,,997711 33,,663377 8844 225500 2018 388 195 438 587 126 277 159 280 941 77 121 95 28 173 3,885 3,589 108 188 2017 2016 349 216 412 518 130 231 132 279 409 140 117 81 35 159 3,208 3,027 136 45 376 235 364 453 110 236 119 258 154 70 114 81 15 54 2,639 2,434 124 81 2015 387 273 320 446 112 223 128 238 209 82 107 88 26 178 2,817 2,737 72 8 5511..22 %% 52.4 % 46.8 % 43.4 % 46.5 % 5500..55 %% 52.4 % 46.8 % 45.0 % 45.4 % (1) (2) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. For fiscal 2019, other revenues includes a $79 million gain on disposal of Fiera Capital Corporation shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss resulting from the fair value measurement of an investment. TTaabbllee 55 –– TTrraaddiinngg AAccttiivviittyy RReevveennuueess(1) Year ended October 31 (taxable equivalent basis)(2) (millions of Canadian dollars) FFiinnaanncciiaall mmaarrkkeettss Equities Fixed-income Commodities and foreign exchange OOtthheerr sseeggmmeennttss 22001199 2018 2017 2016 2015 662244 228899 112266 11,,003399 116600 11,,119999 576 267 130 973 176 506 294 107 907 97 1,149 1,004 438 263 116 817 80 897 450 237 147 834 151 985 (1) (2) Includes net interest income on a taxable equivalent basis and non-interest income on a taxable equivalent basis. See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. National Bank of Canada 105 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information TTaabbllee 66 –– NNoonn--IInntteerreesstt EExxppeennsseess Year ended October 31 (millions of Canadian dollars) Compensation and employee benefits(1) Occupancy(2) Technology Amortization – Premises and equipment Amortization – Technology(3) Communications Professional fees Restructuring charge(4) Travel and business development Capital and payroll taxes Other(5) Total Canada United States Other countries Non-interest expenses as a % of total revenues on a taxable equivalent basis(6) Non-interest expenses as a % of total revenues on a taxable equivalent basis and excluding specified items(6) 22001199 22,,553322 225544 337722 4444 333322 6622 224499 −− 112288 7700 225588 44,,330011 33,,993311 221100 116600 2018 2,466 193 375 43 245 63 244 − 128 79 227 4,063 3,750 205 108 2017 2,358 195 364 41 204 61 254 − 122 73 185 3,857 3,571 209 77 2016 2,161 195 367 38 220 67 276 131 120 71 229 3,875 3,601 235 39 2015 2,160 185 352 38 182 69 233 86 113 69 178 3,665 3,457 192 16 5555..44 %% 54.8 % 56.3 % 63.8 % 60.5 % 5544..55 %% 54.8 % 56.3 % 58.6 % 59.1 % (1) (2) (3) (4) (5) (6) For fiscal 2019, compensation and employee benefits include $10 million in severance pay. For fiscal 2019, occupancy expense includes $45 million in provisions for onerous contracts. For fiscal 2019, the Amortization – Technology expense includes $57 million in impairment losses on premises and equipment and on intangible assets. The fiscal 2016 restructuring charge had included $129 million in compensation and employee benefits and $2 million in occupancy expenses, and the fiscal 2015 restructuring charge had included $51 million in compensation and employee benefits and $35 million in other charges such as occupancy expenses and professional fees. For fiscal 2019, other expenses include an $11 million charge related to Maple; the fiscal 2016 other expenses had included $25 million in litigation charges. See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. 106 106 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information TTaabbllee 77 –– PPrroovviissiioonnss ffoorr CCrreeddiitt LLoosssseess(1) Year ended October 31 (millions of Canadian dollars) PPeerrssoonnaall BBaannkkiinngg(3)(4) Stage 3 Stages 1 and 2 CCoommmmeerrcciiaall BBaannkkiinngg Stage 3 Stages 1 and 2(5) WWeeaalltthh MMaannaaggeemmeenntt(4) Stage 3 Stages 1 and 2 FFiinnaanncciiaall MMaarrkkeettss Stage 3 Stages 1 and 2 UUSSSSFF&&II Stage 3 Stages 1 and 2 POCI loans OOtthheerr Stage 3 Stages 1 and 2(6) TToottaall pprroovviissiioonnss ffoorr ccrreeddiitt lloosssseess Average loans and acceptances Provisions for credit losses on impaired loans(1) as a % of average loans and acceptances Provisions for credit losses as a % of average loans and acceptances 22001199 2018 2017(2) 2016(2) 2015(2) 116666 88 117744 3355 2288 6633 −− −− −− 1188 1122 3300 9944 ((2244)) 1100 8800 −− −− −− 334477 158 9 167 40 21 61 − 1 1 − 4 4 126 (3) (29) 94 − − − 327 153 − 153 43 (40) 3 − − − − − − 48 − − 48 − 40 40 156 − 156 73 250 323 1 − 1 − − − 4 − − 4 − − − 165 − 165 63 − 63 − − − − − − − − − − − − − 244 484 228 114488,,776655 139,603 130,882 122,559 108,740 00..2211 %% 0.23 % 0.19 % 0.19 % 0.21 % 00..2233 %% 0.23 % 0.19 % 0.39 % 0.21 % (1) (2) (3) (4) (5) (6) Given the adoption of IFRS 9, all loans classified in Stage 3 of the expected credit loss model are impaired loans. Under IAS 39, loans were considered impaired according to different criteria. Provisions for credit losses on impaired loans presented in this table exclude provisions for credit losses on POCI loans. These figures are presented in accordance with IAS 39. Includes credit card receivables. For fiscal years prior to 2019, certain amounts have been reclassified, as amounts related to advisor banking service activities were transferred from the Wealth Management segment to the Personal and Commercial segment. During fiscal 2017, the Bank recorded a $40 million reversal of the sectoral provision on non-impaired loans that had been taken collectively for the oil and gas producer and service company loan portfolio. In addition, the fiscal 2016 provisions for credit losses had included a $250 million amount related to the initial recording of this sectoral provision. During fiscal 2017, the provisions for credit losses had included a $40 million increase in the collective allowance for credit risk on non-impaired loans, which was established taking into account the Bank’s overall credit portfolio, except for loans covered by the sectoral allowance and POCI loans. National Bank of Canada 107 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information TTaabbllee 88 –– CChhaannggee iinn AAvveerraaggee VVoolluummeess Year ended October 31 (taxable equivalent basis)(1) (millions of Canadian dollars) AAsssseettss Deposits with financial institutions Securities Securities purchased under reverse repurchase agreements and securities borrowed Residential mortgage loans Personal loans Credit card receivables Business and government loans POCI loans Interest-bearing assets Other assets Total assets LLiiaabbiilliittiieess aanndd eeqquuiittyy Personal deposits Deposit-taking institutions Other deposits Subordinated debt Obligations other than deposits Interest-bearing liabilities Other liabilities Equity Liabilities and equity Net interest margin AAvveerraaggee vvoolluummee $$ 22001199 RRaattee %% Average volume $ 2018(2) Rate % Average volume $ 2017(2) Rate % Average volume $ 2016(2) Rate % Average volume $ 2015(2) Rate % 1133,,114499 8855,,777722 11..6644 11..9977 16,282 75,923 1.27 1.64 15,802 66,591 0.72 1.75 14,079 60,784 0.46 1.98 11,771 57,494 0.26 2.25 2222,,447722 5533,,447744 3333,,007777 22,,221199 5511,,774466 11,,338866 226633,,229955 2222,,886677 228866,,116622 5544,,775566 55,,995500 112233,,775544 118844,,446600 775588 4477,,440044 223322,,662222 3388,,882277 1144,,771133 228866,,116622 11..6600 22..8855 33..9977 1133..7711 55..1100 1122..7788 33..1122 22..8877 11..2277 11..8811 22..0022 11..7799 33..2255 11..3355 11..9900 11..5555 11..3322 20,090 51,497 32,208 2,164 45,649 1,486 245,299 20,641 265,940 50,499 5,980 110,697 167,176 564 47,762 215,502 36,492 13,946 265,940 1.09 2.75 3.69 13.35 4.71 12.76 2.81 2.60 1.12 1.45 1.62 1.47 3.20 1.20 1.57 1.27 1.33 19,878 50,844 30,890 2,206 39,579 1,238 227,028 21,323 248,351 48,408 7,567 98,279 154,254 423 44,204 198,881 36,722 12,748 248,351 1.03 2.61 3.34 12.07 3.95 15.18 2.58 2.36 1.01 0.69 1.20 1.11 3.81 0.74 1.11 0.89 1.47 19,038 46,310 30,409 2,107 34,197 1,545 208,469 27,444 235,913 44,510 12,468 85,874 142,852 1,047 38,804 182,703 41,627 11,583 235,913 0.75 2.69 3.27 11.98 3.22 14.01 2.50 25,610 41,798 28,840 2,023 26,883 1,204 195,623 27,306 0.79 2.85 3.38 11.85 3.22 17.87 2.56 2.12 222,929 2.15 42,480 10,925 76,063 129,468 1,571 40,374 171,413 40,792 10,724 222,929 1.13 0.39 1.10 1.04 3.16 0.31 0.98 0.76 1.36 1.20 0.24 1.12 1.07 3.80 0.41 1.03 0.79 1.36 (1) (2) See the Financial Reporting Method section on pages 14 and 15 for additional information on non-GAAP financial measures. For fiscal years prior to 2019, certain amounts have been reclassified. 108 108 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information TTaabbllee 99 –– DDiissttrriibbuuttiioonn ooff GGrroossss LLooaannss aanndd AAcccceeppttaanncceess bbyy BBoorrrroowweerr CCaatteeggoorryy UUnnddeerr BBaasseell AAsssseett CCllaasssseess As at October 31 (millions of Canadian dollars) Residential mortgage(1)(2) Qualifying revolving retail Other retail Agriculture Oil and gas, and pipelines(3) Mining Utilities Non-real-estate construction(3)(4) Manufacturing(3) Wholesale Retail Transportation(3) Communications Finance and insurance Real estate and real-estate-construction(3)(5) Professional services Education and health care(3) Other services Government Other(2) POCI loans 22001199 %% $$ 2018 % $ 2017 % $ 2016 % $ 2015 % $ 7744,,444488 44,,009999 1111,,660066 66,,330088 44,,332299 775588 33,,337722 11,,116688 66,,330033 22,,222211 33,,228899 11,,668822 11,,661144 44,,333355 1111,,663355 11,,884466 33,,552200 44,,993377 11,,007711 44,,222222 11,,116666 115533,,992299 4488..44 22..77 77..55 44..11 22..88 00..55 22..22 00..88 44..11 11..44 22..11 11..11 11..00 22..88 77..66 11..22 22..33 33..22 00..77 22..77 00..88 110000..00 70,591 4,211 12,246 5,759 4,056 1,032 2,715 1,049 5,303 2,163 3,069 1,452 1,597 4,732 11,629 1,582 3,284 4,715 1,445 2,534 1,576 146,740 48.1 2.9 8.3 3.9 2.8 0.7 1.9 0.7 3.6 1.5 2.1 1.0 1.1 3.2 7.9 1.1 2.2 3.2 1.0 1.7 1.1 100.0 66,398 4,217 12,150 4,923 3,364 470 2,347 1,336 4,274 2,066 3,431 1,425 1,662 4,932 10,418 1,416 2,886 4,762 1,452 1,233 1,990 137,152 48.4 3.1 8.9 3.6 2.5 0.3 1.7 1.0 3.1 1.5 2.5 1.0 1.2 3.6 7.6 1.0 2.1 3.5 1.1 0.9 1.4 100.0 58,265 4,178 10,316 4,599 3,595 582 1,814 1,147 3,561 2,021 2,911 1,565 1,578 3,872 9,458 1,374 2,738 4,647 1,201 7,537 1,846 128,805 45.2 3.2 8.0 3.6 2.8 0.5 1.4 0.9 2.8 1.6 2.3 1.2 1.2 3.0 7.3 1.1 2.1 3.6 0.9 5.9 1.4 100.0 54,004 4,093 9,512 4,433 3,978 429 1,385 1,240 3,738 1,908 2,965 1,189 1,254 2,679 8,639 1,214 2,730 4,200 891 5,326 1,424 117,231 46.1 3.6 8.1 3.8 3.4 0.4 1.2 1.0 3.2 1.6 2.5 1.0 1.1 2.3 7.4 1.0 2.3 3.6 0.7 4.5 1.2 100.0 (1) (2) (3) (4) (5) Includes residential mortgage loans on one to four-unit dwellings (Basel definition) and home equity lines of credit. Since November 1, 2016, the loans acquired by the Financial Markets segment for securitization purposes, and reported in the Other category, are now being reported in the Residential mortgage category. Figures as at October 31, 2016 and from previous years were not adjusted to reflect those modifications. The presentation of certain borrower categories was changed during fiscal 2019. Comparative figures have been revised. Includes civil engineering loans, public-private partnership loans, and project finance loans. Includes residential mortgages on dwellings of five or more units and SME loans. TTaabbllee 1100 –– IImmppaaiirreedd LLooaannss(1) As at October 31 (millions of Canadian dollars) Net impaired loans(3) Personal Banking(4) Commercial Banking Wealth Management(4) Financial Markets USSF&I Other Total net impaired loans Gross impaired loans Allowances for credit losses on impaired loans Individual and collective allowances on impaired loans Net impaired loans(3) Provisioning rate As a % of loans and acceptances 22001199 2018 2017(2) 2016(2) 2015(2) 118877 222222 33 2233 1155 −− 445500 668844 223344 445500 3344..22 %% 00..33 %% 199 187 3 − 15 − 404 630 226 404 35.9 % 0.3 % 81 121 1 − 3 − 206 380 174 206 89 190 1 − 1 − 281 492 211 281 95 157 2 − − − 254 457 203 254 45.8 % 0.2 % 42.9 % 0.2 % 44.4 % 0.2 % (1) (2) (3) (4) Given the adoption of IFRS 9, all loans classified in Stage 3 of the expected credit loss model are impaired loans. Under IAS 39, loans were considered impaired according to different criteria. The impaired loans presented in this table exclude POCI loans. These figures are presented in accordance with IAS 39. Net impaired loans are presented net of allowances for credit losses on Stage 3 loan amounts drawn. For fiscal years prior to 2019, certain amounts have been reclassified, as amounts related to advisor banking service activities were transferred from the Wealth Management segment to the Personal and Commercial segment. National Bank of Canada 109 National Bank of Canada2019 Annual Report Management’s Discussion and Analysis Additional Financial Information TTaabbllee 1111 –– AAlllloowwaanncceess ffoorr CCrreeddiitt LLoosssseess Year ended October 31 (millions of Canadian dollars) Balance at beginning Provisions for credit losses Write-offs Disposals Recoveries Exchange and other movements Balance at end Composition of allowances: Allowances for credit losses on impaired loans(2) Allowances for credit losses on non-impaired loans Allowances for credit losses on off-balance-sheet commitments and other assets Allowances for credit losses on POCI loans Sectoral allowance on non-impaired loans – Oil and gas(3) Collective allowance on non-impaired loans(4) 22001199 771144 334477 ((335511)) ((11)) 5522 ((66)) 775555 223344 550011 7777 ((5577)) 2018 735 327 (367) (24) 45 (2) 714 226 498 56 (66) 2017(1) 2016(1) 2015(1) 769 244 (320) − 13 (11) 695 174 (24) 139 406 555 484 (282) − 13 (1) 769 211 (12) 204 366 605 228 (278) − 13 (13) 555 203 (14) − 366 (1) (2) (3) (4) These figures are presented in accordance with IAS 39. Given the adoption of IFRS 9, all loans classified in Stage 3 of the expected credit loss model are impaired loans. Under IAS 39, loans were considered impaired according to different criteria. Allowances for credit losses on impaired loans presented in this table exclude allowances for credit losses on POCI loans. The sectoral allowance on non-impaired loans – oil and gas was established collectively for the portfolio of loans to producers and service companies in the oil and gas sector. The collective allowance for credit risk on non-impaired loans was established taking into account the Bank’s overall credit portfolio, except for loans covered by the sectoral allowance and POCI loans. TTaabbllee 1122 –– DDeeppoossiittss As at October 31 (millions of Canadian dollars) 22001199 %% $$ 2018 % $ 2017 % $ 2016 % $ $ Personal Business and government Deposit-taking institutions Total Canada United States Other countries Total Personal deposits as a % of total assets 6600,,006655 112255,,226666 44,,223355 118899,,556666 117722,,776644 66,,990077 99,,889955 118899,,556666 3311..77 55,688 6666..11 110,321 4,821 22..22 110000..00 170,830 9911..11 156,054 6,048 33..77 8,728 55..22 110000..00 170,830 2211..33 52,175 99,115 5,381 156,671 145,288 5,825 5,558 156,671 32.6 64.6 2.8 100.0 91.4 3.5 5.1 100.0 21.2 51,163 85,263 5,640 142,066 131,869 4,442 5,755 142,066 33.3 63.3 3.4 100.0 92.8 3.7 3.5 100.0 21.2 36.0 60.0 4.0 47,394 76,845 6,219 100.0 130,458 92.8 116,315 9,655 3.1 4,488 4.1 100.0 130,458 22.0 2015 % 36.3 58.9 4.8 100.0 89.2 7.4 3.4 100.0 21.9 110 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Management’s Responsibility for Financial Reporting Independent Auditor’s Report Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Comprehensive Income Consolidated Statements of Changes in Equity Consolidated Statements of Cash Flows Notes to the Audited Consolidated Financial Statements 111122 111133 111155 111166 111177 111188 111199 112200 MMaannaaggeemmeenntt’’ss RReessppoonnssiibbiilliittyy ffoorr FFiinnaanncciiaall RReeppoorrttiinngg The consolidated financial statements of National Bank of Canada (the Bank) have been prepared in accordance with section 308(4) of the Bank Act (Canada), which states that, except as otherwise specified by the Office of the Superintendent of Financial Institutions (Canada) (OSFI), the financial statements are to be prepared in accordance with International Financial Reporting Standards (IFRS), as issued by the International Accounting Standards Board (IASB). IFRS represent Canadian generally accepted accounting principles (GAAP). None of the OSFI accounting requirements are exceptions to IFRS. Management maintains the accounting and internal control systems needed to discharge its responsibility, which is to provide reasonable assurance that the financial accounts are accurate and complete and that the Bank’s assets are adequately safeguarded. Controls that are currently in place include quality standards on staff hiring and training; the implementation of organizational structures with clear divisions of responsibility and accountability for performance; the Code of Professional Conduct; and the communication of operating policies and procedures. As Chief Executive Officer and as Chief Financial Officer, we have overseen the evaluation of the design and operation of the Bank’s internal controls over financial reporting in accordance with Regulation 52-109 Respecting Certification of Disclosures in Issuers’ Annual and Interim Filings released by the Canadian Securities Administrators. Based on the evaluation work performed, we have concluded that the internal controls over financial reporting were effective as at October 31, 2019 and that they provide reasonable assurance that the financial information is reliable and that the Bank’s consolidated financial statements have been prepared in accordance with IFRS. The Board of Directors (the Board) is responsible for reviewing and approving the financial information contained in the Annual Report. Acting through the Audit Committee, the Board also oversees the presentation of the consolidated financial statements and ensures that accounting and control systems are maintained. Composed of directors who are neither officers nor employees of the Bank, the Audit Committee is responsible, through Internal Audit, for performing an independent and objective review of the Bank’s internal control effectiveness, i.e., governance processes, risk management processes and control measures. Furthermore, the Audit Committee reviews the consolidated financial statements and recommends their approval to the Board. The control systems are further supported by the presence of the Compliance Service, which exercises independent oversight and evaluation in order to assist managers in effectively managing regulatory compliance risk and to obtain reasonable assurance that the Bank is compliant with regulatory requirements. Both the Senior Vice-President, Internal Audit and the Senior Vice-President, Chief Compliance Officer and Chief Anti-Money Laundering Officer have a direct functional link to the Chair of the Audit Committee and to the Chair of the Risk Management Committee. They both also have direct access to the President and Chief Executive Officer. In accordance with the Bank Act (Canada), OSFI is mandated to protect the rights and interests of the depositors. Accordingly, OSFI examines and enquires into the business and affairs of the Bank, as deemed necessary, to ensure that the provisions of the Bank Act (Canada) are being satisfied and that the Bank is in sound financial condition. The independent auditor, Deloitte LLP, whose report follows, was appointed by the shareholders on the recommendation of the Board. The auditor has full and unrestricted access to the Audit Committee to discuss audit and financial reporting matters. LLoouuiiss VVaacchhoonn President and Chief Executive Officer GGhhiissllaaiinn PPaarreenntt Chief Financial Officer and Executive Vice-President, Finance Montreal, Canada, December 3, 2019 112 National Bank of Canada2019 Annual Report IInnddeeppeennddeenntt AAuuddiittoorr’’ss RReeppoorrtt To the Shareholders of National Bank of Canada, OOppiinniioonn We have audited the consolidated financial statements of National Bank of Canada (the Bank), which comprise the consolidated balance sheets as at October 31, 2019 and 2018, and the consolidated statements of income, the consolidated statements of comprehensive income, the consolidated statements of changes in equity and the consolidated statements of cash flows for the years then ended, and notes to the consolidated financial statements, including a summary of significant accounting policies (collectively referred to as the “financial statements”). In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of the Bank as at October 31, 2019 and 2018, and its financial performance and its cash flows for the years then ended in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board (IFRS). BBaassiiss ffoorr OOppiinniioonn We conducted our audit in accordance with Canadian generally accepted auditing standards (Canadian GAAS). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are independent of the Bank in accordance with the ethical requirements that are relevant to our audit of the financial statements in Canada, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. OOtthheerr IInnffoorrmmaattiioonn Management is responsible for the other information. The other information comprises:  Management’s Discussion and Analysis;  The information, other than the financial statements and our auditor’s report thereon, in the Annual Report. Our opinion on the financial statements does not cover the other information and we do not and will not express any form of assurance conclusion thereon. In connection with our audit of the financial statements, our responsibility is to read the other information identified above and, in doing so, consider whether the other information is materially inconsistent with the financial statements or our knowledge obtained in the audit, or otherwise appears to be materially misstated. We obtained Management’s Discussion and Analysis and the Annual Report prior to the date of this auditor’s report. If, based on the work we have performed on this other information, we conclude that there is a material misstatement of this other information, we are required to report that fact in this auditor’s report. We have nothing to report in this regard. RReessppoonnssiibbiilliittiieess ooff MMaannaaggeemmeenntt aanndd TThhoossee CChhaarrggeedd WWiitthh GGoovveerrnnaannccee ffoorr tthhee FFiinnaanncciiaall SSttaatteemmeennttss Management is responsible for the preparation and fair presentation of the financial statements in accordance with IFRS, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is responsible for assessing the Bank’s ability to continue as a going concern, disclosing, as applicable, matters related to a going concern and using the going concern basis of accounting unless management either intends to liquidate the Bank or to cease operations, or has no realistic alternative but to do so. Those charged with governance are responsible for overseeing the Bank’s financial reporting process. AAuuddiittoorr’’ss RReessppoonnssiibbiilliittiieess ffoorr tthhee AAuuddiitt ooff tthhee FFiinnaanncciiaall SSttaatteemmeennttss Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with Canadian GAAS will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements. National Bank of Canada 113 National Bank of Canada2019 Annual Report Independent Auditor’s Report (cont.) As part of an audit in accordance with Canadian GAAS, we exercise professional judgment and maintain professional skepticism throughout the audit. We also:  Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control.  Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Bank’s internal control. Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by management.   Conclude on the appropriateness of management’s use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Bank’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor’s report to the related disclosures in the financial statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However, future events or conditions may cause the Bank to cease to continue as a going concern. Evaluate the overall presentation, structure and content of the financial statements, including the note disclosures, and whether the financial statements represent the underlying transactions and events in a manner that achieves fair presentation.   Obtain sufficient appropriate audit evidence regarding the financial information of the entities or business activities within the Bank to express an opinion on the financial statements. We are responsible for the direction, supervision and performance of the group audit. We remain solely responsible for our audit opinion. We communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit. We also provide those charged with governance with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards. The engagement partner on the audit resulting in this independent auditor’s report is Chantal Leclerc. //ss// DDeellooiittttee LLLLPP11 December 3, 2019 Montreal, Quebec 1 CPA auditor, CA, public accountancy permit No. A121444 114 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements (millions of Canadian dollars) CCoonnssoolliiddaatteedd BBaallaannccee SShheeeettss As at October 31 AAsssseettss CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss SSeeccuurriittiieess At fair value through profit or loss At fair value through other comprehensive income At amortized cost SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd LLooaannss Residential mortgage Personal Credit card Business and government Customers’ liability under acceptances Allowances for credit losses OOtthheerr Derivative financial instruments Investments in associates and joint ventures Premises and equipment Goodwill Intangible assets Other assets LLiiaabbiilliittiieess aanndd eeqquuiittyy DDeeppoossiittss OOtthheerr Acceptances Obligations related to securities sold short Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments Liabilities related to transferred receivables Other liabilities SSuubboorrddiinnaatteedd ddeebbtt EEqquuiittyy EEqquuiittyy aattttrriibbuuttaabbllee ttoo tthhee BBaannkk’’ss sshhaarreehhoollddeerrss Preferred shares Common shares Contributed surplus Retained earnings Accumulated other comprehensive income NNoonn--ccoonnttrroolllliinngg iinntteerreessttss Note 19 The accompanying notes are an integral part of these audited consolidated financial statements. Notes 3, 4 and 6 Note 7 Note 16 Note 9 Note 10 Note 11 Note 11 Note 12 22001199 2018 1133,,669988 12,756 6611,,882233 1100,,664488 99,,775555 8822,,222266 55,817 5,668 8,298 69,783 1177,,772233 18,159 5577,,117711 3366,,994444 22,,332222 5500,,559999 114477,,003366 66,,889933 ((667788)) 115533,,225511 88,,112299 338855 449900 11,,441122 11,,440066 22,,773388 1144,,556600 228811,,445588 53,651 37,357 2,325 46,606 139,939 6,801 (658) 146,082 8,608 645 601 1,412 1,314 3,111 15,691 262,471 Notes 4 and 13 118899,,556666 170,830 Note 16 Notes 4 and 8 Note 14 Note 15 Notes 18 and 22 66,,889933 1122,,884499 2211,,990000 66,,885522 2211,,331122 66,,117777 7755,,998833 777733 22,,445500 22,,994499 5511 99,,331122 1166 1144,,777788 335588 1155,,113366 228811,,445588 6,801 17,780 19,998 6,036 20,100 5,824 76,539 747 2,450 2,822 57 8,472 175 13,976 379 14,355 262,471 LLoouuiiss VVaacchhoonn President and Chief Executive Officer KKaarreenn KKiinnsslleeyy Director National Bank of Canada 115 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements (millions of Canadian dollars) CCoonnssoolliiddaatteedd SSttaatteemmeennttss ooff IInnccoommee Year ended October 31 22001199 2018 IInntteerreesstt iinnccoommee Loans Securities at fair value through profit or loss Securities at fair value through other comprehensive income Securities at amortized cost Deposits with financial institutions IInntteerreesstt eexxppeennssee Deposits Liabilities related to transferred receivables Subordinated debt Other NNeett iinntteerreesstt iinnccoommee(1) NNoonn--iinntteerreesstt iinnccoommee Underwriting and advisory fees Securities brokerage commissions Mutual fund revenues Trust service revenues Credit fees Card revenues Deposit and payment service charges Trading revenues (losses) Gains (losses) on non-trading securities, net Insurance revenues, net Foreign exchange revenues, other than trading Share in the net income of associates and joint ventures Other TToottaall rreevveennuueess PPrroovviissiioonnss ffoorr ccrreeddiitt lloosssseess NNoonn--iinntteerreesstt eexxppeennsseess Compensation and employee benefits Occupancy Technology Communications Professional fees Other IInnccoommee bbeeffoorree iinnccoommee ttaaxxeess Income taxes NNeett iinnccoommee NNeett iinnccoommee aattttrriibbuuttaabbllee ttoo Preferred shareholders Common shareholders Bank shareholders Non-controlling interests EEaarrnniinnggss ppeerr sshhaarree (dollars) Basic Diluted DDiivviiddeennddss ppeerr ccoommmmoonn sshhaarree (dollars) The accompanying notes are an integral part of these audited consolidated financial statements. 66,,446688 11,,008866 119955 221100 221155 88,,117744 33,,446688 444444 2255 664411 44,,557788 33,,559966 331144 117788 444499 660099 441177 117755 227711 882299 7777 113366 9966 3344 225511 33,,883366 77,,443322 334477 77,,008855 22,,553322 229988 770044 6622 224499 445566 44,,330011 22,,778844 446622 22,,332222 111166 22,,114400 22,,225566 6666 22,,332222 66..3399 66..3344 22..6666 5,632 771 152 174 206 6,935 2,562 414 18 559 3,553 3,382 388 195 438 587 403 159 280 840 77 121 95 28 173 3,784 7,166 327 6,839 2,466 236 620 63 244 434 4,063 2,776 544 2,232 105 2,040 2,145 87 2,232 6.01 5.94 2.44 Note 21 Note 9 Notes 9 and 10 Note 7 Note 14 Notes 10 and 11 Note 24 Note 25 Note 18 (1) Net interest income includes dividend income. For additional information, see Note 1 to these audited consolidated financial statements. 116 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements (millions of Canadian dollars) CCoonnssoolliiddaatteedd SSttaatteemmeennttss ooff CCoommpprreehheennssiivvee IInnccoommee Year ended October 31 NNeett iinnccoommee OOtthheerr ccoommpprreehheennssiivvee iinnccoommee,, nneett ooff iinnccoommee ttaaxxeess IItteemmss tthhaatt mmaayy bbee ssuubbsseeqquueennttllyy rreeccllaassssiiffiieedd ttoo nneett iinnccoommee NNeett ffoorreeiiggnn ccuurrrreennccyy ttrraannssllaattiioonn aaddjjuussttmmeennttss Net unrealized foreign currency translation gains (losses) on investments in foreign operations Net foreign currency translation (gains) losses on investments in foreign operations reclassified to net income Impact of hedging net foreign currency translation gains (losses) Impact of hedging net foreign currency translation (gains) losses reclassified to net income NNeett cchhaannggee iinn ddeebbtt sseeccuurriittiieess aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee Net unrealized gains (losses) on debt securities at fair value through other comprehensive income Net (gains) losses on debt securities at fair value through other comprehensive income reclassified to net income NNeett cchhaannggee iinn ccaasshh ffllooww hheeddggeess Net gains (losses) on derivative financial instruments designated as cash flow hedges Net (gains) losses on designated derivative financial instruments reclassified to net income SShhaarree iinn tthhee ootthheerr ccoommpprreehheennssiivvee iinnccoommee ooff aassssoocciiaatteess aanndd jjooiinntt vveennttuurreess IItteemmss tthhaatt wwiillll nnoott bbee ssuubbsseeqquueennttllyy rreeccllaassssiiffiieedd ttoo nneett iinnccoommee RReemmeeaassuurreemmeennttss ooff ppeennssiioonn ppllaannss aanndd ootthheerr ppoosstt--eemmppllooyymmeenntt bbeenneeffiitt ppllaannss NNeett ggaaiinnss ((lloosssseess)) oonn eeqquuiittyy sseeccuurriittiieess ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee NNeett ffaaiirr vvaalluuee cchhaannggee aattttrriibbuuttaabbllee ttoo ccrreeddiitt rriisskk oonn ffiinnaanncciiaall lliiaabbiilliittiieess ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss TToottaall ootthheerr ccoommpprreehheennssiivvee iinnccoommee ((lloossss)),, nneett ooff iinnccoommee ttaaxxeess CCoommpprreehheennssiivvee iinnccoommee CCoommpprreehheennssiivvee iinnccoommee aattttrriibbuuttaabbllee ttoo Bank shareholders Non-controlling interests 22001199 22,,332222 2018 2,232 ((99)) ((22)) 44 −− ((77)) 5544 ((5533)) 11 ((113377)) ((2200)) ((115577)) 33 ((113355)) ((2211)) 55 ((115511)) ((331111)) 22,,001111 11,,994466 6655 22,,001111 41 − (13) − 28 (11) (5) (16) 51 (46) 5 1 103 (2) 21 122 140 2,372 2,284 88 2,372 IInnccoommee TTaaxxeess –– OOtthheerr CCoommpprreehheennssiivvee IInnccoommee The following table presents the income tax expense or recovery for each component of other comprehensive income. Year ended October 31 22001199 2018 NNeett ffoorreeiiggnn ccuurrrreennccyy ttrraannssllaattiioonn aaddjjuussttmmeennttss Net unrealized foreign currency translation gains (losses) on investments in foreign operations Net foreign currency translation (gains) losses on investments in foreign operations reclassified to net income Impact of hedging net foreign currency translation gains (losses) Impact of hedging net foreign currency translation (gains) losses reclassified to net income NNeett cchhaannggee iinn ddeebbtt sseeccuurriittiieess aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee Net unrealized gains (losses) on debt securities at fair value through other comprehensive income Net (gains) losses on debt securities at fair value through other comprehensive income reclassified to net income NNeett cchhaannggee iinn ccaasshh ffllooww hheeddggeess Net gains (losses) on derivative financial instruments designated as cash flow hedges Net (gains) losses on designated derivative financial instruments reclassified to net income SShhaarree iinn tthhee ootthheerr ccoommpprreehheennssiivvee iinnccoommee ooff aassssoocciiaatteess aanndd jjooiinntt vveennttuurreess RReemmeeaassuurreemmeennttss ooff ppeennssiioonn ppllaannss aanndd ootthheerr ppoosstt--eemmppllooyymmeenntt bbeenneeffiitt ppllaannss NNeett ggaaiinnss ((lloosssseess)) oonn eeqquuiittyy sseeccuurriittiieess ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee NNeett ffaaiirr vvaalluuee cchhaannggee aattttrriibbuuttaabbllee ttoo ccrreeddiitt rriisskk oonn ffiinnaanncciiaall lliiaabbiilliittiieess ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss The accompanying notes are an integral part of these audited consolidated financial statements. 33 ((11)) 22 22 66 1199 ((1199)) −− ((5500)) ((77)) ((5577)) −− ((4488)) ((66)) 22 ((110033)) National Bank of Canada 1 − − − 1 (4) (1) (5) 19 (17) 2 − 37 (1) 7 41 117 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements (millions of Canadian dollars) Consolidated Statements of Changes in Equity Note 18 Note 18 Note 22 Note 18 Note 18 Note 18 Year ended October 31 PPrreeffeerrrreedd sshhaarreess aatt bbeeggiinnnniinngg Issuances of Series 40 and 42 preferred shares Redemption of Series 28 preferred shares for cancellation PPrreeffeerrrreedd sshhaarreess aatt eenndd CCoommmmoonn sshhaarreess aatt bbeeggiinnnniinngg Issuances of common shares pursuant to the Stock Option Plan Repurchases of common shares for cancellation Impact of shares purchased or sold for trading CCoommmmoonn sshhaarreess aatt eenndd CCoonnttrriibbuutteedd ssuurrpplluuss aatt bbeeggiinnnniinngg Stock option expense Stock options exercised Other CCoonnttrriibbuutteedd ssuurrpplluuss aatt eenndd RReettaaiinneedd eeaarrnniinnggss aatt bbeeggiinnnniinngg Impact of adopting IFRS 15 on November 1, 2018 (IFRS 9 on November 1, 2017) Net income attributable to the Bank’s shareholders Dividends on preferred shares Dividends on common shares Premium paid on common shares repurchased for cancellation Share issuance expenses, net of income taxes Remeasurements of pension plans and other post-employment benefit plans Net gains (losses) on equity securities designated at fair value through other comprehensive income Net fair value change attributable to the credit risk on financial liabilities designated at fair value through profit or loss Impact of a financial liability resulting from put options written to non-controlling interests Other RReettaaiinneedd eeaarrnniinnggss aatt eenndd AAccccuummuullaatteedd ootthheerr ccoommpprreehheennssiivvee iinnccoommee aatt bbeeggiinnnniinngg Impact of adopting IFRS 9 on November 1, 2017 Net foreign currency translation adjustments Net change in unrealized gains (losses) on debt securities at fair value through other comprehensive income Net change in gains (losses) on cash flow hedges Share in the other comprehensive income of associates and joint ventures AAccccuummuullaatteedd ootthheerr ccoommpprreehheennssiivvee iinnccoommee aatt eenndd 22001199 22,,445500 −− −− 22,,445500 22,,882222 112222 ((4400)) 4455 22,,994499 5577 1111 ((1155)) ((22)) 5511 88,,447722 ((44)) 22,,225566 ((111166)) ((889922)) ((224411)) −− ((113355)) ((2211)) 55 ((1122)) −− 99,,331122 117755 ((66)) 11 ((115577)) 33 1166 2018 2,050 600 (200) 2,450 2,768 128 (64) (10) 2,822 58 12 (15) 2 57 7,706 (139) 2,145 (105) (829) (403) (12) 103 (2) 21 − (13) 8,472 168 (10) 27 (16) 5 1 175 EEqquuiittyy aattttrriibbuuttaabbllee ttoo tthhee BBaannkk’’ss sshhaarreehhoollddeerrss 1144,,777788 13,976 NNoonn--ccoonnttrroolllliinngg iinntteerreessttss aatt bbeeggiinnnniinngg Impact of adopting IFRS 9 on November 1, 2017 Purchase of the non-controlling interest of the Advanced Bank of Asia Limited subsidiary Redemption of trust units issued by NBC Asset Trust Net income attributable to non-controlling interests Other comprehensive income attributable to non-controlling interests Distributions to non-controlling interests NNoonn--ccoonnttrroolllliinngg iinntteerreessttss aatt eenndd Note 19 Note 31 337799 ((3300)) −− 6666 ((11)) ((5566)) 335588 808 (16) − (400) 87 1 (101) 379 EEqquuiittyy 1155,,113366 14,355 Accumulated Other Comprehensive Income As at October 31 AAccccuummuullaatteedd ootthheerr ccoommpprreehheennssiivvee iinnccoommee Net foreign currency translation adjustments Net unrealized gains (losses) on debt securities at fair value through other comprehensive income Net gains (losses) on instruments designated as cash flow hedges Share in the other comprehensive income of associates and joint ventures The accompanying notes are an integral part of these audited consolidated financial statements. 22001199 2018 88 1144 ((66)) −− 1166 14 13 151 (3) 175 118 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements (millions of Canadian dollars) CCoonnssoolliiddaatteedd SSttaatteemmeennttss ooff CCaasshh FFlloowwss Year ended October 31 CCaasshh fflloowwss ffrroomm ooppeerraattiinngg aaccttiivviittiieess Net income Adjustments for Provisions for credit losses Amortization of premises and equipment and intangible assets Gains on disposals of investments in associates and joint ventures Remeasurement at fair value of an investment Provisions for onerous contracts Gain on disposal of premises and equipment Impairment losses on premises and equipment and on intangible assets Deferred taxes Losses (gains) on sales of non-trading securities, net Share in the net income of associates and joint ventures Stock option expense Change in operating assets and liabilities Securities at fair value through profit or loss Securities purchased under reverse repurchase agreements and securities borrowed Loans and acceptances, net of securitization Deposits Obligations related to securities sold short Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments, net Interest and dividends receivable and interest payable Current tax assets and liabilities Other items CCaasshh fflloowwss ffrroomm ffiinnaanncciinngg aaccttiivviittiieess Issuances of preferred shares Redemption of preferred shares for cancellation Issuances of common shares (including the impact of shares purchased for trading) Repurchases of common shares for cancellation Issuance of subordinated debt Purchase of the non-controlling interest of the Advanced Bank of Asia Limited subsidiary Redemption of trust units issued by NBC Asset Trust Share issuance expenses Dividends paid Distributions to non-controlling interests CCaasshh fflloowwss ffrroomm iinnvveessttiinngg aaccttiivviittiieess Disposal of shares of an investment in an associate Disposal of premises and equipment Net change in investments in associates and joint ventures Purchases of non-trading securities Maturities of non-trading securities Sales of non-trading securities Net change in tangible assets leased under operating leases Net change in premises and equipment Net change in intangible assets IImmppaacctt ooff ccuurrrreennccyy rraattee mmoovveemmeennttss oonn ccaasshh aanndd ccaasshh eeqquuiivvaalleennttss IInnccrreeaassee ((ddeeccrreeaassee)) iinn ccaasshh aanndd ccaasshh eeqquuiivvaalleennttss Cash and cash equivalents at beginning CCaasshh aanndd ccaasshh eeqquuiivvaalleennttss aatt eenndd(1) SSuupppplleemmeennttaarryy iinnffoorrmmaattiioonn aabboouutt ccaasshh fflloowwss ffrroomm ooppeerraattiinngg aaccttiivviittiieess Interest paid Interest and dividends received Income taxes paid The accompanying notes are an integral part of these audited consolidated financial statements. Note 9 Note 9 Note 14 Note 10 Notes 10 and 11 Note 31 Note 9 Note 10 22001199 2018 22,,332222 2,232 334477 332288 ((7799)) 3333 4455 ((5500)) 5577 ((220077)) ((7777)) ((3344)) 1111 ((66,,000066)) 443366 ((66,,222211)) 1188,,773366 ((44,,993311)) 11,,990022 11,,229955 ((4411)) ((77)) 442211 88,,228800 −− −− 115522 ((228811)) −− ((8844)) −− −− ((999922)) ((5566)) ((11,,226611)) 112288 118877 ((1166)) ((1166,,335555)) 11,,889933 88,,441133 −− ((114444)) ((335599)) ((66,,225533)) 117766 994422 1122,,775566 1133,,669988 44,,554455 88,,110000 552200 327 302 (4) − − − − 24 (77) (28) 12 (3,589) 2,630 (9,160) 14,159 2,417 (1,769) (761) 53 (127) (777) 5,864 600 (200) 103 (467) 750 − (400) (12) (918) (101) (645) − − (3) (7,790) 509 6,173 69 (233) (256) (1,531) 266 3,954 8,802 12,756 3,440 6,875 596 (1) This item is the equivalent of Consolidated Balance Sheet item Cash and deposits with financial institutions. It includes an amount of $4.1 billion as at October 31, 2019 ($2.5 billion as at October 31, 2018) for which there are restrictions. National Bank of Canada 119 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements (millions of Canadian dollars) NNootteess ttoo tthhee AAuuddiitteedd CCoonnssoolliiddaatteedd FFiinnaanncciiaall SSttaatteemmeennttss Note 1 Note 2 Note 3 Note 4 Note 5 Note 6 Note 7 Note 8 Note 9 Note 10 Note 11 Note 12 Note 13 Note 14 Note 15 Note 16 Note 17 Basis of Presentation and Summary of Significant Accounting Policies Future Accounting Policy Changes Fair Value of Financial Instruments Financial Instruments Designated at Fair Value Through Profit or Loss Offsetting Financial Assets and Financial Liabilities Securities Loans and Allowances for Credit Losses Financial Assets Transferred But Not Derecognized Investments in Associates and Joint Ventures Premises and Equipment Goodwill and Intangible Assets Other Assets Deposits Other Liabilities Subordinated Debt Derivative Financial Instruments Hedging Activities 112200 113355 113366 114477 114488 114499 115511 116644 116655 116677 116688 116699 117700 117700 117711 117711 117744 Note 18 Note 19 Note 20 Note 21 Note 22 Note 23 Note 24 Note 25 Note 26 Note 27 Note 28 Note 29 Note 30 Note 31 Note 32 Share Capital Non-Controlling Interests Capital Disclosure Trading Activity Revenues Share-Based Payments Employee Benefits – Pension Plans and Other Post-Employment Benefits Income Taxes Earnings Per Share Guarantees, Commitments and Contingent Liabilities Structured Entities Related Party Disclosures Management of the Risks Associated With Financial Instruments Segment Disclosures Acquisition Event After the Consolidated Balance Sheet Date 118800 118833 118844 118855 118866 118899 119933 119955 119955 119999 220022 220033 220088 220099 220099 NNoottee 11 –– BBaassiiss ooff PPrreesseennttaattiioonn aanndd SSuummmmaarryy ooff SSiiggnniiffiiccaanntt AAccccoouunnttiinngg PPoolliicciieess National Bank of Canada (the Bank) is a financial institution incorporated and domiciled in Canada and whose shares are listed on the Toronto Stock Exchange. Its head office is located at 600 De La Gauchetière Street West in Montreal, Quebec, Canada. The Bank is a chartered bank under Schedule 1 of the Bank Act (Canada) and is regulated by the Office of the Superintendent of Financial Institutions Canada (OSFI). National Bank of Canada offers financial services to individuals, businesses, institutional clients and governments throughout Canada as well as specialized services at the international level. It operates four business segments, namely, the Personal and Commercial segment, the Wealth Management segment, the Financial Markets segment, and the U.S. Specialty Finance and International (USSF&I) segment. Its full line of services includes banking and investing solutions for individuals and businesses, corporate banking and investment banking services, securities brokerage, insurance, and wealth management. On December 3, 2019, the Board of Directors (the Board) authorized the publication of the Bank’s audited annual consolidated financial statements (the consolidated financial statements) for the year ended October 31, 2019. BBaassiiss ooff PPrreesseennttaattiioonn The Bank’s consolidated financial statements have been prepared in accordance with section 308(4) of the Bank Act (Canada), which states that, except as otherwise specified by OSFI, the financial statements are to be prepared in accordance with International Financial Reporting Standards (IFRS), as issued by the International Accounting Standards Board (IASB). IFRS represent Canadian generally accepted accounting principles (GAAP). None of the OSFI accounting requirements are exceptions to IFRS. The accounting policies covered in the Summary of Significant Accounting Policies section have been applied consistently to all periods presented and include the changes described hereafter in the Accounting Policy Changes section, which have been applied since November 1, 2018 following adoption of IFRS 15 – Revenue From Contracts With Customers (IFRS 15). As permitted by IFRS 15, the Bank did not restate comparative consolidated financial statements. Unless otherwise indicated, all amounts are expressed in Canadian dollars, which is the Bank’s functional and presentation currency. 120 120 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) AAccccoouunnttiinngg PPoolliiccyy CChhaannggeess Effective November 1, 2018, the Bank adopted IFRS 15, which replaces the previous revenue recognition standards and interpretations. Excluded from the scope of IFRS 15 are revenues related to lease contracts, insurance contracts, and financial instruments. Fees earned, which are an integral component of the effective interest rate of financial assets and liabilities measured at amortized cost, are within the scope of IFRS 9 – Financial Instruments and are therefore outside the scope of IFRS 15. Most of the Bank’s revenues, including net interest income, are not impacted by the adoption of this standard. IFRS 15 provides a single comprehensive model to use in accounting for revenue arising from contracts with customers. The new revenue recognition model is based on a control approach that differs from the risks and rewards approach applied under previous IFRS. The revenue streams that fall within the scope of IFRS 15 are fee and commission income, and the applicable significant accounting policies are described in the Summary of Significant Accounting Policies section. However, the adoption of IFRS 15 did not have a significant impact on the Bank’s revenue recognition accounting policies. The core principle of IFRS 15 is to recognize revenue when, or as, a performance obligation is satisfied, i.e., when control of a promised service is transferred to a customer and in an amount that reflects the consideration the entity expects to be entitled to receive in exchange for the service. Revenue may therefore be recognized at a point in time, upon completion of the service, or over time as services are provided. The Bank has elected to apply IFRS 15 using the modified retrospective basis, recognizing the cumulative effect of initially applying the standard as an adjustment to the opening balance of Retained earnings without restating comparative figures. Adoption of IFRS 15 resulted in a $4 million decrease to opening Retained earnings as at November 1, 2018. SSuummmmaarryy ooff SSiiggnniiffiiccaanntt AAccccoouunnttiinngg PPoolliicciieess JJuuddggmmeennttss,, EEssttiimmaatteess aanndd AAssssuummppttiioonnss In preparing consolidated financial statements in accordance with IFRS, management must exercise judgment and make estimates and assumptions that affect the reporting date carrying amounts of assets and liabilities, net income, and related information. Furthermore, certain accounting policies require complex judgments and estimates because they apply to matters that are inherently uncertain, in particular accounting policies applicable to the following: the fair value determination of financial instruments, the impairment of financial assets, the impairment of non-financial assets, pension plans and other post-employment benefits, income taxes, provisions, the consolidation of structured entities, and the classification of debt instruments. Descriptions of these judgments and estimates are provided in each of the notes related thereto in the consolidated financial statements. Actual results could therefore differ from these estimates, in which case the impacts are recognized in the consolidated financial statements of future fiscal periods. The accounting policies described in this note provide greater detail about the use of estimates and assumptions and reliance on judgment. BBaassiiss ooff CCoonnssoolliiddaattiioonn Subsidiaries These consolidated financial statements include all the assets, liabilities, operating results and cash flows of the Bank and its subsidiaries, after elimination of intercompany transactions and balances. Subsidiaries are entities, including structured entities, controlled by the Bank. A structured entity is an entity created to accomplish a narrow and well-defined objective and is designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when voting rights relate solely to administrative tasks and the relevant activities are directed by means of contractual arrangements. Management must exercise judgment in determining whether the Bank must consolidate an entity. The Bank controls an entity only if the following three conditions are met:    it has decision-making authority regarding the entity’s relevant activities; it has exposure or rights to variable returns from its involvement with the entity; and it has the ability to use its power to affect the amount of the returns. When determining decision-making authority, the Bank considers many factors, including the existence and effect of actual and potential voting rights held by the Bank that can be exercised as well as the holding of instruments that are convertible into voting shares. In addition, the Bank must determine whether, as an investor with decision-making rights, it acts as a principal or agent. Based on these principles, an assessment of control is performed at the inception of a relationship between any entity and the Bank. When performing this assessment, the Bank considers all facts and circumstances, and it must reassess whether it still controls an investee if facts and circumstances indicate that there are changes to one or more of the three conditions of control. The Bank consolidates the entities it controls from the date on which control is obtained and ceases to consolidate them from the date control ceases. The Bank uses the acquisition method to account for the acquisition of a subsidiary from a third party on the date control is obtained. National Bank of Canada 121 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 1 – Basis of Presentation and Summary of Significant Accounting Policies (cont.) Non-Controlling Interests Non-controlling interests in subsidiaries represent the equity interests held by third parties in the Bank’s subsidiaries and are presented in total Equity, separately from Equity attributable to the Bank’s shareholders. The non-controlling interests’ proportionate shares of the net income and other comprehensive income of the Bank’s subsidiaries are presented separately in the Consolidated Statement of Income and in the Consolidated Statement of Comprehensive Income, respectively. With respect to units issued to third parties by mutual funds and certain other funds that are consolidated, they are presented at fair value in Other liabilities on the Consolidated Balance Sheet. Lastly, changes in ownership interests in subsidiaries that do not result in a loss of control are recognized as equity transactions. The difference between the adjustment in the carrying value of the non-controlling interest and the fair value of the consideration paid or received is recognized directly in Equity attributable to the Bank’s shareholders. Investments in Associates and Joint Ventures The Bank exercises significant influence over an entity when it has the power to participate in the financial and operating policy decisions of the investee. The Bank has joint control when there’s a contractually agreed sharing of control of an arrangement, and joint control exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. Investments in associates, i.e., entities over which the Bank exercises significant influence, and investments in joint ventures, i.e., entities over which the Bank has rights to the net assets and exercises joint control, are accounted for using the equity method. Under the equity method, the investment is initially recorded at cost and, following acquisition, the Bank’s shares in the net income and in the other comprehensive income are recognized, respectively, in Non-interest income in the Consolidated Statement of Income and in Other comprehensive income in the Consolidated Statement of Comprehensive Income. The carrying value of the investment is adjusted by an equivalent amount on the Consolidated Balance Sheet and reduced by distributions received. TTrraannssllaattiioonn ooff FFoorreeiiggnn CCuurrrreenncciieess The consolidated financial statements are presented in Canadian dollars, which is the Bank’s functional and presentation currency. Each foreign operation of the Bank determines its own functional currency, and the items reported in the financial statements of each foreign operation are measured using that currency. Monetary items and non-monetary items measured at fair value and denominated in foreign currencies are translated into the functional currency at exchange rates prevailing at the Consolidated Balance Sheet date. Non-monetary items not measured at fair value are translated into the functional currency at historical rates. Revenues and expenses denominated in foreign currencies are translated at the average exchange rates for the period. Translation gains and losses are recognized in Non-interest income in the Consolidated Statement of Income, except for equity instruments designated at fair value through other comprehensive income, for which unrealized gains and losses are recorded in Other comprehensive income and will not be subsequently reclassified to net income. In the consolidated financial statements, the assets and liabilities of all foreign operations are translated into the Bank’s functional currency at the exchange rates prevailing at the Consolidated Balance Sheet date, whereas the revenues and expenses of such foreign operations are translated into the Bank’s functional currency at the average exchange rates for the period. Any goodwill resulting from the acquisition of a foreign operation that does not have the same functional currency as the parent company, and any fair value adjustments to the carrying amounts of assets and liabilities resulting from the acquisition, are treated as assets and liabilities of the foreign operation and translated at the exchange rates prevailing at the Consolidated Balance Sheet date. Unrealized translation gains and losses relating to foreign operations, along with the impact of hedges and income taxes on the related results, are presented in Other comprehensive income. On disposal of a foreign operation, any accumulated translation gains and losses, along with the related hedges, recorded in the Accumulated other comprehensive income item of this foreign operation, are reclassified to Non-interest income in the Consolidated Statement of Income. CCllaassssiiffiiccaattiioonn aanndd MMeeaassuurreemmeenntt ooff FFiinnaanncciiaall IInnssttrruummeennttss At initial recognition, all financial instruments are recorded at fair value on the Consolidated Balance Sheet. At initial recognition, financial assets must be classified as subsequently measured at fair value through other comprehensive income, at amortized cost, or at fair value through profit or loss. The Bank determines the classification based on the contractual cash flow characteristics of the financial assets and on the business model it uses to manage these financial assets. At initial recognition, financial liabilities are classified as subsequently measured at amortized cost or as at fair value through profit or loss. For the purpose of classifying a financial asset, the Bank must determine whether the contractual cash flows associated with the financial asset are solely payments of principal and interest on the principal amount outstanding. The principal is generally the fair value of the financial asset at initial recognition. The interest consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period, and for other basic lending risks and costs as well as of a profit margin. If the Bank determines that the contractual cash flows associated with a financial asset are not solely payments of principal and interest, the financial assets must be classified as measured at fair value through profit or loss. 122 122 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) When classifying financial assets, the Bank determines the business model used for each portfolio of financial assets that are managed together to achieve a same business objective. The business model reflects how the Bank manages its financial assets and the extent to which the financial asset cash flows are generated by the collection of the contractual cash flows, the sale of the financial assets, or both. The Bank determines the business model using scenarios that it reasonably expects to occur. Consequently, the business model determination is a matter of fact and requires the use of judgment and consideration of all the relevant evidence available at the date of determination. A financial asset portfolio falls within a “hold to collect” business model when the Bank’s primary objective is to hold these financial assets in order to collect contractual cash flows from them and not to sell them. When the Bank’s objective is achieved both by collecting contractual cash flows and by selling the financial assets, the financial asset portfolio falls within a “hold to collect and sell” business model. In this type of business model, collecting contractual cash flows and selling financial assets are both integral components to achieving the Bank’s objective for this financial asset portfolio. Financial assets are mandatorily measured at fair value through profit or loss if they do not fall within either a “hold to collect” business model or a “hold to collect and sell” business model. Financial Instruments Designated at Fair Value Through Profit or Loss A financial asset may be irrevocably designated at fair value through profit or loss at initial recognition if certain conditions are met. The Bank may apply this option if, consistent with a documented risk management strategy, doing so eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or liabilities or recognizing gains and losses on them on different bases and if the fair values are reliable. Financial assets thus designated are recognized at fair value, and any change in fair value is recorded in Non-interest income in the Consolidated Statement of Income. Interest income arising from these financial instruments designated at fair value through profit or loss is recorded in Net interest income in the Consolidated Statement of Income. A financial liability may be irrevocably designated at fair value through profit or loss when it is initially recognized. Financial liabilities thus designated are recognized at fair value, and any changes in fair value attributable to changes in the Bank's own credit risk are recognized in Other comprehensive income unless these changes offset the amounts recognized in Net income. Fair value changes not attributable to the Bank's own credit risk are recognized in Non-interest income in the Consolidated Statement of Income. The amounts recognized in Other comprehensive income will not be subsequently reclassified to Net income. Interest expense arising from these financial liabilities designated at fair value through profit or loss is recorded in the Net interest income item of the Consolidated Statement of Income. The Bank may use this option in the following cases:    If, consistent with a documented risk management strategy, using this option allows the Bank to eliminate or significantly reduce a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or liabilities on different bases, and if the fair values are reliable. If a group of financial assets and financial liabilities to which an instrument belongs is managed and its performance is evaluated on a fair value basis, in accordance with the Bank’s documented risk management or investment strategy, and information is provided on that basis to senior management. Consequently, the Bank may use this option if it has implemented a documented risk management strategy to manage a group of financial instruments together on the fair value basis, if it can demonstrate that significant financial risks are eliminated or significantly reduced, and if the fair values are reliable. For hybrid financial instruments with one or more embedded derivatives that would significantly modify the cash flows of the financial instruments and that would otherwise be bifurcated and accounted for separately. Financial Instruments Designated at Fair Value Through Other Comprehensive Income At initial recognition, an investment in an equity instrument that is neither held for trading nor a contingent consideration recognized in a business combination may be irrevocably designated as being at fair value through other comprehensive income. In accordance with this designation, any change in fair value is recognized in Other comprehensive income with no subsequent reclassification to net income. Dividend income is recorded in Interest income in the Consolidated Statement of Income. Securities Measured at Fair Value Through Other Comprehensive Income Securities measured at fair value through other comprehensive income include: (i) debt securities for which the contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal amount outstanding and that fall within a “hold to collect and sell” business model and (ii) equity securities designated at fair value through other comprehensive income with no subsequent reclassification of gains and losses to net income. The Bank recognizes securities transactions at fair value through other comprehensive income on the trade date, and the transaction costs are capitalized. Interest income and dividend income are recognized in Interest income in the Consolidated Statement of Income. National Bank of Canada 123 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 1 – Basis of Presentation and Summary of Significant Accounting Policies (cont.) Debt Securities Measured at Fair Value Through Other Comprehensive Income Debt securities measured at fair value through other comprehensive income are recognized at fair value. Unrealized gains and losses are recognized, net of expected credit losses and income taxes, and provided that they are not hedged by derivative financial instruments in a fair value hedging relationship, in Other comprehensive income. When the securities are sold, realized gains or losses, determined on an average cost basis, are reclassified to Non-interest income – Gains (losses) on non-trading securities, net in the Consolidated Statement of Income. Premiums, discounts and related transaction costs are amortized over the expected life of the instrument to interest income using the effective interest rate method. Equity Securities Designated at Fair Value Through Other Comprehensive Income Equity securities designated at fair value through other comprehensive income are recognized at fair value. Unrealized gains and losses are presented, net of income taxes, in Other comprehensive income with no subsequent reclassification of realized gains and losses to net income. Transaction costs incurred upon the purchase of such equity securities are not reclassified to net income upon the sale of the securities. Securities Measured at Amortized Cost Securities measured at amortized cost include debt securities for which the contractual terms give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal amount outstanding and that fall within a “hold to collect” business model. The Bank recognizes these securities transactions at fair value on the trade date, and the transaction costs are capitalized. After initial recognition, debt securities in this category are recorded at amortized cost. Interest income is recognized in Interest income in the Consolidated Statement of Income. Premiums, discounts and related transaction costs are amortized over the expected life of the instrument to interest income using the effective interest rate method. Securities measured at amortized cost are presented net of allowances for credit losses on the Consolidated Balance Sheet. Securities Measured at Fair Value Through Profit or Loss Securities not classified or designated as measured at fair value through other comprehensive income or at amortized cost are classified as measured at fair value through profit or loss. Securities measured at fair value through profit or loss include (i) securities held for trading, (ii) securities designated at fair value through profit or loss, (iii) all equity securities other than those designated as measured at fair value through other comprehensive income with no subsequent reclassifications of gains and losses to net income, and (iv) debt securities for which the contractual cash flows are not solely payments of principal and any interest on the principal amount outstanding. The Bank recognizes securities transactions at fair value through profit or loss on the settlement date on the Consolidated Balance Sheet. Changes in fair value between the trade date and the settlement date are recognized in Non-interest income in the Consolidated Statement of Income. Securities at fair value through profit or loss are recognized at fair value. Interest income, any transaction costs, as well as realized and unrealized gains or losses on securities held for trading are recognized in Non-interest income – Trading revenues (losses) in the Consolidated Statement of Income. Dividend income is recorded in Interest income in the Consolidated Statement of Income. Interest income on securities designated at fair value through profit or loss is recorded in Interest income in the Consolidated Statement of Income. Realized and unrealized gains or losses on these securities are recognized in Non-interest income – Trading revenues (losses) in the Consolidated Statement of Income. Realized and unrealized gains or losses on equity securities at fair value through profit or loss, other than those held for trading, as well as debt securities for which the contractual cash flows are not solely payments of principal and interest on the principal amount outstanding, are recognized in Non-interest income – Gains (losses) on non-trading securities, net in the Consolidated Statement of Income. The dividend and interest income on these financial assets are recognized in Interest income in the Consolidated Statement of Income. Securities Purchased Under Reverse Repurchase Agreements, Obligations Related to Securities Sold Under Repurchase Agreements, and Securities Borrowed and Loaned The Bank recognizes these transactions at amortized cost using the effective interest rate method, except when they are designated at fair value through profit or loss and are recorded at fair value. These transactions are held within a business model whose objective is to collect contractual cash flows, i.e., cash flows that are solely payments of principal and interest on the principal amount outstanding. Securities sold under repurchase agreements remain on the Consolidated Balance Sheet, whereas securities purchased under reverse repurchase agreements are not recognized. Reverse repurchase agreements and repurchase agreements are treated as collateralized lending and borrowing transactions. 124 124 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) The Bank also borrows and lends securities. Securities loaned remain on the Consolidated Balance Sheet while securities borrowed are not recognized. As part of these transactions, the Bank pledges or receives collateral in the form of cash or securities. Collateral pledged in the form of securities remains on the Consolidated Balance Sheet. Collateral received in the form of securities is not recognized on the Consolidated Balance Sheet. Collateral pledged or received in the form of cash is recognized in financial assets or liabilities on the Consolidated Balance Sheet. When the collateral is pledged or received in the form of cash, the interest income and expense are recorded in Net interest income in the Consolidated Statement of Income. Loans Loans Measured at Amortized Cost Loans classified as measured at amortized cost include loans originated or purchased by the Bank that are not classified as measured at fair value through profit or loss or designated at fair value through profit or loss. These loans are held within a business model whose objective is to collect contractual cash flows, i.e., cash flows that are solely payments of principal and interest on the principal amount outstanding. All loans originated by the Bank are recognized when cash is advanced to a borrower. Purchased loans are recognized when the cash consideration is paid by the Bank. All loans are initially recognized at fair value plus directly attributable costs and are subsequently measured at amortized cost using the effective interest rate method, net of an allowance for expected credit losses. For purchased performing loans, the acquisition date fair value adjustment on each loan is amortized to interest income over the expected remaining life of the loan using the effective interest rate method. For purchased credit-impaired loans, the acquisition date fair value adjustment on each loan consists of management’s estimate of the shortfall of principal and interest cash flows that the Bank expects to collect and of the time value of money. The time value of money component of the fair value adjustment is amortized to interest income over the remaining life of the loan using the effective interest rate method. Loans are presented net of allowances for credit losses on the Consolidated Balance Sheet. Loans Measured at Fair Value Through Profit or Loss Loans classified as measured at fair value through profit or loss, loans designated at fair value through profit or loss, and loans for which the contractual cash flows are not solely payments of principal and interest on the principal amount outstanding are recognized at fair value on the Consolidated Balance Sheet. The interest income on loans at fair value through profit or loss is recorded in Interest income in the Consolidated Statement of Income. Changes in the fair value of loans classified as at fair value through profit or loss and loans designated at fair value through profit or loss are recognized in Non- interest income – Trading revenues (losses) in the Consolidated Statement of Income. With respect to loans whose contractual cash flows are not solely payments of principal and interest on the principal amount outstanding, changes in fair value are recognized in Non-interest income – Other in the Consolidated Statement of Income. Reclassification of Financial Assets A financial asset, other than a derivative financial instrument or a financial asset that, at initial recognition, was designated as measured at fair value through profit or loss, is reclassified only in rare situations, i.e., when there is a change in the business model used to manage the financial asset. The reclassification is applied prospectively from the reclassification date. EEssttaabblliisshhiinngg FFaaiirr VVaalluuee The fair value of a financial instrument is the price that would be received to sell a financial asset or paid to transfer a financial liability in an orderly transaction in the principal market at the measurement date under current market conditions (i.e., an exit price). Unadjusted quoted prices in active markets, based on bid prices for financial assets and offered prices for financial liabilities, provide the best evidence of fair value. A financial instrument is considered quoted in an active market when prices in exchange, dealer, broker or principal-to-principal markets are accessible at the measurement date. An active market is one where transactions occur with sufficient frequency and volume to provide quoted prices on an ongoing basis. When there is no quoted price in an active market, the Bank uses another valuation technique that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The chosen valuation technique incorporates all the factors that market participants would consider when pricing a transaction. Judgment is required when applying a large number of acceptable valuation techniques and estimates to determine fair value. The estimated fair value reflects market conditions on the valuation date and, consequently, may not be indicative of future fair value. The best evidence of the fair value of a financial instrument at initial recognition is the transaction price, i.e., the fair value of the consideration received or paid. If there is a difference between the fair value at initial recognition and the transaction price, and the fair value is determined using a valuation technique based on observable market inputs or, in the case of a derivative, if the risks are fully offset by other contracts entered into with third parties, this difference is recognized in the Consolidated Statement of Income. In other cases, the difference between the fair value at initial recognition and the transaction price is deferred on the Consolidated Balance Sheet. The amount of the deferred gain or loss is recognized over the term of the financial instrument. The unamortized balance is immediately recognized in net income when (i) observable market inputs can be obtained and support the fair value of the transaction, (ii) the risks associated with the initial contract are substantially offset by other contracts entered into with third parties, (iii) the gain or loss is realized through a cash receipt or payment, or (iv) the transaction matures or is cancelled before maturity. National Bank of Canada 125 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 1 – Basis of Presentation and Summary of Significant Accounting Policies (cont.) In certain cases, measurement adjustments are recognized to address factors that market participants would use at the measurement date to determine fair value but that are not included in the measurement technique due to system limitations or uncertainty surrounding the measure. These factors include, but are not limited to, the unobservable nature of inputs used in the valuation model, assumptions about risk such as market risk, credit risk, or risk related to the valuation model, and future administration costs. The Bank may also consider market liquidity risk when determining the fair value of financial instruments when it believes these instruments could be disposed of for a consideration below the fair value otherwise determined due to a lack of market liquidity or an insufficient volume of transactions in a given market. As permitted when certain criteria are met, the Bank has elected to determine fair value based on net exposure to credit risk or market risk for certain portfolios of financial instruments, mainly derivative financial instruments. IImmppaaiirrmmeenntt ooff FFiinnaanncciiaall AAsssseettss At the end of each reporting period, the Bank applies a three-stage impairment approach to measure the expected credit losses (ECL) on all debt instruments measured at amortized cost or at fair value through other comprehensive income and on loan commitments and financial guarantees that are not measured at fair value. The ECL model is forward looking. Measurement of ECLs at each reporting period reflects reasonable and supportable information about past events, current conditions, and forecasts of future events and economic conditions. Determining the Stage The ECL three-stage impairment approach is based on the change in the credit quality of financial assets since initial recognition. If, at the reporting date, the credit risk of non-impaired financial instruments has not increased significantly since initial recognition, these financial instruments are classified in Stage 1, and an allowance for credit losses that is measured, at each reporting date, in an amount equal to 12-month expected credit losses is recorded. When there is a significant increase in credit risk since initial recognition, these non-impaired financial instruments are migrated to Stage 2, and an allowance for credit losses that is measured, at each reporting date, in an amount equal to lifetime expected credit losses is recorded. In subsequent reporting periods, if the credit risk of the financial instrument improves such that there is no longer a significant increase in credit risk since initial recognition, the ECL model requires reverting to Stage 1, i.e., recognition of 12-month expected credit losses. When one or more events that have a detrimental impact on the estimated future cash flows of a financial asset have occurred, the financial asset is considered credit-impaired and is migrated to Stage 3, and an allowance for credit losses equal to lifetime expected losses continues to be recorded or the financial asset is written off. Interest income is calculated on the gross carrying amount for financial assets in Stages 1 and 2 and on the net carrying amount for financial assets in Stage 3. Assessment of Significant Increase in Credit Risk In determining whether credit risk has increased significantly, the Bank uses an internal credit risk grading system, external risk ratings, and forward-looking information to assess deterioration in credit quality of a financial instrument. To assess whether or not the credit risk of a financial instrument has increased significantly, the Bank compares the probability of default (PD) occurring over its expected life as at the reporting date with the PD occurring over its expected life on the date of initial recognition and considers reasonable and supportable information indicative of a significant increase in credit risk since initial recognition. The Bank includes relative and absolute thresholds in the definition of significant increase in credit risk and a backstop of 30 days past due. All financial instruments that are 30 days past due are migrated to Stage 2 even if other metrics do not indicate that a significant increase in credit risk has occurred. The assessment of a significant increase in credit risk requires significant judgment. Measurement of Expected Credit Losses ECLs are measured as the probability-weighted present value of all expected cash shortfalls over the remaining expected life of the financial instrument, and reasonable and supportable information about past events, current conditions and forecasts of future events and economic conditions is considered. The estimation and application of forward-looking information requires significant judgment. The cash shortfall is the difference between all contractual cash flows owed to the Bank and all cash flows that the Bank expects to receive. The measurement of ECLs is primarily based on the product of the financial instrument’s PD, loss given default (LGD), and exposure at default (EAD). Forward- looking macroeconomic factors such as unemployment rates, housing price indices, interest rates, and GDP are incorporated into the risk parameters. The estimate of expected credit losses reflects an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes. The Bank incorporates three forward-looking macroeconomic scenarios in its ECL calculation process: a base scenario, an upside scenario and a downside scenario. Probability weights are attributed to each scenario. The scenarios and probability weights are reassessed quarterly and are subject to management review. The Bank applies experienced credit judgment to adjust the modelled ECL results when it becomes evident that known or expected risk factors and information were not considered in the credit risk rating and modelling process. 126 126 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) ECLs for all financial instruments are recognized in Provisions for credit losses in the Consolidated Statement of Income. In the case of debt instruments measured at fair value through other comprehensive income, ECLs are recognized in Provisions for credit losses in the Consolidated Statement of Income, and a corresponding amount is recognized in Other comprehensive income with no reduction in the carrying amount of the asset on the Consolidated Balance Sheet. As for debt instruments measured at amortized cost, they are presented net of the related allowance for credit losses on the Consolidated Balance Sheet. Allowances for credit losses for off-balance-sheet credit exposures that are not measured at fair value are included in Other liabilities on the Consolidated Balance Sheet. Purchased or Originated Credit-Impaired Financial Assets On initial recognition of a financial asset, the Bank determines whether the asset is credit-impaired. For financial assets that are credit-impaired upon purchase or origination, the lifetime expected credit losses are reflected in the initial fair value. In subsequent reporting periods, the Bank recognizes only the cumulative changes in these lifetime ECLs since initial recognition as an allowance for credit losses. The Bank recognizes changes in ECLs in Provisions for credit losses in the Consolidated Statement of Income, even if the lifetime ECLs are less than ECLs that were included in the estimated cash flows on initial recognition. Definition of Default The definition of default used by the Bank to measure ECLs and transfer financial instruments between stages is consistent with the definition of default used for internal credit risk management purposes. The Bank considers a financial asset, other than a credit card receivable, to be credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of the financial asset have occurred or when contractual payments are 90 days past due. Credit card receivables are considered credit-impaired and are fully written off at the earlier of the following: when a notice of bankruptcy is received, a settlement proposal is made, or contractual payments are 180 days past due. Write-offs A financial asset and its related allowance for credit losses are normally written off in whole or in part when the Bank considers the probability of recovery to be non-existent and when all guarantees and other remedies available to the Bank have been exhausted or if the borrower is bankrupt or winding up and balances owing are not likely to be recovered. DDeerreeccooggnniittiioonn ooff FFiinnaanncciiaall AAsssseettss aanndd SSeeccuurriittiizzaattiioonn A financial asset is considered for derecognition when the Bank has transferred contractual rights to receive the cash flows or assumed an obligation to transfer these cash flows to a third party. The Bank derecognizes a financial asset when it considers that substantially all the risks and rewards of ownership of the asset have been transferred or when the contractual rights to the cash flows of the financial asset expire. When the Bank considers that it has retained substantially all the risks and rewards of ownership of the transferred asset, it continues to recognize the financial asset and, if applicable, recognizes a financial liability on the Consolidated Balance Sheet. If, due to a derivative financial instrument, the transfer of a financial asset does not result in derecognition, the derivative financial instrument is not recognized on the Consolidated Balance Sheet. When the Bank has neither transferred nor retained substantially all the risks and rewards of ownership of the financial asset, it derecognizes the financial asset it no longer controls. Any rights and obligations retained following the asset transfer are recognized separately as an asset or liability. If the Bank retains control of the financial asset, it continues to recognize the asset to the extent of its continuing involvement in that asset, i.e., to the extent to which it is exposed to changes in the value of the transferred asset. In order to diversify its funding sources, the Bank participates in two Canada Mortgage and Housing Corporation (CMHC) securitization programs: the Mortgage- Backed Securities Program under the National Housing Act (Canada) (NHA) and Canada Mortgage Bond (CMB) program. Under the first program, the Bank issues NHA securities backed by insured residential mortgages and, under the second, the Bank sells NHA securities to Canada Housing Trust (CHT). As part of these transactions, the Bank retains substantially all the risks and rewards related to ownership of the mortgage loans sold. Therefore, the insured mortgage loans securitized under the CMB program continue to be recognized in the Loans item of the Bank’s Consolidated Balance Sheet and the liabilities for the considerations received from the transfer are recognized in Liabilities related to transferred receivables on the Consolidated Balance Sheet. Moreover, insured mortgage loans securitized and retained by the Bank continue to be recognized in Loans on the Consolidated Balance Sheet. DDeerreeccooggnniittiioonn ooff FFiinnaanncciiaall LLiiaabbiilliittiieess A financial liability is derecognized when the obligation is discharged, cancelled or expires. The difference between the carrying value of the financial liability transferred and the consideration paid is recognized in the Consolidated Statement of Income. CCaasshh aanndd DDeeppoossiittss WWiitthh FFiinnaanncciiaall IInnssttiittuuttiioonnss Cash and deposits with financial institutions consist of cash and cash equivalents, amounts pledged as collateral as well as amounts placed in escrow. Cash comprises cash and bank notes. Cash equivalents consist of deposits with the Bank of Canada, deposits with financial institutions, including net receivables related to cheques and other items in the clearing process as well as the net amount of cheques and other items in transit. AAcccceeppttaanncceess aanndd CCuussttoommeerrss’’ LLiiaabbiilliittyy UUnnddeerr AAcccceeppttaanncceess The potential liability of the Bank under acceptances is recorded as a customer commitment liability on the Consolidated Balance Sheet. The Bank’s potential recourse vis à vis clients is recorded as an equivalent offsetting asset. Fees are recorded in Non-interest income in the Consolidated Statement of Income. National Bank of Canada 127 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 1 – Basis of Presentation and Summary of Significant Accounting Policies (cont.) OObblliiggaattiioonnss RReellaatteedd ttoo SSeeccuurriittiieess SSoolldd SShhoorrtt This financial liability represents the Bank’s obligation to deliver the securities it sold but did not own at the time of sale. Obligations related to securities sold short are recorded at fair value and presented as liabilities on the Consolidated Balance Sheet. Realized and unrealized gains and losses are recognized in Non- interest income in the Consolidated Statement of Income. DDeerriivvaattiivvee FFiinnaanncciiaall IInnssttrruummeennttss In the normal course of business, the Bank uses derivative financial instruments to meet the needs of its clients, to generate trading activity revenues, and to manage its exposure to interest rate risk, foreign exchange risk, credit risk and other market risks. All derivative financial instruments are measured at fair value on the Consolidated Balance Sheet. Derivative financial instruments with a positive fair value are included in assets, and derivative financial instruments with a negative fair value are included in liabilities on the Consolidated Balance Sheet. Where there are offsetting financial assets and financial liabilities, the net fair value of certain derivative financial instruments is reported either as an asset or as a liability. Embedded Derivative Financial Instruments An embedded derivative is a component of a hybrid contract that also includes a non-derivative host, the effect being that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to one of the parties to the contract. A derivative embedded in a financial liability is separated from the host contract and treated as a separate derivative if, and only if, the following three conditions are met: the economic characteristics and risks of the embedded derivative are not closely related to those of the host contract, the embedded derivative is a separate instrument that meets the definition of a derivative financial instrument, and the hybrid contract is not measured at fair value through profit or loss. Embedded derivatives that are separately accounted for are measured at fair value on the Consolidated Balance Sheet, and subsequent changes in fair value are recognized in Non-interest income in the Consolidated Statement of Income. In general, all embedded derivatives are presented on a combined basis with the host contract. However, certain embedded derivatives that are separated from the host contract are presented in Derivative financial instruments on the Consolidated Balance Sheet. Held-for-Trading Derivative Financial Instruments Derivative financial instruments are recognized at fair value, and the realized and unrealized gains and losses (including interest income and expense) are recorded in Non-interest income in the Consolidated Statement of Income. Derivative Financial Instruments Designated as Hedging Instruments Policy The purpose of a hedging transaction is to modify the Bank’s exposure to one or more risks by creating an offset between changes in the fair value of, or the cash flows attributable to, the hedged item and the hedging instrument. Hedge accounting ensures that offsetting gains, losses, revenues and expenses are recognized in the Consolidated Statement of Income in the same period or periods. Documenting and Assessing Effectiveness The Bank designates and formally documents each hedging relationship, at its inception, by detailing the risk management objective and the hedging strategy. The documentation identifies the specific asset, liability, or cash flows being hedged, the related hedging instrument, the nature of the specific risk exposure or exposures being hedged, the intended term of the hedging relationship, and the method for assessing the effectiveness or ineffectiveness of the hedging relationship. At the inception of the hedging relationship, and for every financial reporting period for which the hedge has been designated, the Bank ensures that the hedging relationship is highly effective and consistent with its originally documented risk management objective and strategy. When a hedging relationship meets the hedge accounting requirements, it is designated as either a fair value hedge, a cash flow hedge or a foreign exchange hedge of a net investment in a foreign operation. Fair Value Hedges For fair value hedges, the Bank mainly uses interest rate swaps to hedge changes in the fair value of a hedged item. The carrying amount of the hedged item is adjusted based on the effective portion of the gains or losses attributable to the hedged risk, which are recognized in the Consolidated Statement of Income, as well as the change in the fair value of the hedging instrument. The resulting ineffective portion is recognized in Non-interest income in the Consolidated Statement of Income. 128 128 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) The Bank prospectively discontinues hedge accounting if the hedging instrument is sold or expires or if the hedging relationship no longer qualifies for hedge accounting or if the Bank revokes the designation. When the designation is revoked, the hedged item is no longer adjusted to reflect changes in fair value, and the amounts previously recorded as cumulative adjustments with respect to the effective portion of gains and losses attributable to the hedged risk are amortized using the effective interest rate method and recognized in the Consolidated Statement of Income over the remaining useful life of the hedged item. If the hedged item is sold or terminated before maturity, the cumulative adjustments with respect to the effective portion of gains and losses attributable to the hedged risk are immediately recorded in the Consolidated Statement of Income. Cash Flow Hedges For cash flow hedges, the Bank mainly uses interest rate swaps and total return swaps to hedge variable cash flows attributable to the hedged risk related to a financial asset or liability (or to a group of financial assets or liabilities). The effective portion of changes in fair value of the hedging instrument is recognized in Other comprehensive income and the ineffective portion in Non-interest income in the Consolidated Statement of Income. The amounts previously recorded in Accumulated other comprehensive income are reclassified to the Consolidated Statement of Income of the period or periods during which the cash flows of the hedged item affect the Consolidated Statement of Income. If the hedging instrument is sold or expires or if the hedging relationship no longer qualifies for hedge accounting or if the Bank cancels that designation, then the amounts previously recognized in Accumulated other comprehensive income are reclassified to the Consolidated Statement of Income in the period or periods during which the cash flows of the hedged item affect the Consolidated Statement of Income. Hedges of Net Investments in Foreign Operations Derivative and non-derivative financial instruments are used to hedge foreign exchange risk related to investments made in foreign operations whose functional currency is not the Canadian dollar. The effective portion of the gains and losses on the hedging instrument is recognized in Other comprehensive income and the ineffective portion in Non-interest income in the Consolidated Statement of Income. Upon the total or partial sale of a net investment in a foreign operation, amounts reported in Accumulated other comprehensive income are reclassified, in whole or in part, to Non-interest income in the Consolidated Statement of Income. OOffffsseettttiinngg ooff FFiinnaanncciiaall AAsssseettss aanndd LLiiaabbiilliittiieess Financial assets and liabilities are offset, and the net amount is presented on the Consolidated Balance Sheet when the Bank has a legally enforceable right to set off the recognized amounts and intends to settle on a net basis or to realize the asset and settle the liability simultaneously. PPrreemmiisseess aanndd EEqquuiippmmeenntt Premises and equipment, except for land and the head office building under construction, are recognized at cost less accumulated amortization and accumulated impairment losses. Land and the head office building under construction are recorded at cost less any impairment losses. Premises and equipment and the significant components of a building that have different useful lives or that provide economic benefits at a different pace are systematically amortized over their useful lives. Amortization methods and useful lives are reviewed on an annual basis. The amortization expense is recorded in Non-interest expenses in the Consolidated Statement of Income. Significant components of a building Exterior design Interior design, roofing and electromechanical system Structure Other buildings Computer equipment Equipment and furniture Leasehold improvements Method Useful life Straight-line Straight-line Straight-line 5% declining balance Straight-line Straight-line Straight-line 20 years 30 years 75 years 3-4 years 1-8 years (1) (1) The average amortization period is 15 years, determined using the lesser of the useful life or the lease term plus the first renewal option. GGooooddwwiillll The Bank uses the acquisition method to account for business combinations. The consideration transferred in a business combination is measured at the acquisition-date fair value, and the transaction costs related to the acquisition are expensed as incurred. When the Bank acquires control of a business, all of the identifiable assets and liabilities of the acquiree, including intangible assets, are recorded at fair value. The interests previously held in the acquiree are also measured at fair value. Goodwill represents the excess of the purchase consideration and all previously held interests over the fair value of the identifiable net assets of the acquiree. If the fair value of the identifiable net assets exceeds the purchase consideration and all previously held interests, the difference is immediately recognized as a gain on a bargain purchase. National Bank of Canada 129 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 1 – Basis of Presentation and Summary of Significant Accounting Policies (cont.) Non-controlling interests in the net assets of consolidated subsidiaries are identified separately from the Bank’s ownership interest and can be initially measured at either fair value or at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets. The measurement basis is selected on a case- by-case basis. Following an acquisition, non-controlling interests consist of the value assigned to those interests at initial recognition plus the non-controlling interests’ share of changes in equity since the date of the acquisition. IInnttaannggiibbllee AAsssseettss Intangible Assets With Finite Useful Lives Software and certain other intangible assets are recognized at cost less accumulated amortization and accumulated impairment losses. These intangible assets are systematically amortized on a straight-line basis over their useful lives, which vary between four and ten years. The amortization expense is recorded in Non- interest expenses in the Consolidated Statement of Income. Intangible Assets With Indefinite Useful Lives The Bank’s intangible assets with indefinite useful lives come from the acquisition of subsidiaries or groups of assets and consist of management contracts and a trademark. They are recognized at the acquisition-date fair value. The management contracts are for the management of open-ended funds. At the end of each reporting period, the Bank reviews the useful lives to determine whether events and circumstances continue to support an indefinite useful life assessment. Intangible assets are deemed to have an indefinite useful life following an examination of all relevant factors, in particular: (a) the contracts do not have contractual maturities; (b) the stability of the business segment to which the intangible assets belong; (c) the Bank’s capacity to control the future economic benefits of the intangible assets; and (d) the continued economic benefits generated by the intangible assets. IImmppaaiirrmmeenntt ooff NNoonn--FFiinnaanncciiaall AAsssseettss Premises and equipment and intangible assets with finite useful lives are tested for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. At the end of each reporting period, the Bank determines whether there is an indication that premises and equipment or intangible assets with finite useful lives may be impaired. Goodwill and intangible assets that are not yet available for use or that have indefinite useful lives are tested for impairment annually or more frequently if there is an indication that the asset might be impaired. An asset is tested for impairment by comparing its carrying amount with its recoverable amount. The recoverable amount must be estimated for the individual asset. Where it is not possible to estimate the recoverable amount of an individual asset, the recoverable amount of the cash-generating unit (CGU) to which the asset belongs will be determined. A CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. The Bank uses judgment to identify CGUs. An asset’s recoverable amount is the higher of fair value less costs to sell and the value in use of the asset or CGU. Value in use is the present value of expected future cash flows from the asset or CGU. The recoverable amount of the CGU is determined using valuation models that consider various factors such as projected future cash flows, discount rates, and growth rates. The use of different estimates and assumptions in applying the impairment tests could have a significant impact on income. Corporate assets, such as the head office building and computer equipment, do not generate cash inflows that are largely independent of the cash inflows generated by other assets or groups of assets. Therefore, the recoverable amount of an individual corporate asset cannot be determined unless management has decided to dispose of the asset. However, if there is an indication that a corporate asset may be impaired, the recoverable amount is determined for the CGU or group of CGUs to which the corporate asset belongs, and that recoverable amount is compared with the carrying amount of this CGU or group of CGUs. Goodwill is always tested for impairment at the level of a CGU or group of CGUs. For impairment testing purposes, from the acquisition date, goodwill resulting from a business combination must be allocated to the CGU or group of CGUs expected to benefit from the synergies of the business combination. Each CGU or group of CGUs to which goodwill is allocated must represent the lowest level for which the goodwill is monitored internally at the Bank and must not be larger than an operating segment. The allocation of goodwill to a CGU or group of CGUs involves management’s judgment. If an impairment loss is to be recognized, the Bank does so by first reducing the carrying amount of goodwill allocated to the CGU or group of CGUs and then reducing the carrying amounts of the other assets of the CGU or group of CGUs in proportion to the carrying amount of each asset in the CGU or group of CGUs. If the recoverable amount of an asset or a CGU is less than its carrying amount, the carrying amount is reduced to its recoverable amount and an impairment loss is recognized in Non-interest expenses in the Consolidated Statement of Income. An impairment loss recognized in prior periods for an asset other than goodwill must be reversed if, and only if, there has been a change in the estimates used to determine the asset’s recoverable amount since the last impairment was recognized. If this is the case, the carrying amount of the asset is increased, given that the impairment loss was reversed, but shall not exceed the carrying amount that would have been determined, net of amortization, had no impairment loss been recognized for this asset in previous years. 130 130 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) LLeeaasseess A lease is an agreement whereby the lessor conveys to the lessee the right to use an asset for an agreed period of time in return for a payment or series of payments. A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of the leased asset to the lessee. Title may or may not eventually be transferred. An operating lease is a lease other than a finance lease. The Bank primarily enters into operating leases. When the Bank is the lessee under an operating lease, the rental expense is recognized on a straight-line basis over the lease term in Non-interest expenses in the Consolidated Statement of Income. When the Bank is the lessor, the lease assets remain on the Consolidated Balance Sheet and are reported in premises and equipment, and the rental income is recognized net of related expenses in Non-interest income in the Consolidated Statement of Income. PPrroovviissiioonnss Provisions are liabilities of uncertain timing and amount. A provision is recognized when the Bank has a present obligation (legal or constructive) arising from a past event, when it is probable that an outflow of economic resources will be required to settle the obligation and when the amount of the obligation can be reliably estimated. Provisions are based on the Bank’s best estimates of the economic resources required to settle the present obligation, given all relevant risks and uncertainties, and, when it is significant, the effect of the time value of money. Provisions are reviewed at the end of each reporting period. Provisions are presented in Other liabilities on the Consolidated Balance Sheet. IInntteerreesstt IInnccoommee aanndd EExxppeennssee Interest income and expense, except for the interest income on securities classified as at fair value through profit or loss, are recognized in Net interest income and calculated using the effective interest rate method. The effective interest rate is the rate that exactly discounts estimated future cash inflows and outflows through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortized cost of a financial liability. When calculating the effective interest rate, the Bank estimates expected cash flows by considering all the contractual terms of the financial instrument but does not consider expected credit losses. The calculation includes all fees and points paid or received between the parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. Interest income is calculated by applying the effective interest rate to the gross carrying amount of a financial asset except for purchased or originated credit-impaired financial assets and financial assets that were not impaired upon their purchase or origination but became impaired thereafter. For purchased or originated credit-impaired financial assets, the Bank applies the credit-adjusted effective interest rate to the amortized cost of the financial asset from initial recognition. The credit-adjusted effective interest rate reflects expected credit losses. As for loans that have subsequently become credit-impaired, interest income is calculated by applying the effective interest rate to the net carrying amount (net of allowances for credit losses) rather than to the carrying amount. Loan origination fees, including commitment, restructuring, and renegotiation fees, are considered an integral part of the yield earned on the loan. They are deferred and amortized using the effective interest rate method, and the amortization is recognized in Interest income over the term of the loan. Direct costs for originating a loan are netted against the loan origination fees. If it is likely that a commitment will result in a loan, commitment fees receive the same accounting treatment, i.e., they are deferred and amortized using the effective interest rate method and the amortization is recognized in Interest income over the term of the loan. Otherwise, they are recorded in Non-interest income over the term of the commitment. Loan syndication fees are recorded in Non-interest income unless the yield on the loan retained by the Bank is less than that of other comparable lenders involved in the financing. In such cases, an appropriate portion of the fees is deferred and amortized using the effective interest rate method, and the amortization is recognized in Interest income over the term of the loan. Certain mortgage loan prepayment fees are recognized in Interest income in the Consolidated Statement of Income when earned. DDiivviiddeenndd IInnccoommee Dividends from an equity instrument are recognized in Net interest income in the Consolidated Statement of Income when the Bank’s right to receive payment is established. FFeeee aanndd CCoommmmiissssiioonn IInnccoommee Fee and commission income is recognized when, or as, a performance obligation is satisfied, i.e., when control of a promised service is transferred to a customer and in an amount that reflects the consideration that the entity expects to be entitled to receive in exchange for the service. The revenue may therefore be recognized at a point in time, upon completion of the service, or over time as services are provided. The Bank must also determine whether its performance obligation is to provide the service itself or to arrange for another party to provide the service (in other words, whether the Bank is acting as a principal or agent). A principal may itself satisfy its performance obligation to provide the specified good or service or it may engage another party to satisfy some or all of the performance obligation on its behalf. A principal also has the primary responsibility for fulfilling the promise to provide the good or service to the customer and has discretion in establishing the price for the service. If the Bank is acting as a principal, revenue is recognized on a gross basis in an amount corresponding to the consideration to which the Bank expects to be entitled. If the Bank is acting as an agent, then revenue is recognized net of the service fees and other costs incurred in relation to the commission and fees earned. National Bank of Canada 131 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 1 – Basis of Presentation and Summary of Significant Accounting Policies (cont.) Underwriting and Advisory Fees Underwriting and advisory fees include underwriting fees, financial advisory fees, and loan syndication fees. These fees are mainly earned in the Financial Markets segment and are recognized at a point in time as revenue upon successful completion of the engagement. Financial advisory fees are fees earned for assisting customers with transactions related to mergers and acquisitions and financial restructurings. Loan syndication fees represent fees earned as the agent or lead lender responsible for structuring, arranging, and administering a loan syndication and are recorded in Non-interest income unless the yield on the loan retained by the Bank is less than that of other comparable lenders involved in the financing. In such cases, an appropriate portion of the fees is deferred and amortized using the effective interest rate method, and the amortization is recognized in Interest income over the term of the loan. Securities Brokerage Commissions Securities brokerage commissions are earned in the Wealth Management segment and are recognized at a point in time when the transaction is executed. Mutual Fund and Trust Service Revenues Mutual fund and trust service revenues include management and administration fees. These fees are earned in the Wealth Management segment. Management fees are primarily calculated on assets under management and are recorded over the period the services are performed. Administration fees are generally based on assets under administration or management and are recorded over the period the services are performed. Card Revenues Card revenues are earned in the Personal and Commercial segment and include card fees such as annual and transactional fees as well as interchange fees. Interchange fees are recognized when a card transaction is settled. Card fees are recognized on the transaction date except for annual fees, which are recorded evenly throughout the year. Reward costs are recorded as a reduction to interchange fees. Credit Fees and Deposit and Payment Service Charges Credit fees and deposit and payment service charges are earned in the Personal and Commercial, Financial Markets, and U.S. Specialty Finance and International segments. Credit fees are generally recognized in income over the period the services are provided. Deposit and payment service charges include fees related to account maintenance activities and transaction-based service charges. Fees related to account maintenance activities are recognized over the period the services are provided, whereas transaction-based service charges are recognized at a point in time when the transaction is completed. IInnssuurraannccee RReevveennuueess Insurance contracts, including reinsurance contracts, are arrangements under which one party accepts significant insurance risk by agreeing to compensate the policyholder if a specified uncertain future event was to occur. Gross premiums, net of premiums transferred under reinsurance contracts, are recognized when they become due. Royalties received from reinsurers are recognized when earned. Claims are recognized when received and an amount is estimated as they are being processed. All these amounts are recognized on a net basis in Non-interest income in the Consolidated Statement of Income. Upon recognition of a premium, a reinsurance asset and insurance liability are recognized, respectively, in Other assets and in Other liabilities on the Consolidated Balance Sheet. Subsequent changes in the carrying value of the reinsurance asset and insurance liability are recognized on a net basis in Non-interest income in the Consolidated Statement of Income. IInnccoommee TTaaxxeess Income taxes include current taxes and deferred taxes and are recorded in net income except for income taxes generated by items recognized in Other comprehensive income or directly in equity. Current tax is the amount of income tax payable on the taxable income for a period. It is calculated using the enacted or substantively enacted tax rates prevailing on the reporting date, and any adjustments recognized in the period for the current tax of prior periods. Current tax assets and liabilities are offset, and the net balance is presented in either Other assets or Other liabilities on the Consolidated Balance Sheet when the Bank has a legally enforceable right to set off the recognized amounts and intends to settle on a net basis or to simultaneously realize the asset and settle the liability. 132 132 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Deferred tax is established based on temporary differences between the carrying values and the tax bases of assets and liabilities, in accordance with enacted or substantively enacted income tax laws and rates that will apply on the date the differences will reverse. Deferred tax is not recognized for temporary differences related to the following:     the initial accounting of goodwill; the initial accounting of an asset or liability in a transaction that is not a business combination and that, at the time of the transaction, affects neither accounting income nor taxable income; investments in subsidiaries, associates and joint ventures when it is probable that the temporary difference will not reverse in the foreseeable future and that the Bank controls the timing of the reversal of the temporary difference; investments in subsidiaries, associates and joint ventures when it is probable that the temporary difference will not reverse in the foreseeable future and that there will not be taxable income to which the temporary difference can be recognized. Deferred tax assets are tax benefits in the form of deductions that the Bank may claim to reduce its taxable income in future years. At the end of each reporting period, the carrying amount of deferred tax assets is revised, and it is reduced to the extent that it is no longer probable that sufficient taxable income will be available to allow the benefit of the deferred tax asset to be utilized. Deferred tax assets and liabilities are offset, and the net balance is presented in either Other assets or Other liabilities on the Consolidated Balance Sheet when the Bank has a legally enforceable right to set off the current tax assets and liabilities and if the deferred tax assets and liabilities relate to taxes levied by the same taxation authority on the same taxable entity or on different taxable entities that intend to settle current tax assets and liabilities based on their net amount. The Bank makes assumptions to estimate income taxes as well as deferred tax assets and liabilities. This process includes estimating the actual amount of current taxes and evaluating tax loss carryforwards and temporary differences arising from differences between the values of items reported for accounting and for income tax purposes. Deferred tax assets and liabilities presented on the Consolidated Balance Sheet are calculated according to the tax rates to be applied in future periods. Previously recorded deferred tax assets and liabilities must be adjusted when the date of the future event is revised based on current information. The Bank is subject to the jurisdictions of various tax authorities. In the normal course of its business, the Bank is involved in a number of transactions for which the tax impacts are uncertain. As a result, the Bank accounts for provisions for uncertain tax positions that adequately represent the tax risk stemming from tax matters under discussion or being audited by tax authorities or from other matters involving uncertainty. The amounts of these provisions reflect the best possible estimates of the amounts that may have to be paid based on qualitative assessments of all relevant factors. The provisions are estimated at the end of each reporting period. However, it is possible that, at a future date, a provision might need to be adjusted following an audit by the tax authorities. When the final assessment differs from the initially provisioned amounts, the difference will impact the income taxes of the period in which the assessment was made. FFiinnaanncciiaall GGuuaarraanntteeee CCoonnttrraaccttss A financial guarantee contract is a contract or indemnification agreement that could require the Bank to make specified payments (in cash, financial instruments, other assets, Bank shares, or provisions of services) to reimburse a beneficiary in the event of a loss resulting from a debtor defaulting on the original or amended terms of a debt instrument. To reflect the fair value of the obligation assumed at the inception of a financial guarantee, a liability is recorded in Other liabilities on the Consolidated Balance Sheet. After initial recognition, the Bank must measure financial guarantee contracts at the higher of the allowance for credit losses determined using the ECL model and of the initially recognized amount less, where applicable, the cumulative amount of income recognized. This revenue is recognized in Credit fees in the Consolidated Statement of Income. EEmmppllooyyeeee BBeenneeffiittss –– PPeennssiioonn PPllaannss aanndd OOtthheerr PPoosstt--EEmmppllooyymmeenntt BBeenneeffiittss The Bank offers defined benefit pension plans and other post-employment benefit plans to eligible employees. Other post-employment benefit plans include post-employment medical, dental, and life insurance coverage. While pension plans are funded, the other plans are not. Plan expenses and obligations are actuarially determined based on the projected benefit method prorated on service. The calculations use management’s best estimates of various actuarial assumptions such as discount rates, rates of compensation increase, health care cost trend rates, mortality rates, and retirement age. The net asset or net liability of pension plans and other post-employment benefit plans are calculated separately for each plan as the difference between the present value of the future benefits earned by employees in respect of current- and prior-period service and the fair value of plan assets. The net asset or net liability is included in either the Other assets or Other liabilities item of the Consolidated Balance Sheet. National Bank of Canada 133 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 1 – Basis of Presentation and Summary of Significant Accounting Policies (cont.) The expense related to pension plans and other post-employment benefit plans consists of the following items: current service cost, net interest on the net plan asset or liability, administration costs, and past service cost, if any, recognized when a plan is amended. This expense is recognized in Compensation and employee benefits in the Consolidated Statement of Income. The net amount of interest income and expense is determined by applying a discount rate to the net plan asset or liability amount. Remeasurements resulting from pension plans and other post-employment benefit plans represent actuarial gains and losses related to the defined benefit obligation and the actual return on plan assets, excluding net interest determined by applying a discount rate to the net asset or liability of the plans. Remeasurements are immediately recognized in Other comprehensive income and will not be subsequently reclassified to net income; these cumulative gains and losses are reclassified to Retained earnings. SShhaarree--BBaasseedd PPaayymmeennttss The Bank has several share-based compensation plans: the Stock Option Plan, the Stock Appreciation Rights (SAR) Plan, the Deferred Stock Unit (DSU) Plan, the Restricted Stock Unit (RSU) Plan, the Performance Stock Unit (PSU) Plan, the Deferred Compensation Plan (DCP) of National Bank Financial, and the Employee Share Ownership Plan. Compensation expense is recognized over the service period required for employees to become fully entitled to the award. This period is generally the same as the vesting period, except where the required service period begins before the award date. Compensation expense related to awards granted to employees eligible to retire on the award date is immediately recognized on the award date. Compensation expense related to awards granted to employees who will become eligible to retire during the vesting period is recognized over the period from the award date to the date the employee becomes eligible to retire. For all of these plans, as of the first year of recognition, the expense includes cancellation and forfeiture estimates. These estimates are subsequently revised as necessary. The Bank uses derivative financial instruments to hedge the risks associated with some of these plans. The compensation expense for these plans, net of related hedges, is recognized in the Consolidated Statement of Income. Under the Stock Option Plan, the Bank uses the fair value method to account for stock options awarded. The options vest at 25% per year, and each tranche is treated as though it was a separate award. The fair value of each of the tranches is measured on the award date using the Black-Scholes model, and this fair value is recognized in Compensation and employee benefits and Contributed surplus. When the options are exercised, the Contributed surplus amount is credited to Equity – Common shares on the Consolidated Balance Sheet. The proceeds received from the employees when these options are exercised are also credited to Equity – Common shares on the Consolidated Balance Sheet. SARs are recorded at fair value when awarded and their fair value is remeasured at the end of each reporting period until they are exercised. The cost is recognized in Compensation and employee benefits in the Consolidated Statement of Income and in Other liabilities on the Consolidated Balance Sheet. The obligation that results from the change in fair value at each period is recognized in net income gradually over the vesting period, and periodically thereafter, until the SARs are exercised. When a SAR is exercised, the Bank makes a cash payment equal to the increase in the stock price since the date of the award. The obligation that results from the award of a DSU, RSU, PSU and DCP unit is recognized in net income, and the corresponding amount is included in Other liabilities on the Consolidated Balance Sheet. For the DSU, RSU and DCP plans, the change in the obligation attributable to variations in the share price and dividends paid on common shares for these plans is recognized in Compensation and employee benefits in the Consolidated Statement of Income for the period in which the variations occur. On the redemption date, the Bank makes a cash payment equal to the value of the common shares on that date. For the PSU Plan, the change in the obligation attributable to changes in the stock price, adjusted upward or downward depending on the relative result of the performance criteria, and the change in the obligation attributable to dividends paid on the shares awarded under the plan, are recognized in Compensation and employee benefits in the Consolidated Statement of Income for the period in which the changes occur. On the redemption date, the Bank makes a cash payment equal to the value of the common shares on that date, adjusted upward or downward according to the performance criteria. The Bank’s contributions to the employee share ownership plan are expensed as incurred. 134 134 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 22 –– FFuuttuurree AAccccoouunnttiinngg PPoolliiccyy CChhaannggeess The IASB issues revisions and amendments to a number of standards, some of which have already had an impact on the Bank and others that could have an impact in the future. The Bank is currently assessing the impact that adoption of the following standards will have on its consolidated financial statements. A summary of these amendments and the effective dates applicable to the Bank are presented below. EEffffeeccttiivvee DDaattee –– NNoovveemmbbeerr 11,, 22001199 IFRS 16 – Leases In January 2016, the IASB issued IFRS 16 – Leases. The new standard replaces the previous lease accounting standard, IAS 17 – Leases, and related interpretations. Under IAS 17, lessees and lessors were required to classify their leases as either finance leases or operating leases and to account for these two types of leases differently. IFRS 16 provides a single accounting model for lessees, requiring lessees to recognize a right-of-use asset as well as a liability that reflects the present value of future lease payments. Lessees will also recognize depreciation expense on the right-of-use asset and interest expense on the lease liability in the Consolidated Statement of Income. As for lessors, IFRS 16 substantially carries forward the lessor accounting in IAS 17, with the distinction between finance and operating leases being retained. The Bank has elected to apply IFRS 16 using the modified retrospective basis by adjusting the Consolidated Balance Sheet as at November 1, 2019, the date of initial application, with no restatement of comparative periods. The most significant impact to the Bank will be related to real estate leases, which are currently classified as operating leases. On transition, the Bank will apply, on a lease-by-lease basis, certain practical expedients. More specifically, it will measure the right-of-use assets at an amount equal to the lease liability, it will rely on the Bank’s assessment about whether leases are onerous as at October 31, 2019 as an alternative to performing an impairment test as at November 1, 2019, and it will exclude initial direct costs from the measurement of the right-of-use assets as at November 1, 2019. Furthermore, on transition and thereafter, the Bank will exclude leases for which the underlying asset is of low value, will exclude short-term leases and, for real estate leases, will elect not to separate non-lease components from lease components. As at October 31, 2019, the Bank’s best estimate of the impact of adopting IFRS 16 is an increase in total assets of approximately $653 million representing leased premises, an increase in total liabilities of approximately $653 million primarily representing lease liabilities, and a decrease of approximately 9 basis points in the Common Equity Tier 1 (CET 1) capital ratio as at November 1, 2019. IFRIC Interpretation 23 – Uncertainty Over Income Tax Treatments In June 2017, the IASB issued IFRIC Interpretation 23, which addresses how to reflect tax treatment uncertainty in accounting for income taxes. This interpretation will not have an impact on the Bank’s Consolidated Balance Sheet as at November 1, 2019. EEffffeeccttiivvee DDaattee –– NNoovveemmbbeerr 11,, 22002200 Conceptual Framework for Financial Reporting On March 29, 2018, the IASB published Conceptual Framework for Financial Reporting to replace its 2010 conceptual framework. For the IASB, the revised conceptual framework has been in effect since its publication date. Early application is permitted. Reform to Benchmark Interest Rates (Amendments to IFRS 9, IAS 39 and IFRS 7) In September 2019, in response to uncertainty arising from the phasing-out of benchmark interest rates such as interbank offered rates (IBORs), the IASB issued amendments to its new and former financial instrument standards, IFRS 9 – Financial Instruments and IAS 39 – Financial Instruments: Recognition and Measurement as well as to the related standard on disclosures, IFRS 7 – Financial Instruments: Disclosures. The amendments modify certain hedge accounting requirements in IFRS 9 and IAS 39 to provide relief from the potential effects of the uncertainty caused by the IBOR reform. In addition, the amendments to IFRS 7 require additional disclosure about hedging relationships directly affected by this uncertainty. When the Bank adopted IFRS 9 on November 1, 2017, it made an accounting policy choice to continue applying the IAS 39 hedge accounting requirements. For the Bank, the effective date of these amendments is November 1, 2020. However, early adoption is permitted. EEffffeeccttiivvee DDaattee –– NNoovveemmbbeerr 11,, 22002211 IFRS 17 – Insurance Contracts In May 2017, the IASB issued IFRS 17 – Insurance Contracts, a new standard that replaces IFRS 4, the current insurance contract accounting standard. IFRS 17 introduces a new accounting framework that will improve the comparability and quality of financial information. At its meeting on November 14, 2018, the IASB tentatively decided to defer the IFRS 17 effective date to fiscal years beginning on or after January 1, 2022. National Bank of Canada 135 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 3 – Fair Value of Financial Instruments Fair Value and Carrying Value of Financial Instruments by Category Financial assets and financial liabilities are recognized on the Consolidated Balance Sheet at fair value or at amortized cost in accordance with the categories set out in the accounting framework for financial instruments. FFiinnaanncciiaall iinnssttrruummeennttss ccllaassssiiffiieedd aass aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss FFiinnaanncciiaall iinnssttrruummeennttss ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss DDeebbtt sseeccuurriittiieess ccllaassssiiffiieedd aass aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee CCaarrrryyiinngg vvaalluuee aanndd ffaaiirr vvaalluuee EEqquuiittyy sseeccuurriittiieess ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee AAss aatt OOccttoobbeerr 3311,, 22001199 CCaarrrryyiinngg vvaalluuee FFaaiirr vvaalluuee FFiinnaanncciiaall iinnssttrruummeennttss aatt aammoorrttiizzeedd ccoosstt,, nneett FFiinnaanncciiaall iinnssttrruummeennttss aatt aammoorrttiizzeedd ccoosstt,, nneett TToottaall ccaarrrryyiinngg vvaalluuee TToottaall ffaaiirr vvaalluuee FFiinnaanncciiaall aasssseettss CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss SSeeccuurriittiieess SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd LLooaannss aanndd aacccceeppttaanncceess,, nneett ooff aalllloowwaanncceess OOtthheerr Derivative financial instruments Other assets FFiinnaanncciiaall lliiaabbiilliittiieess DDeeppoossiittss OOtthheerr Acceptances Obligations related to securities sold short Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments Liabilities related to transferred receivables Other liabilities SSuubboorrddiinnaatteedd ddeebbtt (1) Includes embedded derivative financial instruments. −− 5588,,555566 −− 33,,226677 −− 1100,,002266 −− 662222 1133,,669988 99,,775555 1133,,669988 1133,,669988 1133,,669988 99,,882244 8822,,222266 8822,,229955 −− 66,,779988 88,,112299 −− 8877 −− −− −− −− −− −− −− −− −− −− −− 1177,,663366 114466,,445533 −− 11,,119933 1177,,663366 1177,,772233 1177,,772233 114477,,005511 115533,,225511 115533,,884499 −− 11,,119933 88,,112299 11,,119933 88,,112299 11,,119933 −− 1111,,220033 117788,,336633 (1) 117788,,886611 118899,,556666 119900,,006644 −− 1122,,884499 −− 66,,885522 −− 2244 −− −− −− −− −− 88,,221155 −− −− 66,,889933 −− 66,,889933 −− 66,,889933 1122,,884499 66,,889933 1122,,884499 2211,,990000 −− 1133,,009977 33,,001188 777733 2211,,990000 −− 1133,,118866 33,,001199 2211,,990000 66,,885522 2211,,331122 33,,004422 2211,,990000 66,,885522 2211,,440011 33,,004433 776655 777733 776655 136 6 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Financial instruments classified as at fair value through profit or loss Financial instruments designated at fair value through profit or loss Debt securities classified as at fair value through other comprehensive income Carrying value and fair value Equity securities designated at fair value through other comprehensive income As at October 31, 2018 Carrying value Fair value Financial instruments at amortized cost, net Financial instruments at amortized cost, net Total carrying value Total fair value FFiinnaanncciiaall aasssseettss CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss SSeeccuurriittiieess SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd LLooaannss aanndd aacccceeppttaanncceess,, nneett ooff aalllloowwaanncceess OOtthheerr Derivative financial instruments Other assets FFiinnaanncciiaall lliiaabbiilliittiieess DDeeppoossiittss OOtthheerr Acceptances Obligations related to securities sold short Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments Liabilities related to transferred receivables Other liabilities SSuubboorrddiinnaatteedd ddeebbtt (1) Includes embedded derivative financial instruments. Establishing Fair Value − − 51,927 3,890 − 5,317 − 351 12,756 8,298 12,756 12,756 12,756 8,237 69,783 69,722 − 6,108 8,608 − 479 − − − − − − − − − − − 17,680 17,680 18,159 18,159 139,974 139,551 146,082 145,659 − 1,804 − 1,804 8,608 1,804 8,608 1,804 − 10,126 160,704 (1) 160,938 170,830 171,064 − 17,780 − 6,036 − 21 − − − − − 7,714 − − 6,801 − 6,801 − 6,801 17,780 6,801 17,780 19,998 − 12,386 3,163 747 19,998 − 12,361 3,152 19,998 6,036 20,100 3,184 19,998 6,036 20,075 3,173 734 747 734 The fair value of a financial instrument is the price that would be received to sell a financial asset or paid to transfer a financial liability in an orderly transaction in the principal market at the measurement date under current market conditions (i.e., an exit price). Unadjusted quoted prices in active markets provide the best evidence of fair value. When there is no quoted price in an active market, the Bank applies other valuation techniques that maximize the use of relevant observable inputs and that minimize the use of unobservable inputs. Such valuation techniques include the following: using information available from recent market transactions, referring to the current fair value of a comparable financial instrument, applying discounted cash flow analysis, applying option pricing models, or relying on any other valuation technique that is commonly used by market participants and has proven to yield reliable estimates. Judgment is required when applying many of the valuation techniques. The Bank’s valuation was based on its assessment of the conditions prevailing as at October 31, 2019 and may change in the future. Furthermore, there may be valuation uncertainty resulting from the choice of valuation model used. National Bank of Canada 137 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 3 –– Fair Value of Financial Instruments (cont.) VVaalluuaattiioonn GGoovveerrnnaannccee Fair value is established in accordance with a rigorous control framework. The Bank has policies and procedures that govern the process for determining fair value. These policies are documented and periodically reviewed by the Risk Management Group. All valuation models are validated, and controls have been implemented to ensure that they are applied. The fair value of existing or new products is determined and validated by functions independent of the risk-taking team. Complex fair value matters are reviewed by valuation committees made up of experts from various specialized functions. For financial instruments classified in Level 3 of the fair value hierarchy, the Bank has documented the classification policies to determine the hierarchy, and there are controls in place to ensure that fair value is measured appropriately, reliably, and consistently. Valuation methods and the underlying assumptions are reviewed on a regular basis. VVaalluuaattiioonn MMeetthhooddss aanndd AAssssuummppttiioonnss Financial Instruments Whose Fair Value Equals Carrying Value The carrying value of the following financial instruments is a reasonable approximation of fair value: cash and deposits with financial institutions;  securities purchased under reverse repurchase agreements and securities borrowed;   obligations related to securities sold under repurchase agreements and securities loaned;    customers’ liability under acceptances; acceptances; certain items of other assets and other liabilities. Securities and Obligations Related to Securities Sold Short These financial instruments, except for securities at amortized cost, are recognized at fair value on the Consolidated Balance Sheet. Their fair value is based on quoted prices in active markets, i.e., bid prices for financial assets and offered prices for financial liabilities. If there are no quoted prices in an active market, fair value is estimated using prices for securities that, in substance, are identical. If such prices are not available, fair value is determined using valuation techniques that incorporate assumptions based primarily on observable market inputs such as current market prices, the contractual prices of the underlying instruments, the time value of money, credit risk, interest rate yield curves and currency rates. When one or more significant inputs are not observable in the markets, fair value is established primarily on the basis of internal estimates and data that consider the valuation policies in effect at the Bank, economic conditions, the specific characteristics of the financial asset or liability, and other relevant factors. Securities Issued or Guaranteed by Governments Securities issued or guaranteed by governments include government debt securities of the governments of Canada (federal, provincial and municipal) as well as debt securities of the U.S. government (U.S. Treasury), of other U.S. agencies and of other foreign governments. The fair value of these securities is based on unadjusted quoted prices in active markets. For those classified in Level 2, quoted prices for identical or similar instruments in active markets are used to determine fair value. In the absence of an observable market, valuation techniques such as the discounted cash flow method could be used, incorporating assumptions on benchmark yields (CDOR, LIBOR and other) and the risk spreads of similar securities. Equity Securities and Other Debt Securities The fair value of equity securities is determined primarily by using quoted prices in active markets. For equity securities and other debt securities classified in Level 2, a valuation technique based on quoted prices of identical and similar instruments in an active market is used to determine fair value. In the absence of observable inputs, valuation techniques such as the discounted cash flow method could be used, incorporating assumptions on benchmark yields (CDOR, LIBOR and other) and the risk spreads of similar securities. For those classified in Level 3, fair value can be determined based on the net asset value, which represents the estimated value of a security based on valuations received from investment or fund managers or the general partners of the limited partnerships. Fair value can also be determined using internal valuation techniques adjusted for risk factors related to the financial instruments and for economic conditions. 138 138 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Derivative Financial Instruments Derivative financial instruments are recorded at fair value on the Consolidated Balance Sheet. For exchange-traded derivative financial instruments, fair value is based on the quoted price in an active market, i.e., bid prices for financial assets or offered prices for financial liabilities. For over-the-counter (OTC) derivative financial instruments, fair value is determined using well established valuation techniques that incorporate assumptions based primarily on observable market inputs such as current market prices and the contractual prices of the underlying instruments, the time value of money, interest rate yield curves, credit curves, currency rates as well as price and rate volatility factors. In establishing the fair value of OTC derivative financial instruments, the Bank also incorporates the following factors: Credit Valuation Adjustment (CVA) The CVA is a valuation adjustment applied to derivative financial instruments to reflect the credit risk of the counterparty. For each counterparty, the CVA is based on the expected positive exposure and probabilities of default through time. The exposures are determined by incorporating relevant factors such as current and potential future market values, master netting arrangements, collateral agreements and expected recovery rates. The default probabilities are inferred using credit default swap (CDS) spreads. When unavailable, relevant proxies are used. While the general methodology currently assumes independence between expected positive exposures and probabilities of default, adjustments are applied to certain types of transactions where there is a direct link between the exposure at default and the default probabilities. Debit Valuation Adjustment (DVA) The DVA reflects the Bank’s own credit risk in the valuation of derivative financial instruments. The DVA is based on the expected negative exposure and probabilities of default of the Bank over time. The exposures are determined by incorporating relevant factors such as current and potential future market values, master netting arrangements, collateral agreements and expected recovery rates. The market-implied spreads of the Bank are used in the calculation of the DVA. Funding Valuation Adjustment (FVA) The FVA is a valuation adjustment applied to derivative financial instruments to reflect the market-implied cost or benefits of funding collateral for uncollateralized or partly collateralized transactions. The expected exposures are determined using methodologies consistent with the CVA and DVA framework. The funding level used to determine the FVA is based on the average funding level of relevant market participants. When the valuation techniques incorporate one or more significant inputs that are not observable in the markets, the fair value of OTC derivative financial instruments is established primarily on the basis of internal estimates and data that consider the valuation policies in effect at the Bank, economic conditions, the specific characteristics of the financial asset or financial liability and other relevant factors. Loans The fair value of fixed-rate mortgage loans is determined by discounting expected future contractual cash flows, adjusted for several factors, including prepayment options, current market interest rates for similar loans, and other relevant variables where applicable. The fair value of variable-rate mortgage loans is deemed to equal carrying value. The fair value of other fixed-rate loans is determined by discounting expected future contractual cash flows using current market interest rates charged for similar new loans. The fair value of other variable-rate loans is deemed to equal carrying value. Deposits The fair value of fixed-term deposits is determined primarily by discounting expected future contractual cash flows and considering several factors such as redemption options and market interest rates currently offered for financial instruments with similar conditions. For certain term funding instruments, fair value is determined using market prices for similar instruments. The fair value of demand deposits and notice deposits is deemed to equal carrying value. The fair value of structured deposit notes is established using valuation models that maximize the use of observable inputs when available, such as benchmark indices, and also incorporates the DVA, which reflects the Bank’s own credit risk. In calculating DVA, the market implied spreads of the Bank are used to infer its probabilities of default. Lastly, when fair value is determined using option pricing models, the valuation techniques are similar to those described for derivative financial instruments. Liabilities Related to Transferred Receivables These liabilities arise from sale transactions to Canada Housing Trust (CHT) of securities backed by insured residential mortgages and other securities under the Canada Mortgage Bond (CMB) program. These transactions do not qualify for derecognition. They are recorded as guaranteed borrowings, which results in the recording of liabilities on the Consolidated Balance Sheet. The fair value of these liabilities is established using valuation techniques based on observable market inputs such as Canada Mortgage Bond prices. National Bank of Canada 139 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 3 –– Fair Value of Financial Instruments (cont.) Other Liabilities and Subordinated Debt The fair value of these financial liabilities is based on quoted market prices in an active market. If there is no active market, fair value is determined by discounting contractual cash flows using the current market interest rates offered for similar financial instruments that have the same term to maturity. HHiieerraarrcchhyy ooff FFaaiirr VVaalluuee MMeeaassuurreemmeennttss DDeetteerrmmiinniinngg tthhee LLeevveellss ooff tthhee FFaaiirr VVaalluuee MMeeaassuurreemmeenntt HHiieerraarrcchhyy IFRS establishes a fair value hierarchy that classifies the inputs used in financial instrument fair value measurement techniques according to three levels. This fair value hierarchy requires observable market inputs to be used whenever such inputs exist. According to the hierarchy, the highest level of inputs are unadjusted quoted prices in active markets for identical instruments and the lowest level of inputs are unobservable inputs. If inputs from different levels of the hierarchy are used, the financial instrument is classified in the same level as the lowest level input that is significant to the fair value measurement. The fair value hierarchy has the following levels: Level 1 Inputs corresponding to unadjusted quoted prices in active markets for identical assets and liabilities and accessible to the Bank at the measurement date. These instruments consist primarily of equity securities, derivative financial instruments traded in active markets, and certain highly liquid debt securities actively traded in over-the-counter markets. Level 2 Valuation techniques based on inputs, other than the quoted prices included in Level 1 inputs, that are directly or indirectly observable in the market for the asset or liability. These inputs are quoted prices of similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; inputs other than quoted prices used in a valuation model that are observable for that instrument; and inputs that are derived principally from or corroborated by observable market inputs by correlation or other means. These instruments consist primarily of certain loans, certain deposits, derivative financial instruments traded in over-the-counter markets, certain debt securities, certain equity securities whose value is not directly observable in an active market, liabilities related to transferred receivables and certain other liabilities. Level 3 Valuation techniques based on one or more significant inputs that are not observable in the market for the asset or liability. The Bank classifies financial instruments in Level 3 when the valuation technique is based on at least one significant input that is not observable in the markets. The valuation technique may also be partly based on observable market inputs. Financial instruments whose fair values are classified in Level 3 consist of the following:    financial instruments measured at fair value through profit or loss: investments in hedge funds for which there are certain restrictions on unit or security redemptions, equity securities and debt securities of private companies, as well as certain derivative financial instruments whose fair value is established using internal valuation models that are based on significant unobservable market inputs; securities at fair value through other comprehensive income: equity and debt securities of private companies; certain loans and certain deposits (structured deposit notes) whose fair value is established using internal valuation models that are based on significant unobservable market inputs. TTrraannssffeerrss BBeettwweeeenn tthhee FFaaiirr VVaalluuee HHiieerraarrcchhyy LLeevveellss Transfers of financial instruments between Levels 1 and 2 and transfers to (or from) Level 3 are deemed to have taken place at the beginning of the quarter in which the transfer occurred. Significant transfers can occur between the fair value hierarchy levels due to new information on inputs used to determine fair value and the observable nature of those inputs. During fiscal 2019, $50 million in securities classified as at fair value through profit or loss and $1 million in obligations related to securities sold short were transferred from Level 2 to Level 1 resulting from changing market conditions ($324 million in securities classified as at fair value through profit or loss and $33 million in obligations related to securities sold short in fiscal 2018). In addition, during fiscal 2019, $20 million in securities classified as at fair value through profit or loss and $2 million in obligations related to securities sold short were transferred from Level 1 to Level 2 (for fiscal 2018, $37 million in securities classified as at fair value through profit or loss and $3 million in obligations related to securities sold short). During fiscal years 2019 and 2018, financial instruments were transferred to (or from) Level 3 due to changes in the availability of observable market inputs resulting from changing market conditions. 140 140 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) FFiinnaanncciiaall IInnssttrruummeennttss RReeccoorrddeedd aatt FFaaiirr VVaalluuee oonn tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett The following tables show financial instruments recorded at fair value on the Consolidated Balance Sheet according to the fair value hierarchy. FFiinnaanncciiaall aasssseettss SSeeccuurriittiieess AAtt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities AAtt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd LLooaannss OOtthheerr Derivative financial instruments FFiinnaanncciiaall lliiaabbiilliittiieess DDeeppoossiittss OOtthheerr Obligations related to securities sold short Derivative financial instruments Liabilities related to transferred receivables Other liabilities LLeevveell 11 LLeevveell 22 AAss aatt OOccttoobbeerr 3311,, 22001199 TToottaall ffiinnaanncciiaall aasssseettss//lliiaabbiilliittiieess aatt ffaaiirr vvaalluuee LLeevveell 33 22,,110022 −− 11,,777700 −− 3388,,883366 4422,,770088 119966 −− 33,,447711 −− 5533 33,,772200 −− −− 88,,332211 66,,776622 9900 22,,666666 881188 1188,,665577 44,,223366 11,,667744 7755 337744 220077 66,,556666 8877 66,,443388 −− −− −− 2277 443311 445588 −− −− −− −− 336622 336622 −− 336600 117799 4466,,660077 77,,992244 3399,,667722 2266 11,,220066 −− 1111,,338833 88,,335522 115566 −− −− 88,,550088 44,,449977 66,,667744 88,,221155 2244 3300,,779933 −− −− 2222 −− −− 2222 1100,,442233 66,,776622 11,,886600 22,,669933 4400,,008855 6611,,882233 44,,443322 11,,667744 33,,554466 337744 662222 1100,,664488 8877 66,,779988 88,,112299 8877,,448855 1111,,338833 1122,,884499 66,,885522 88,,221155 2244 3399,,332233 National Bank of Canada 141 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 3 –– Fair Value of Financial Instruments (cont.) FFiinnaanncciiaall aasssseettss SSeeccuurriittiieess AAtt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities AAtt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd LLooaannss OOtthheerr Derivative financial instruments FFiinnaanncciiaall lliiaabbiilliittiieess DDeeppoossiittss OOtthheerr Obligations related to securities sold short Derivative financial instruments Liabilities related to transferred receivables Other liabilities Level 1 Level 2 As at October 31, 2018 Total financial assets/liabilities at fair value Level 3 5,469 − 314 − 25,928 31,711 265 − 123 − − 388 − − 9,130 10,628 249 3,391 395 23,793 2,320 2,184 − 425 118 5,047 479 5,722 97 32,196 8,491 43,532 − 10,210 12,524 211 − − 12,735 5,256 5,798 7,714 21 28,999 − − − 25 288 313 − − − − 233 233 − 386 20 952 11 − 27 − − 38 14,599 10,628 563 3,416 26,611 55,817 2,585 2,184 123 425 351 5,668 479 6,108 8,608 76,680 10,221 17,780 6,036 7,714 21 41,772 142 142 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) FFiinnaanncciiaall IInnssttrruummeennttss CCllaassssiiffiieedd iinn LLeevveell 33 The Bank classifies financial instruments in Level 3 when the valuation technique is based on at least one significant input that is not observable in the markets. The valuation technique may also be based, in part, on observable market inputs. The following table shows the significant unobservable inputs used for the fair value measurements of financial instruments classified in Level 3 of the hierarchy. FFiinnaanncciiaall aasssseettss SSeeccuurriittiieess Equity securities and other debt securities LLooaannss Loans at fair value through profit or loss OOtthheerr Derivative financial instruments Interest rate contracts Equity contracts FFiinnaanncciiaall lliiaabbiilliittiieess OOtthheerr Derivative financial instruments Equity contracts FFaaiirr vvaalluuee 882200 336600 66 2200 11,,220066 2222 2222 Primary valuation techniques Significant unobservable inputs LLooww AAss aatt OOccttoobbeerr 3311,, 22001199 RRaannggee ooff iinnppuutt vvaalluueess HHiigghh Net asset value Market comparable Discounted cash flows Discounted cash flows Discounted cash flows Discounted cash flows Discounted cash flows Option pricing model Net asset value EV/EBITDA(1) multiple Credit spread Discount Rate 110000 %% 1133 xx 446600 BBppss(2) 44..5500 %% 110000 %% 1166 xx 770055 BBppss(2) 1144..3388 %% Discount rate Liquidity premium 55..2266 %% 33..5566 %% 88..8899 %% 77..3344 %% Discount rate Long-term volatility Market correlation 22..2200 %% 44 %% 2211 %% 22..2200 %% 3355 %% 3311 %% Option pricing model Long-term volatility Market correlation 55 %% ((2299)) %% 4499 %% 8899 %% Fair value Primary valuation techniques Significant unobservable inputs Low As at October 31, 2018 Range of input values High FFiinnaanncciiaall aasssseettss SSeeccuurriittiieess Equity securities and other debt securities LLooaannss Loans at fair value through profit or loss OOtthheerr Derivative financial instruments Equity contracts FFiinnaanncciiaall lliiaabbiilliittiieess DDeeppoossiittss Structured deposit notes OOtthheerr Derivative financial instruments Interest rate contracts Equity contracts 546 386 20 952 11 2 25 38 Net asset value Market comparable Discounted cash flows Discounted cash flows Discounted cash flows Net asset value EV/EBITDA(1) multiple Credit spread 100 % 11 x 100 % 16 x 460 Bps(2) 690 Bps(2) Discount rate Liquidity premium 5.81 % 2.68 % 8.92 % 5.80 % Option pricing model Long-term volatility 7 % 21 % Option pricing model Long-term volatility Market correlation 3 % (36) % 52 % 82 % Discounted cash flows Option pricing model Discount rate Long-term volatility Market correlation 2.20 % 7 % (34) % 2.20 % 70 % 83 % (1) (2) EV/EBITDA means Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization. Bps or basis point is a unit of measure equal to 0.01%. National Bank of Canada 143 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 3 –– Fair Value of Financial Instruments (cont.) SSiiggnniiffiiccaanntt UUnnoobbsseerrvvaabbllee IInnppuuttss UUsseedd ffoorr FFaaiirr VVaalluuee MMeeaassuurreemmeennttss ooff FFiinnaanncciiaall IInnssttrruummeennttss CCllaassssiiffiieedd iinn LLeevveell 33 Net Asset Value Net asset value is the estimated value of a security based on valuations received from the investment or fund managers, the administrators of the conduits or the general partners of the limited partnerships. The net asset value of a fund is the total fair value of assets less liabilities. EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization) Multiple and Price Equivalent Private equity valuation inputs include earnings multiples, which are determined based on comparable companies, and a higher multiple will translate into a higher fair value. Price equivalent is a percentage of the market price based on the liquidity of the security. Discount Rate When discounted cash flow methods are used, the discount rate is the input used to bring future cash flows to their present value. A higher discount rate will translate into a lower fair value. Long-Term Volatility Volatility is a measure of the expected future variability of market prices. Volatility is generally observable in the market through options prices. However, the long-term volatility of options with a longer maturity might not be observable. An increase (decrease) in long-term volatility is generally associated with an increase (decrease) in long-term correlation. Higher long-term volatility may increase or decrease an instrument’s fair value depending on its terms. Market Correlation Correlation is a measure of the inter-relationship between two different variables. A positive correlation means that the variables tend to move in the same direction; a negative correlation means that the variables tend to move in opposite directions. Correlation is used to measure financial instruments whose future returns depend on several variables. Changes in correlation will either increase or decrease a financial instrument’s fair value depending on the terms of its contractual payout. SSeennssiittiivviittyy AAnnaallyyssiiss ooff FFiinnaanncciiaall IInnssttrruummeennttss CCllaassssiiffiieedd iinn LLeevveell 33 The Bank performs sensitivity analyses for the fair value measurements of financial instruments classified in Level 3, substituting unobservable inputs with one or more reasonably possible alternative assumptions. For equity securities and other debt securities, the Bank varies significant unobservable inputs such as net asset values, EV/EBITDA multiples, or price equivalents and establishes a reasonable fair value range that could result in a $121 million increase or decrease in the fair value recorded as at October 31, 2019 (a $70 million increase or decrease as at October 31, 2018). For the loans, the Bank varies unobservable inputs such as a liquidity premium and establishes a reasonable fair value range that could result in a $54 million increase or decrease in the fair value recorded as at October 31, 2019 ($43 million increase or decrease as at October 31, 2018). For derivative financial instruments and embedded derivatives related to structured deposit notes, the Bank varies long-term volatility and market correlation inputs and establishes a reasonable fair value range. As at October 31, 2019, for derivative financial instruments, the net fair value could result in a $1 million increase or decrease ($5 million increase or decrease as at October 31, 2018), whereas for structured deposit notes, the fair value could have resulted in a $1 million increase or decrease as at October 31, 2018. For all Level 3 financial instruments, the reasonable fair value ranges could result in an 8% increase or decrease in net income as at October 31, 2019 (a 5 % increase or decrease in net income as at October 31, 2018). 144 144 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) CChhaannggee iinn tthhee FFaaiirr VVaalluuee ooff FFiinnaanncciiaall IInnssttrruummeennttss CCllaassssiiffiieedd iinn LLeevveell 33 The Bank may hedge the fair value of financial instruments classified in the various levels through offsetting hedge positions. Gains and losses for financial instruments classified in Level 3 presented in the following tables do not reflect the inverse gains and losses on financial instruments used for economic hedging purposes that may have been classified in Level 1 or 2 by the Bank. In addition, the Bank may hedge the fair value of financial instruments classified in Level 3 using other financial instruments classified in Level 3. The effect of these hedges is not included in the net amount presented in the following tables. The gains and losses presented hereafter may comprise changes in fair value based on observable and unobservable inputs. Fair value as at October 31, 2018 Total realized and unrealized gains (losses) included in Net income (2) Total realized and unrealized gains (losses) included in Other comprehensive income Purchases Sales Issuances Settlements and other Financial instruments transferred into Level 3 Financial instruments transferred out of Level 3 FFaaiirr vvaalluuee aass aatt OOccttoobbeerr 3311,, 22001199 Change in unrealized gains and losses included in Net income with respect to financial assets and financial liabilities held as at October 31, 2019(3) Fair value as at November 1, 2017 Total realized and unrealized gains (losses) included in Net income (4) Total realized and unrealized gains (losses) included in Other comprehensive income Purchases Sales Issuances Settlements and other Financial instruments transferred into Level 3 Financial instruments transferred out of Level 3 FFaaiirr vvaalluuee aass aatt OOccttoobbeerr 3311,, 22001188 Change in unrealized gains and losses included in Net income with respect to financial assets and financial liabilities held as at October 31, 2018(5) SSeeccuurriittiieess aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss SSeeccuurriittiieess aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee 331133 ((6699)) −− 225533 ((3399)) −− −− −− −− 445588 ((7766)) 223333 −− ((44)) 113333 −− −− −− −− −− 336622 −− Securities at fair value through profit or loss Securities at fair value through other comprehensive income 184 29 − 117 (21) − − 4 − 313 7 158 − − 75 − − − − − 233 − YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 DDeerriivvaattiivvee ffiinnaanncciiaall iinnssttrruummeennttss(1) DDeeppoossiittss ((77)) 1166 −− −− −− −− 33 ((1100)) 22 44 1166 ((1111)) −− −− −− −− −− −− −− 1111 −− −− Year ended October 31, 2018 Derivative financial instruments(1) Deposits 20 − − − − − (8) (1) (18) (7) − (1) − − − − (8) − (3) 1 (11) − LLooaannss 338866 1122 −− −− −− 66 ((4444)) −− −− 336600 1122 Loans 428 16 − − − 8 (66) − − 386 16 (1) (2) (3) (4) (5) The derivative financial instruments include assets and liabilities presented on a net basis. Total gains (losses) included in Non-interest income was a loss of $41 million. Total unrealized gains (losses) included in Non-interest income was an unrealized loss of $48 million. Total gains (losses) included in Non-interest income was a gain of $45 million. Total unrealized gains (losses) included in Non-interest income was an unrealized gain of $23 million. National Bank of Canada 145 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 3 –– Fair Value of Financial Instruments (cont.) FFiinnaanncciiaall IInnssttrruummeennttss NNoott RReeccoorrddeedd aatt FFaaiirr VVaalluuee oonn tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett The following tables show the financial instruments that have not been recorded at fair value on the Consolidated Balance Sheet according to the fair value hierarchy, except for those whose carrying value is a reasonable approximation of fair value. FFiinnaanncciiaall aasssseettss SSeeccuurriittiieess aatt aammoorrttiizzeedd ccoosstt Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities LLooaannss,, nneett ooff aalllloowwaanncceess FFiinnaanncciiaall lliiaabbiilliittiieess DDeeppoossiittss OOtthheerr Liabilities related to transferred receivables Other liabilities SSuubboorrddiinnaatteedd ddeebbtt FFiinnaanncciiaall aasssseettss SSeeccuurriittiieess aatt aammoorrttiizzeedd ccoosstt Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities LLooaannss,, nneett ooff aalllloowwaanncceess FFiinnaanncciiaall lliiaabbiilliittiieess DDeeppoossiittss OOtthheerr Liabilities related to transferred receivables Other liabilities SSuubboorrddiinnaatteedd ddeebbtt LLeevveell 11 LLeevveell 22 LLeevveell 33 TToottaall AAss aatt OOccttoobbeerr 3311,, 22001199 −− −− −− −− −− −− −− −− −− −− −− 55,,229922 11,,880055 113388 22,,558899 99,,882244 5599,,885577 117788,,886611 1133,,118866 991122 776655 119933,,772244 −− −− −− −− −− 55,,229922 11,,880055 113388 22,,558899 99,,882244 8800,,330011 114400,,115588 −− −− −− −− −− 117788,,886611 1133,,118866 991122 776655 119933,,772244 Level 1 Level 2 Level 3 Total As at October 31, 2018 − − − − − − − − − − − 4,914 1,667 21 1,635 8,237 − − − − − 4,914 1,667 21 1,635 8,237 56,938 75,812 132,750 160,938 12,361 899 734 174,932 − − − − − 160,938 12,361 899 734 174,932 146 146 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 44 –– FFiinnaanncciiaall IInnssttrruummeennttss DDeessiiggnnaatteedd aatt FFaaiirr VVaalluuee TThhrroouugghh PPrrooffiitt oorr LLoossss The Bank chose to designate certain financial instruments at fair value through profit or loss according to the criteria presented in Note 1 to these consolidated financial statements. Consistent with its risk management strategy and in accordance with the fair value option, which permits the designation if it eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets and liabilities or recognizing the gains and losses thereon on different bases, the Bank designated at fair value through profit or loss certain securities, certain securities purchased under reverse repurchase agreements, and certain liabilities related to transferred receivables. The fair value of liabilities related to transferred receivables does not include credit risk, as the holders of these liabilities are not exposed to the Bank’s credit risk. The Bank also designated certain deposits that include embedded derivative financial instruments at fair value through profit or loss. To determine a change in fair value arising from a change in the credit risk of deposits designated at fair value through profit or loss, the Bank calculates, at the beginning of the period, the present value of the instrument’s contractual cash flows using the following rates: first, using an observed discount rate for similar securities that reflects the Bank’s credit spread and, then, using a rate that excludes the Bank’s credit spread. The difference obtained between the two values is then compared to the difference obtained using the same rates at the end of the period. Information about the financial assets and financial liabilities designated at fair value through profit or loss is provided in the following tables. FFiinnaanncciiaall aasssseettss ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss Securities Securities purchased under reverse repurchase agreements FFiinnaanncciiaall lliiaabbiilliittiieess ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss Deposits(1)(2) Liabilities related to transferred receivables FFiinnaanncciiaall aasssseettss ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss Securities Securities purchased under reverse repurchase agreements FFiinnaanncciiaall lliiaabbiilliittiieess ddeessiiggnnaatteedd aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss Deposits(1)(2) Liabilities related to transferred receivables CCaarrrryyiinngg vvaalluuee aass aatt OOccttoobbeerr 3311,, 22001199 UUnnrreeaalliizzeedd ggaaiinnss ((lloosssseess)) ffoorr tthhee yyeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 UUnnrreeaalliizzeedd ggaaiinnss ((lloosssseess)) ssiinnccee tthhee iinniittiiaall rreeccooggnniittiioonn ooff tthhee iinnssttrruummeenntt 33,,226677 8877 33,,335544 1111,,220033 88,,221155 1199,,441188 8866 −− 8866 ((778899)) ((116633)) ((995522)) 2266 −− 2266 ((220044)) ((7755)) ((227799)) Carrying value as at October 31, 2018 Unrealized gains (losses) for the year ended October 31, 2018 Unrealized gains (losses) since the initial recognition of the instrument 3,890 479 4,369 10,126 7,714 17,840 (55) − (55) 518 172 690 (92) − (92) 551 87 638 (1) (2) For the year ended October 31, 2019, the change in the fair value of deposits designated at fair value through profit or loss attributable to credit risk, and recorded in Other comprehensive income, resulted in a gain of $7 million ($28 million gain for the year ended October 31, 2018). The amount at maturity that the Bank will be contractually required to pay to the holders of these deposits varies and will differ from the reporting date fair value. National Bank of Canada 147 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 55 –– OOffffsseettttiinngg FFiinnaanncciiaall AAsssseettss aanndd FFiinnaanncciiaall LLiiaabbiilliittiieess Financial assets and liabilities are offset and the net amount is presented on the Consolidated Balance Sheet when the Bank has a legally enforceable right to set off the recognized amounts and intends to settle on a net basis or to realize the asset and settle the liability simultaneously. Generally, over-the-counter financial derivatives subject to master netting arrangements of the International Swaps & Derivatives Association, Inc. or other similar agreements do not meet the netting criteria on the Consolidated Balance Sheet because the right of set-off is legally enforceable only in the event of default, insolvency or bankruptcy. Generally, securities purchased under reverse repurchase agreements and securities borrowed as well as obligations related to securities sold under repurchase agreements and securities loaned, subject to master agreements, do not meet the netting criteria since they confer a right of set-off that is enforceable only in the event of default, insolvency or bankruptcy. However, the above-mentioned transactions may be subject to contractual netting agreements concluded with clearing houses. If the netting criteria are met, these transactions are netted on the Consolidated Balance Sheet. In addition, as part of these transactions, the Bank may give or receive cash or other financial instruments used as collateral. The following tables present information on financial assets and financial liabilities that are netted on the Consolidated Balance Sheet because they meet the netting criteria and on those that are not netted and are subject to an enforceable master netting arrangement or similar agreement. FFiinnaanncciiaall aasssseettss Securities purchased under reverse repurchase agreements and securities borrowed Derivative financial instruments FFiinnaanncciiaall lliiaabbiilliittiieess Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments FFiinnaanncciiaall aasssseettss Securities purchased under reverse repurchase agreements and securities borrowed Derivative financial instruments FFiinnaanncciiaall lliiaabbiilliittiieess Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments AAss aatt OOccttoobbeerr 3311,, 22001199 AAmmoouunnttss sseett ooffff oonn tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett NNeett aammoouunnttss rreeppoorrtteedd oonn tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett AAssssoocciiaatteedd aammoouunnttss nnoott sseett ooffff oonn tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett FFiinnaanncciiaall aasssseettss rreecceeiivveedd//pplleeddggeedd aass ccoollllaatteerraall(2) FFiinnaanncciiaall iinnssttrruummeennttss(1) GGrroossss aammoouunnttss rreeccooggnniizzeedd 2200,,888899 1100,,994477 3311,,883366 2255,,006666 99,,667700 3344,,773366 33,,116666 22,,881188 55,,998844 33,,116666 22,,881188 55,,998844 1177,,772233 88,,112299 2255,,885522 2211,,990000 66,,885522 2288,,775522 44,,449933 33,,441155 77,,990088 44,,449933 33,,441155 77,,990088 1133,,119922 22,,552299 1155,,772211 1177,,332277 22,,005511 1199,,337788 NNeett aammoouunnttss 3388 22,,118855 22,,222233 8800 11,,338866 11,,446666 As at October 31, 2018 Amounts set off on the Consolidated Balance Sheet Net amounts reported on the Consolidated Balance Sheet Associated amounts not set off on the Consolidated Balance Sheet Financial assets received/pledged as collateral(2) Financial instruments(1) Gross amounts recognized 18,446 10,923 29,369 20,285 8,351 28,636 287 2,315 2,602 287 2,315 2,602 18,159 8,608 26,767 19,998 6,036 26,034 3,156 3,151 6,307 3,156 3,151 6,307 14,943 3,748 18,691 16,752 1,381 18,133 Net amounts 60 1,709 1,769 90 1,504 1,594 148 (1) (2) Carrying amount of financial instruments that are subject to an enforceable master netting agreement or similar agreement but that do not satisfy offsetting criteria. Excludes non-financial instruments collateral. 148 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 66 –– SSeeccuurriittiieess RReessiidduuaall CCoonnttrraaccttuuaall MMaattuurriittiieess ooff SSeeccuurriittiieess As at October 31 SSeeccuurriittiieess aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities SSeeccuurriittiieess aatt ffaaiirr vvaalluuee tthhrroouugghh ootthheerr ccoommpprreehheennssiivvee iinnccoommee Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities SSeeccuurriittiieess aatt aammoorrttiizzeedd ccoosstt(1) Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities 11 yyeeaarr oorr lleessss OOvveerr 11 yyeeaarr ttoo 55 yyeeaarrss OOvveerr 55 yyeeaarrss NNoo ssppeecciiffiieedd mmaattuurriittyy 22001199 2018 TToottaall Total 660000 660077 11,,667799 331144 −− 33,,220000 4455 3366 −− 11 −− 8822 550066 112222 111188 6699 881155 77,,667722 22,,558855 8822 11,,332277 −− 1111,,666666 33,,662277 990099 33,,334411 8855 −− 77,,996622 44,,774422 11,,442288 2200 11,,336677 77,,555577 22,,115511 33,,557700 9999 11,,005522 −− 66,,887722 776600 772299 220055 228888 −− 11,,998822 −− 223388 11 11,,114444 11,,338833 −− −− −− −− 4400,,008855 4400,,008855 −− −− −− −− 662222 662222 −− −− −− −− −− 1100,,442233 66,,776622 11,,886600 22,,669933 4400,,008855 6611,,882233 44,,443322 11,,667744 33,,554466 337744 662222 1100,,664488 55,,224488 11,,778888 113399 22,,558800 99,,775555 14,599 10,628 563 3,416 26,611 55,817 2,585 2,184 123 425 351 5,668 4,952 1,680 21 1,645 8,298 (1) As at October 31, 2019, securities at amortized cost are presented net of $1 million in allowances for credit losses ($1 million as at October 31, 2018). CCrreeddiitt QQuuaalliittyy As at October 31, 2019 and 2018, securities at fair value through other comprehensive income and securities at amortized cost are classified in Stage 1, with their credit quality falling mainly in the “Excellent” category according to the Bank’s internal risk-rating categories. For additional information on the reconciliation of allowances for credit losses, see Note 7 to these consolidated financial statements. National Bank of Canada 149 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 6 – Securities (cont.) GGrroossss GGaaiinnss ((LLoosssseess)) oonn SSeeccuurriittiieess aatt FFaaiirr VVaalluuee TThhrroouugghh OOtthheerr CCoommpprreehheennssiivvee IInnccoommee Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities Securities issued or guaranteed by Canadian government Canadian provincial and municipal governments U.S. Treasury, other U.S. agencies and other foreign governments Other debt securities Equity securities AAmmoorrttiizzeedd ccoosstt GGrroossss uunnrreeaalliizzeedd ggaaiinnss GGrroossss uunnrreeaalliizzeedd lloosssseess AAss aatt OOccttoobbeerr 3311,, 22001199 CCaarrrryyiinngg vvaalluuee(1) 44,,441111 11,,661144 33,,552211 336644 664499 1100,,555599 2266 6600 2255 1111 22 112244 ((55)) −− −− ((11)) ((2299)) ((3355)) 44,,443322 11,,667744 33,,554466 337744 662222 1100,,664488 Amortized cost Gross unrealized gains Gross unrealized losses As at October 31, 2018 Carrying value(1) 2,624 2,196 123 434 356 5,733 1 22 − 1 − 24 (40) (34) − (10) (5) (89) 2,585 2,184 123 425 351 5,668 (1) The allowances for credit losses on securities at fair value through other comprehensive income, representing a negligible amount as at October 31, 2019 and 2018, are reported in Other comprehensive income. For additional information, see Note 7 to these consolidated financial statements. EEqquuiittyy SSeeccuurriittiieess DDeessiiggnnaatteedd aatt FFaaiirr VVaalluuee TThhrroouugghh OOtthheerr CCoommpprreehheennssiivvee IInnccoommee The Bank designated certain equity securities, the main business objective of which is to generate dividend income, at fair value through other comprehensive income without subsequent reclassification of gains and losses to net income. During the year ended October 31, 2019, an amount of $25 million in dividend income was recognized for these investments ($17 million for the year ended October 31, 2018), including $1 million for investments that were sold during the year ended October 31, 2019 (negligible amounts for the year ended October 31, 2018). Fair value at beginning Change in fair value Designated at fair value through other comprehensive income(1)(2) Sales(3) FFaaiirr vvaalluuee aatt eenndd YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 Year ended October 31, 2018 EEqquuiittyy sseeccuurriittiieess ooff pprriivvaattee ccoommppaanniieess EEqquuiittyy sseeccuurriittiieess ooff ppuubblliicc ccoommppaanniieess 223333 (( 44)) 113333 −− 336622 111188 ((2233)) 225533 ((8888)) 226600 TToottaall 335511 ((2277)) 338866 ((8888)) 662222 Equity securities of private companies Equity securities of public companies 158 − 75 − 233 122 (2) 34 (36) 118 Total 280 (2) 109 (36) 351 (1) On June 30, 2019, the Bank concluded that it had lost significant influence over NSIA Participations (NSIA) and therefore ceased using the equity method to account for this investment. The Bank designated its investment in NSIA as a financial asset measured at fair value through other comprehensive income. For additional information, see Note 9 to these consolidated financial statements. (2) On May 9, 2019, after disposing of a portion of its investment in Fiera Capital Corporation, the Bank designated the retained interest as a financial asset measured at fair value through other comprehensive income. For additional information, see Note 9 to these consolidated financial statements. The Bank disposed of public company equity securities for economic reasons. (3) GGaaiinnss ((LLoosssseess)) oonn DDiissppoossaallss ooff SSeeccuurriittiieess aatt AAmmoorrttiizzeedd CCoosstt During the years ended October 31, 2019 and 2018, the Bank sold certain debt securities measured at amortized cost. The carrying value of these securities upon disposal was $461 million for the year ended October 31, 2019 ($134 million for the year ended October 31, 2018), and the Bank recognized gains of $9 million for the year ended October 31, 2019 (negligible amounts for the year ended October 31, 2018) in Non-interest income – Gains (losses) on non-trading securities, net in the Consolidated Statement of Income. 150 150 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 77 –– LLooaannss aanndd AAlllloowwaanncceess ffoorr CCrreeddiitt LLoosssseess Loans are recognized either at fair value through profit or loss or at amortized cost using the financial asset classification criteria defined in IFRS 9. DDeetteerrmmiinniinngg aanndd MMeeaassuurriinngg EExxppeecctteedd CCrreeddiitt LLoosssseess ((EECCLL)) DDeetteerrmmiinniinngg EExxppeecctteedd CCrreeddiitt LLoosssseess Expected credit losses are determined using a three-stage impairment approach that is based on the change in the credit quality of financial assets since initial recognition. Stage 1 Financial assets that have experienced no significant increase in credit risk between initial recognition and the reporting date and for which 12-month expected credit losses are recorded at the reporting date are classified in Stage 1. Stage 2 Financial assets that have experienced a significant increase in credit risk between initial recognition and the reporting date, and for which lifetime expected credit losses are recorded at the reporting date, are classified in Stage 2. Stage 3 Financial assets for which there is objective evidence of impairment, for which one or more events have had a detrimental impact on the estimated future cash flows of these financial assets at the reporting date, and for which lifetime expected credit losses are recorded, are classified in Stage 3. POCI Financial assets that are credit-impaired when purchased or originated (POCI) are classified in the POCI category. IImmppaaiirrmmeenntt GGoovveerrnnaannccee A rigorous control framework is applied to the determination of expected credit losses. The Bank has policies and procedures that govern impairments arising from credit risk. These policies are documented and periodically reviewed by the Risk Management group. All models used to calculate expected credit losses are validated, and controls are in place to ensure they are applied. These models are validated by groups that are independent of the team that prepares the calculations. Complex questions on measurement methodologies and assumptions are reviewed by a group of experts from various functions. Furthermore, the inputs and assumptions used to determine expected credit losses are reviewed on a regular basis. MMeeaassuurreemmeenntt ooff EExxppeecctteedd CCrreeddiitt LLoosssseess ((EECCLL)) Expected credit losses are estimated using three main variables: (1) probability of default (PD), (2) loss given default (LGD) and (3) exposure at default (EAD). For accounting purposes, 12-month PD and lifetime PD are the probabilities of a default occurring over the next 12 months or over the life of a financial instrument, respectively, based on conditions existing at the balance sheet date and on future economic conditions that have, or will have, an impact on credit risk. LGD reflects the losses expected should default occur and considers such factors as the mitigating effects of collateral, the realizable value thereof, and the time value of money. EAD is the expected balance owing at default and considers such factors as repayments of principal and interest between the balance sheet date and the time of default as well as any amounts expected to be drawn on a committed facility. Twelve-month expected credit losses are estimated by multiplying 12-month PD by LGD and by EAD. Lifetime expected credit losses are estimated using the lifetime PD. For most financial instruments, expected credit losses are measured on an individual basis. Financial instruments that have credit losses measured on a collective basis are grouped according to similar credit risk characteristics such as type of instrument, geographic location, comparable risk level, and business sector or industry. IInnppuuttss,, AAssssuummppttiioonnss aanndd EEssttiimmaattiioonn TTeecchhnniiqquueess The Bank’s approach to calculating expected credit losses consists essentially of leveraging existing regulatory models and then adjusting their parameters for IFRS 9 purposes. These models have the advantage of having been thoroughly tested and validated. In addition, using the same base models, regardless of the purpose, provides consistency across risk assessments. These models use inputs, assumptions and estimation techniques that require a high degree of management judgment. The main factors that contribute to changes in ECL that are subject to significant judgment include the following: calibration of regulatory parameters in order to obtain point-in-time and forward-looking parameters; forecasts of macroeconomic variables for multiple scenarios and the probability weighting of the scenarios;    determination of the significant increases in credit risk (SICR) of a loan. National Bank of Canada 151 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 7 – Loans and Allowances for Credit Losses (cont.) Main Parameters PD Estimates Since the objective of the regulatory calibration of PD is to align historical data to the long-run default rate, adjustments are required to obtain a point-in-time, forward-looking PD, as required by IFRS 9. The Bank performs the following: (1) A point-in-time calibration, where the PD of the portfolio is aligned with the appropriate default rate. The resulting PD estimate generally equals the prior-year default rate. The prior-year default rate is selected for the calibration performed at this stage, as it often reflects one of the most accurate and appropriate estimates of the current-year default rate; (2) Forward-looking adjustments are incorporated through, among other measures, a calibration factor based on forecasts produced by the stress testing team's analyses. The team considers three macroeconomic scenarios, and, for each scenario, produces a forward-looking assessment covering the three upcoming years. LGD Estimates The LGD estimation method consists of using, for each of the three macroeconomic scenarios, expected LGD based on the LGD values observed using backtesting, the economic LGD estimated and used to calculate economic capital, and lastly, the estimated downturn LGD used to calculate regulatory capital. EAD Estimates For term loans, the Bank uses expected EAD, which is the outstanding balance anticipated at each point in time. Expected EAD decreases over time according to contractual repayments and to prepayments. For revolving loans, the EAD percentage is based on the percentage estimated by the corresponding regulatory model and, thereafter, is converted to dollars according to the authorized balance. Expected Life For most financial instruments, the expected life used when measuring expected credit losses is the remaining contractual life. For revolving financial instruments where there is no contractual maturity, such as credit cards or lines of credit, the expected life is based on the behavioural life of clients who have defaulted or closed their account. Incorporation of Forward-Looking Information The Bank’s Economy and Strategy Group is responsible for developing three macroeconomic scenarios and for recommending probability weights for each scenario. Macroeconomic scenarios are not developed for specific portfolios, as the Economy and Strategy Group provides a set of variables for each of the defined scenarios for the next three years. The PDs are also adjusted to incorporate economic assumptions (interest rates, unemployment rates, GDP forecasts, oil prices, housing price indices, etc.) that can be statistically tied to PD changes that will have an impact beyond the next 12 months. These statistical relationships are determined using the processes developed for stress testing. In addition, the group considers other relevant factors that may not be adequately reflected in the information used to calculate the PDs (including late payments and whether the financial asset is subject to additional monitoring within the watchlist process for business and government loan portfolios). Determination of a Significant Increase in the Credit Risk of a Financial Instrument At each reporting period, the Bank determines whether credit risk has increased significantly since initial recognition by examining the change in the risk of default occurring over the remaining life of the financial instrument. First, the Bank compares the point-in-time forward-looking remaining lifetime PD at the reporting date with the expected point-in-time forward-looking remaining lifetime PD established at initial recognition. Based on this comparison, the Bank determines whether the loan has deteriorated when compared to the initial conditions. Because the comparison includes an adjustment based on origination- date forward-looking information and reporting-date forward-looking information, the deterioration may be caused by the following factors: (i) deterioration of the economic outlook used in the forward-looking assessment; (ii) deterioration of the borrower’s conditions (payment defaults, worsening financial ratios, etc.); or (iii) a combination of both factors. The quantitative criteria used to determine a significant increase in credit risk are a series of relative and absolute thresholds, and a backstop is also applied. All financial instruments that are over 30 days past due but below 90 days past due are migrated to Stage 2, even if the other criteria do not indicate a significant increase in credit risk. CCrreeddiitt QQuuaalliittyy ooff LLooaannss The following tables present the gross carrying amounts of loans as at October 31, 2019 and 2018, according to credit quality and ECL impairment stage of each loan category at amortized cost, and according to credit quality for loans at fair value through profit or loss. For additional information on credit quality according to the Advanced Internal Rating-Based (AIRB) categories, see the Internal Default Risk Ratings table on page 69 in the Credit Risk Management section of the MD&A for the year ended October 31, 2019. 152 152 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) AAss aatt OOccttoobbeerr 3311,, 22001199 NNoonn--iimmppaaiirreedd llooaannss SSttaaggee 22 SSttaaggee 11 SSttaaggee 33 IImmppaaiirreedd llooaannss PPOOCCII LLooaannss aatt ffaaiirr vvaalluuee tthhrroouugghh pprrooffiitt oorr lloossss(1) RReessiiddeennttiiaall mmoorrttggaaggee Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt PPeerrssoonnaall Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt CCrreeddiitt ccaarrdd Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt BBuussiinneessss aanndd ggoovveerrnnmmeenntt(3) Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt TToottaall llooaannss Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt 2211,,884400 1144,,337755 88,,117788 441133 110011 −− 4444,,990077 33,,668866 4488,,559933 3377 4488,,555566 1144,,333311 1100,,111199 44,,997733 441166 110099 −− 2299,,994488 33,,554455 3333,,449933 6644 3333,,442299 337700 331166 778866 442211 2222 −− 11,,991155 3344 11,,994499 2266 11,,992233 44,,778833 2222,,995511 2222,,336677 8877 4455 −− 5500,,223333 33,,777799 5544,,001122 5588 5533,,995544 113388,,004477 118855 113377,,886622 −− 1111 667744 449977 224488 −− 11,,443300 1199 11,,444499 1122 11,,443377 −− 220066 11,,447777 771111 119999 −− 22,,559933 8833 22,,667766 110033 22,,557733 −− −− 2200 224411 111122 −− 337733 −− 337733 110022 227711 −− 44 11,,334466 11,,113311 225555 −− 22,,773366 −− 22,,773366 9999 22,,663377 77,,223344 331166 66,,991188 −− −− −− −− −− 111177 111177 2277 114444 2255 111199 −− −− −− −− −− 113399 113399 2233 116622 6699 9933 −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− 330066 330066 7722 337788 114400 223388 668844 223344 445500 −− −− −− −− −− −− −− 555533 555533 ((5533)) 660066 −− −− −− −− −− −− −− 661133 661133 ((44)) 661177 −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− 66,,443322 66,,443322 −− 66,,443322 −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− 111122 5533 7722 −− −− −− 223377 112299 336666 −− 336666 TToottaall 2211,,884400 1144,,338866 88,,885522 991100 334499 111177 4466,,445544 1100,,771177 5577,,117711 2211 5577,,115500 1144,,333311 1100,,332255 66,,445500 11,,112277 330088 113399 3322,,668800 44,,226644 3366,,994444 223322 3366,,771122 337700 331166 880066 666622 113344 −− 22,,228888 3344 22,,332222 112288 22,,119944 44,,889955 2233,,000088 2233,,778855 11,,221188 330000 330066 5533,,551122 33,,998800 5577,,449922 229977 5577,,119955 11,,116666 ((5577)) 11,,222233 66,,779988 −− 66,,779988 115533,,992299 667788 115533,,225511 (1) (2) (3) Not subject to expected credit losses. The allowances for credit losses do not include the amounts related to undrawn commitments reported in the Other liabilities item of the Consolidated Balance Sheet. Includes customers’ liability under acceptances. National Bank of Canada 153 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 7 – Loans and Allowances for Credit Losses (cont.) As at October 31, 2018 Non-impaired loans Stage 2 Stage 1 Stage 3 Impaired loans POCI Loans at fair value through profit or loss(1) RReessiiddeennttiiaall mmoorrttggaaggee Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt PPeerrssoonnaall Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt CCrreeddiitt ccaarrdd Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt BBuussiinneessss aanndd ggoovveerrnnmmeenntt(3) Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt TToottaall llooaannss Gross carrying amount Allowances for credit losses(2) CCaarrrryyiinngg aammoouunntt 19,035 14,928 8,838 421 81 − 43,303 2,546 45,849 31 45,818 13,625 10,089 5,430 456 91 − 29,691 4,421 34,112 71 34,041 416 306 888 294 12 − 1,916 27 1,943 24 1,919 4,736 24,005 18,986 493 55 − 48,275 2,611 50,886 48 50,838 132,790 174 132,616 − 10 348 621 300 − 1,279 27 1,306 13 1,293 2 52 902 694 204 − 1,854 140 1,994 120 1,874 − − 37 249 96 − 382 − 382 105 277 − 6 1,068 758 121 − 1,953 1 1,954 86 1,868 5,636 324 5,312 − − − − − 128 128 23 151 21 130 − − − − − 137 137 27 164 71 93 − − − − − − − − − − − − − − − − 276 276 39 315 134 181 630 226 404 − − − − − − − 487 487 (64) 551 − − − − − − − 1,087 1,087 (3) 1,090 − − − − − − − − − − − − − − − − − − 2 2 1 1 − − − − − − − 5,858 5,858 − 5,858 − − − − − − − − − − − − − − − − − − − − − − 111 55 84 − − − 250 − 250 − 250 Total 19,035 14,938 9,186 1,042 381 128 44,710 8,941 53,651 1 53,650 13,627 10,141 6,332 1,150 295 137 31,682 5,675 37,357 259 37,098 416 306 925 543 108 − 2,298 27 2,325 129 2,196 4,847 24,066 20,138 1,251 176 276 50,754 2,653 53,407 269 53,138 1,576 (66) 1,642 6,108 − 6,108 146,740 658 146,082 (1) (2) (3) Not subject to expected credit losses. The allowances for credit losses do not include the amounts related to undrawn commitments reported in the Other liabilities item of the Consolidated Balance Sheet. Includes customers’ liability under acceptances. 154 154 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) The following table presents the credit risk exposures of off-balance-sheet commitments as at October 31, 2019 and 2018 according to credit quality and ECL impairment stage. OOffff--bbaallaannccee--sshheeeett ccoommmmiittmmeennttss(1) RReettaaiill Excellent Good Satisfactory Special mention Substandard Default NNoonn--rreettaaiill Excellent Good Satisfactory Special mention Substandard Default AIRB approach Standardized approach Total exposure Allowances for credit losses TToottaall eexxppoossuurree,, nneett ooff aalllloowwaanncceess SSttaaggee 11 SSttaaggee 22 SSttaaggee 33 TToottaall Stage 1 Stage 2 Stage 3 Total AAss aatt OOccttoobbeerr 3311,, 22001199 As at October 31, 2018 1122,,008888 33,,558855 11,,332288 111144 55 −− 1100,,005500 1144,,664400 66,,116655 1177 116677 −− 4488,,115599 66,,115544 5544,,331133 5533 5544,,226600 22 5511 118800 8822 1199 −− −− 11 551133 116611 2299 −− 11,,003388 −− 11,,003388 2200 11,,001188 −− −− −− −− −− 44 −− −− −− −− −− 1166 2200 11 2211 11 2200 1122,,009900 33,,663366 11,,550088 119966 2244 44 1100,,005500 1144,,664411 66,,667788 117788 119966 1166 4499,,221177 66,,115555 5555,,337722 7744 5555,,229988 11,440 2,450 969 79 2 − 5,881 13,570 4,302 133 3 − 38,829 6,434 45,263 38 45,225 9 13 117 77 13 − − − 353 142 6 − 730 − 730 15 715 − − − − − 2 − − − − − 4 6 5 11 1 10 11,449 2,463 1,086 156 15 2 5,881 13,570 4,655 275 9 4 39,565 6,439 46,004 54 45,950 (1) Represent letters of guarantee and documentary letters of credit, undrawn commitments, and backstop liquidity and credit enhancement facilities. National Bank of Canada 155 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 7 – Loans and Allowances for Credit Losses (cont.) LLooaannss PPaasstt DDuuee BBuutt NNoott IImmppaaiirreedd(1) RReessiiddeennttiiaall mmoorrttggaaggee PPeerrssoonnaall CCrreeddiitt ccaarrdd BBuussiinneessss aanndd ggoovveerrnnmmeenntt(2) Residential mortgage Personal AAss aatt OOccttoobbeerr 3311,, 22001199 As at October 31, 2018 Business and government(2) Credit card Past due but not impaired 31 to 60 days 61 to 90 days Over 90 days(3) 9922 3344 −− 112266 8822 3344 −− 111166 2277 1133 2288 6688 3311 2211 −− 5522 105 41 − 146 102 59 − 161 27 13 27 67 36 41 − 77 (1) (2) (3) Loans less than 31 days past due are not presented as they are not considered past due from an administrative standpoint. Includes customers’ liability under acceptances. All loans more than 90 days past due, except for credit card receivables, are considered impaired (Stage 3). IImmppaaiirreedd LLooaannss LLooaannss – SSttaaggee 33 Residential mortgage Personal Credit card(1) Business and government(2) LLooaannss – PPOOCCII AAss aatt OOccttoobbeerr 3311,, 22001199 As at October 31, 2018 GGrroossss AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess NNeett Gross Allowances for credit losses 114444 116622 −− 337788 668844 11,,116666 11,,885500 2255 6699 −− 114400 223344 ((5577)) 117777 111199 9933 −− 223388 445500 11,,222233 11,,667733 151 164 − 315 630 1,576 2,206 21 71 − 134 226 (66) 160 Net 130 93 − 181 404 1,642 2,046 (1) (2) Credit card receivables are considered impaired, at the latest, when payment is 180 days past due, and they are written off at that time. Includes customers’ liability under acceptances. MMaaxxiimmuumm EExxppoossuurree ttoo CCrreeddiitt RRiisskk oonn IImmppaaiirreedd LLooaannss The following table presents the maximum exposure to credit risk of impaired loans, the percentage of exposure covered by guarantees, and the main types of collateral and guarantees held for each loan category. As at October 31 22001199 GGrroossss iimmppaaiirreedd llooaannss PPeerrcceennttaaggee ccoovveerreedd bbyy gguuaarraanntteeeess(1) Gross impaired loans 2018 Percentage covered by guarantees(1) Types of collateral and guarantees LLooaannss – SSttaaggee 33 Residential mortgage Personal Business and government(2) LLooaannss – PPOOCCII 114444 116622 337788 11,,116666 110000 %% 4466 %% 5533 %% 2288 %% 151 164 315 1,576 100 % 44 % 54 % 14 % Residential buildings Buildings and automobiles Buildings, equipment, government and bank guarantees Buildings and automobiles (1) (2) For gross impaired loans, the ratio is calculated on a weighted average basis using the estimated value of the collateral and guarantees held for each loan category presented. The value of the collateral and guarantees held for a specific loan may exceed the balance of the loan; when this is the case, the ratio is capped at 100%. Includes customers’ liability under acceptances. 156 156 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) AAlllloowwaanncceess ffoorr CCrreeddiitt LLoosssseess The tables below present a reconciliation of the allowances for credit losses by Consolidated Balance Sheet item and by type of off-balance-sheet commitment. AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess aass aatt OOccttoobbeerr 3311,, 22001188 PPrroovviissiioonnss ffoorr ccrreeddiitt lloosssseess WWrriittee--ooffffss(1) DDiissppoossaallss YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess aass aatt OOccttoobbeerr 3311,, 22001199 RReeccoovveerriieess aanndd ootthheerr BBaallaannccee sshheeeett CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss(2)(3) SSeeccuurriittiieess(3) At fair value through other comprehensive income(4) At amortized cost(2) SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd(2)(3) LLooaannss(5) Residential mortgage Personal Credit card Business and government Customers' liability under acceptances OOtthheerr aasssseettss(2)(3) OOffff--bbaallaannccee--sshheeeett ccoommmmiittmmeennttss(6) Letters of guarantee and documentary letters of credit Undrawn commitments Backstop liquidity and credit enhancement facilities BBaallaannccee sshheeeett CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss(2)(3) SSeeccuurriittiieess(3) At fair value through other comprehensive income(4) At amortized cost(2) SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd(2)(3) LLooaannss(5) Residential mortgage Personal Credit card Business and government Customers' liability under acceptances OOtthheerr aasssseettss(2)(3) OOffff--bbaallaannccee--sshheeeett ccoommmmiittmmeennttss(6) Letters of guarantee and documentary letters of credit Undrawn commitments Backstop liquidity and credit enhancement facilities 11 −− 11 −− 11 225599 112299 224499 2200 665588 −− 33 4499 22 5544 771144 11 −− −− −− 2266 113377 8888 6666 99 332266 −− 33 1177 −− 2200 334477 −− −− −− −− ((77)) ((118888)) ((110044)) ((5522)) −− ((335511)) −− −− −− −− −− ((335511)) −− −− −− −− −− −− −− ((11)) −− ((11)) −− −− −− −− −− ((11)) −− −− −− −− 11 2244 1155 66 −− 4466 −− −− −− −− −− 4466 22 −− 11 −− 2211 223322 112288 226688 2299 667788 −− 66 6666 22 7744 775555 Allowances for credit losses as at November 1, 2017 Provisions for credit losses Write-offs(1) Disposals Year ended October 31, 2018 Allowances for credit losses as at October 31, 2018 Recoveries and other 1 − 3 − 18 261 128 250 16 673 − 3 54 1 58 735 − − (2) − (3) 179 91 68 4 339 − − (11) 1 (10) 327 − − − − (9) (196) (98) (64) − (367) − − − − − − − − − (6) (5) − (13) − (24) − − − − − (367) (24) − − − − 1 20 8 8 − 37 − − 6 − 6 43 1 − 1 − 1 259 129 249 20 658 − 3 49 2 54 714 (1) (2) (3) (4) (5) (6) The contractual amount outstanding on financial assets that were written off during the year ended October 31, 2019 and that are still subject to enforcement activity was $166 million ($152 million for the year ended October 31, 2018). These financial assets are presented net of the allowances for credit losses on the Consolidated Balance Sheet. As at October 31, 2019 and 2018, these financial assets were mainly classified in Stage 1 and their credit quality fell within the Excellent category. The allowances for credit losses are reported in the Accumulated other comprehensive income item of the Consolidated Balance Sheet. The allowances for credit losses are reported in the Allowances for credit losses item of the Consolidated Balance Sheet. The allowances for credit losses are reported in the Other liabilities item of the Consolidated Balance Sheet. National Bank of Canada 157 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 7 – Loans and Allowances for Credit Losses (cont.) The following tables present the reconciliation of allowances for credit losses for each loan category at amortized cost according to ECL impairment stage. YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 Year ended October 31, 2018 RReessiiddeennttiiaall mmoorrttggaaggee Balance at beginning Originations or purchases Transfers(2): to Stage 1 to Stage 2 to Stage 3 Net remeasurement of loss allowances(3) Derecognitions(4) Changes to models Provisions for credit losses Write-offs Disposals Recoveries Foreign exchange movements and other BBaallaannccee aatt eenndd Includes: Amounts drawn Undrawn commitments(5) PPeerrssoonnaall Balance at beginning Originations or purchases Transfers(2): to Stage 1 to Stage 2 to Stage 3 Net remeasurement of loss allowances(3) Derecognitions(4) Changes to models Provisions for credit losses Write-offs Disposals Recoveries Foreign exchange movements and other BBaallaannccee aatt eenndd Includes: Amounts drawn Undrawn commitments(5) AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess oonn nnoonn--iimmppaaiirreedd llooaannss SSttaaggee 22 SSttaaggee 11 AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess oonn iimmppaaiirreedd llooaannss PPOOCCII(1) SSttaaggee 33 Allowances for credit losses on non-impaired loans Stage 2 Stage 1 Allowances for credit losses on impaired loans POCI(1) Stage 3 TToottaall 3311 1177 1133 ((11)) −− ((2222)) ((11)) −− 66 −− −− −− −− 3377 3377 −− 7722 4488 7722 ((1199)) ((77)) ((9911)) ((1111)) −− ((88)) −− −− −− 11 6655 6644 11 1133 −− ((1100)) 22 ((44)) 1122 ((11)) −− ((11)) −− −− −− −− 1122 1122 −− 112211 −− ((6644)) 2233 ((9911)) 112277 ((1111)) −− ((1166)) −− −− −− ((11)) 110044 110033 11 2211 −− ((33)) ((11)) 44 1100 −− −− 1100 ((77)) −− 22 ((11)) 2255 2255 −− 7711 −− ((88)) ((44)) 9988 8811 ((55)) −− 116622 ((118888)) −− 2277 ((33)) 6699 6699 −− ((6644)) −− −− −− −− 1111 −− −− 1111 −− −− −− −− ((5533)) ((5533)) −− ((33)) −− −− −− −− ((11)) −− −− ((11)) −− −− −− −− ((44)) ((44)) −− 11 1177 −− −− −− 1111 ((22)) −− 2266 ((77)) −− 22 ((11)) 2211 2211 −− 226611 4488 −− −− −− 111166 ((2277)) −− 113377 ((118888)) −− 2277 ((33)) 223344 223322 22 22 14 12 − − (15) (1) − 10 − − − (1) 31 31 − 91 48 80 (29) (8) (100) (15) 4 (20) − − − 1 72 71 1 10 − (10) 2 (4) 17 (2) − 3 − − − − 13 13 − 107 − (76) 35 (123) 203 (14) (13) 12 − − − 2 121 120 1 17 − (2) (2) 4 14 (4) − 10 (9) − 4 (1) 21 21 − 59 − (4) (6) 131 71 (2) − 190 (196) − 20 (2) 71 71 − (31) − − − − (26) − − (26) − (6) − (1) (64) (64) − 7 − − − − (4) − − (4) − (5) − (1) (3) (3) − Total 18 14 − − − (10) (7) − (3) (9) (6) 4 (3) 1 1 − 264 48 − − − 170 (31) (9) 178 (196) (5) 20 − 261 259 2 (1) (2) (3) (4) (5) The total amount of undiscounted initially expected credit losses on the POCI loans acquired for the year ended October 31, 2019 was $92 million ($258 million for the year ended October 31, 2018). The expected credit losses reflected in the purchase price were discounted. Represent stage transfers deemed to have taken place at the beginning of the quarter in which the transfer occurred. Includes the net remeasurement of loss allowances (after transfers) attributable mainly to changes in volumes and in the credit quality of existing loans as well as to changes in risk parameters. Represent reversals to loss allowances arising from full loan repayments (excluding write-offs and disposals). The allowances for credit losses on undrawn commitments are reported in the Other liabilities item of the Consolidated Balance Sheet. 158 158 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 Year ended October 31, 2018 AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess oonn nnoonn--iimmppaaiirreedd llooaannss SSttaaggee 22 SSttaaggee 11 AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess oonn iimmppaaiirreedd llooaannss PPOOCCII(1) SSttaaggee 33 Allowances for credit losses on non-impaired loans Stage 2 Stage 1 Allowances for credit losses on impaired loans POCI(1) Stage 3 CCrreeddiitt ccaarrdd Balance at beginning Originations or purchases Transfers(2): to Stage 1 to Stage 2 to Stage 3 Net remeasurement of loss allowances(3) Derecognitions(4) Changes to models Provisions for credit losses Write-offs Disposals Recoveries Foreign exchange movements and other BBaallaannccee aatt eenndd Includes: Amounts drawn Undrawn commitments(5) BBuussiinneessss aanndd ggoovveerrnnmmeenntt(6) Balance at beginning Originations or purchases Transfers(2): to Stage 1 to Stage 2 to Stage 3 Net remeasurement of loss allowances(3) Derecognitions(4) Changes to models Provisions for credit losses Write-offs Disposals Recoveries Foreign exchange movements and other BBaallaannccee aatt eenndd Includes: Amounts drawn Undrawn commitments(5) TToottaall aalllloowwaanncceess ffoorr ccrreeddiitt lloosssseess aatt eenndd(7) Includes: Amounts drawn Undrawn commitments(5) 4400 88 9977 ((1155)) ((22)) ((8899)) ((44)) 1122 77 −− −− −− −− 4477 2266 2211 6655 2299 2277 ((88)) ((11)) ((1199)) ((1100)) −− 1188 −− −− −− −− 8833 5588 2255 223322 118855 4477 111155 −− ((9977)) 1155 ((3399)) 112288 ((22)) ((77)) ((22)) −− −− −− −− 111133 110022 1111 8899 −− ((1199)) 1188 ((44)) 2266 ((55)) −− 1166 −− −− −− −− 110055 9999 66 333344 331166 1188 −− −− −− −− 4411 4488 −− −− 8899 ((110044)) −− 1155 −− −− −− −− 113355 −− ((88)) ((1100)) 55 7755 ((1100)) −− 5522 ((5522)) −− 88 ((22)) 114411 114400 11 223355 223344 11 TToottaall 115555 88 −− −− −− 8877 ((66)) 55 9944 ((110044)) −− 1155 −− 116600 112288 3322 229900 2299 −− −− −− 8822 ((2255)) −− 8866 ((5522)) ((11)) 88 ((22)) 332299 229977 3322 −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− 11 −− −− −− −− −− −− −− −− −− ((11)) −− −− −− −− −− ((5577)) 774444 ((5577)) −− 667788 6666 41 8 95 (14) − (89) (1) − (1) − − − − 40 24 16 53 32 21 (4) − (26) (12) − 11 − − − 1 65 48 17 208 174 34 112 − (95) 14 (53) 172 (35) − 3 − − − − 115 105 10 74 − (16) 7 (2) 30 (4) − 15 − − − − 89 86 3 338 324 14 − − − − 53 31 − − 84 (98) − 14 − − − − 165 − (5) (3) 2 55 (9) − 40 (64) (13) 7 − 135 134 1 227 226 1 Total 153 8 − − − 114 (36) − 86 (98) − 14 − 155 129 26 292 32 − − − 60 (25) − 67 (64) (13) 7 1 290 269 21 − − − − − − − − − − − − − − − − − − − − − 1 − − 1 − − − − 1 1 − (66) 707 (66) − 658 49 (1) (2) (3) (4) (5) (6) (7) The total amount of undiscounted initially expected credit losses on the POCI loans acquired during the year ended October 31, 2019 was $92 million ($258 million for the year ended October 31, 2018). The expected credit losses reflected in the purchase price were discounted. Represent stage transfers deemed to have taken place at the beginning of the quarter in which the transfer occurred. Includes the net remeasurement of loss allowances (after transfers) attributable mainly to changes in volumes and in the credit quality of existing loans as well as to changes in risk parameters. Represent reversals to loss allowances arising from full loan repayments (excluding write-offs and disposals). The allowances for credit losses on undrawn commitments are reported in the Other liabilities item of the Consolidated Balance Sheet. Includes customers’ liability under acceptances. Excludes allowances for credit losses on other financial assets at amortized cost and on off-balance-sheet commitments other than undrawn commitments. National Bank of Canada 159 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 7 – Loans and Allowances for Credit Losses (cont.) Distribution of Gross and Impaired Loans by Borrower Category Under the Basel Asset Classes RReettaaiill Residential mortgage(3) Qualifying revolving retail(4) Other retail(5) NNoonn--rreettaaiill Agriculture Oil and gas and pipelines Mining Utilities Non-real-estate construction(6) Manufacturing Wholesale Retail Transportation Communications Finance and insurance Real estate services and real estate construction(7) Professional services Education and health care Other services Government Other SSttaaggeess 11 aanndd 22(8) PPOOCCII GGrroossss llooaannss(1) IImmppaaiirreedd llooaannss(1) AAss aatt OOccttoobbeerr 3311 AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess oonn iimmppaaiirreedd llooaannss(1)(2) 22001199 YYeeaarr eennddeedd OOccttoobbeerr 3311 PPrroovviissiioonnss ffoorr ccrreeddiitt lloosssseess WWrriittee--ooffffss 7744,,444488 44,,009999 1111,,660066 9900,,115533 66,,330088 44,,332299 775588 33,,337722 11,,116688 66,,330033 22,,222211 33,,228899 11,,668822 11,,661144 44,,333355 1111,,663355 11,,884466 33,,552200 44,,993377 11,,007711 44,,222222 6622,,661100 118833 2244 8844 229911 7777 6633 −− −− −− 5500 2288 44 99 2277 1122 3322 88 6622 2200 −− 11 339933 11,,116666 115533,,992299 11,,116666 11,,885500 2288 1155 4499 9922 44 3322 −− −− −− 2288 1100 22 11 1111 11 1144 55 2211 1122 −− 11 114422 557788 ((5577)) 775555 1100 111122 113399 226611 ((33)) 44 −− −− −− 77 77 ((11)) 77 55 −− 1100 11 1144 ((11)) −− 11 5511 2255 1100 334477 88 112277 116644 229999 −− 2211 −− −− −− 33 33 11 66 77 −− 33 33 −− 55 −− −− 5522 335511 (1) (2) (3) (4) (5) (6) (7) (8) Includes customers’ liability under acceptances. Allowances for credit losses on drawn amounts. Includes residential mortgages on one-to-four-unit dwellings (Basel definition) and home equity lines of credit. Includes lines of credit and credit card receivables. Includes consumer loans and other retail loans but excludes SME loans. Includes civil engineering loans, public-private partnership loans, and project finance loans. Includes residential mortgages on dwellings of five or more units and SME loans. Includes other financial assets at amortized cost and off-balance-sheet commitments; the allowances for credit losses on off-balance-sheet commitments include an amount of $1 million for undrawn Stage 3 commitments related to business and government loans. 160 160 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) RReettaaiill Residential mortgage(3) Qualifying revolving retail(4) Other retail(5) NNoonn--rreettaaiill Agriculture Oil and gas and pipelines(6) Mining Utilities Non-real-estate construction(6)(7) Manufacturing(6) Wholesale Retail Transportation(6) Communications Finance and insurance Real estate services and real estate construction(6)(8) Professional services Education and health care(6) Other services Government Other SSttaaggeess 11 aanndd 22(9) PPOOCCII Gross loans(1) Impaired loans(1) As at October 31 Allowances for credit losses on impaired loans(1)(2) 2018 Year ended October 31 Provisions for credit losses Write-offs 70,591 4,211 12,246 87,048 5,759 4,056 1,032 2,715 1,049 5,303 2,163 3,069 1,452 1,597 4,732 11,629 1,582 3,284 4,715 1,445 2,534 58,116 190 23 91 304 63 97 − − 1 48 13 11 2 19 19 18 6 4 24 − 1 326 1,576 146,740 1,576 2,206 22 14 53 89 7 53 − − 1 22 6 4 1 12 1 5 3 4 17 − 1 137 554 (66) 714 10 108 165 283 1 12 − − − 11 − 11 1 3 − (3) 1 3 5 − (4) 41 32 (29) 327 9 123 171 303 − 12 − 3 − 2 1 22 2 − − 16 1 − 3 − 2 64 367 (1) (2) (3) (4) (5) (6) (7) (8) (9) Includes customers’ liability under acceptances. Allowances for credit losses on drawn amounts. Includes residential mortgages on one-to-four-unit dwellings (Basel definition) and home equity lines of credit. Includes lines of credit and credit card receivables. Includes consumer loans and other retail loans but excludes SME loans. The presentation of certain borrower categories was changed during fiscal 2019. Comparative figures have been reclassified. Includes civil engineering loans, public-private partnership loans, and project finance loans. Includes residential mortgages on dwellings of five or more units and SME loans. Includes other financial assets at amortized cost and off-balance-sheet commitments; the allowances for credit losses on off-balance-sheet commitments include an amount of $1 million for undrawn Stage 3 commitments related to business and government loans. National Bank of Canada 161 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 7 – Loans and Allowances for Credit Losses (cont.) MMaaiinn MMaaccrrooeeccoonnoommiicc FFaaccttoorrss The following tables show the main macroeconomic factors used to estimate the allowances for credit losses on loans. For each scenario, namely, the base case, upside scenario and downside scenario, the average values of the factors over the next 12 months (used for Stage 1 credit loss calculations) and over the remaining forecast period (used for Stage 2 credit loss calculations) are presented. MMaaccrrooeeccoonnoommiicc ffaaccttoorrss(1) GDP growth(2) Unemployment rate Housing price index growth(2) BBB spread(3) S&P/TSX growth(2)(4) WTI oil price(5) (US$ per barrel) MMaaccrrooeeccoonnoommiicc ffaaccttoorrss(1) GDP growth(2) Unemployment rate Housing price index growth(2) BBB spread(3) S&P/TSX growth(2)(4) WTI oil price(5) (US$ per barrel) NNeexxtt 1122 mmoonntthhss BBaassee sscceennaarriioo RReemmaaiinniinngg ffoorreeccaasstt ppeerriioodd NNeexxtt 1122 mmoonntthhss UUppssiiddee sscceennaarriioo RReemmaaiinniinngg ffoorreeccaasstt ppeerriioodd NNeexxtt 1122 mmoonntthhss AAss aatt OOccttoobbeerr 3311,, 22001199 DDoowwnnssiiddee sscceennaarriioo RReemmaaiinniinngg ffoorreeccaasstt ppeerriioodd 11..55 %% 55..88 %% 33..11 %% 11..66 %% 44..99 %% 6611 11..66 %% 55..77 %% 33..11 %% 11..66 %% 22..44 %% 6600 22..00 %% 55..66 %% 66..11 %% 11..55 %% 88..55 %% 7711 22..11 %% 55..33 %% 22..33 %% 11..44 %% 22..99 %% 6699 ((22..00)) %% 66..88 %% ((1100..99)) %% 22..77 %% ((1144..11)) %% 3399 11..66 %% 77..55 %% ((00..33)) %% 22..66 %% 66..66 %% 3399 Next 12 months Base scenario Remaining forecast period Next 12 months Upside scenario Remaining forecast period Next 12 months As at October 31, 2018 Downside scenario Remaining forecast period 1.9 % 5.7 % 2.8 % 1.6 % 3.5 % 71 1.5 % 5.5 % 0.8 % 1.5 % 2.4 % 68 2.5 % 5.6 % 3.4 % 1.4 % 6.4 % 75 2.0 % 5.3 % 2.1 % 1.2 % 3.8 % 81 (2.3) % 7.0 % (10.6) % 2.6 % (18.5) % 46 1.5 % 7.8 % (0.3) % 2.6 % 6.9 % 36 All macroeconomic factors are based on the Canadian economy unless otherwise indicated. Growth rate is annualized. Yield on corporate BBB bonds less yield on Canadian federal government bonds with 10-year maturity. (1) (2) (3) (4) Main stock index in Canada. (5) The West Texas Intermediate (WTI) oil price index is commonly used as a benchmark. The main macroeconomic factors used for the personal credit portfolio are unemployment rate and housing price index growth, based on the economy of Canada or Quebec. The main macroeconomic factors used for the business and government credit portfolio are unemployment rate, BBB spread, S&P/TSX growth, and WTI oil price. An increase in unemployment rate or BBB spread will generally correlate with higher allowances for credit losses, whereas an increase in the other macroeconomic factors (GDP growth, S&P/TSX growth, housing price index growth, and WTI oil price) will generally correlate with lower allowances for credit losses. 162 162 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) SSeennssiittiivviittyy AAnnaallyyssiiss ooff AAlllloowwaanncceess ffoorr CCrreeddiitt LLoosssseess oonn NNoonn--IImmppaaiirreedd LLooaannss SScceennaarriiooss The following table shows a comparison of the Bank's allowances for credit losses on non-impaired loans (Stages 1 and 2) as at October 31, 2019 based on the probability weightings of three scenarios with allowances for credit losses resulting from simulations of each scenario weighted at 100%. BBaallaannccee aass aatt OOccttoobbeerr 3311,, 22001199 SSiimmuullaattiioonnss 100% upside scenario 100% base scenario 100% downside scenario AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess oonn nnoonn--iimmppaaiirreedd llooaannss 556666 446677 449944 777744 MMiiggrraattiioonn The following table shows a comparison of the Bank's allowances for credit losses on non-impaired loans (Stages 1 and 2) as at October 31, 2019 with the estimated allowances for credit losses that would result if all these non-impaired loans were in Stage 1. BBaallaannccee aass aatt OOccttoobbeerr 3311,, 22001199 SSiimmuullaattiioonnss Non-impaired loans if they were all in Stage 1 AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess oonn nnoonn--iimmppaaiirreedd llooaannss 556666 443399 National Bank of Canada 163 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 88 –– FFiinnaanncciiaall AAsssseettss TTrraannssffeerrrreedd BBuutt NNoott DDeerreeccooggnniizzeedd In the normal course of its business, the Bank enters into transactions in which it transfers financial assets such as securities or loans directly to third parties, in particular structured entities. According to the terms of some of those transactions, the Bank retains substantially all of the risks and rewards related to those financial assets. The risks include credit risk, interest rate risk, foreign exchange risk, prepayment risk and other price risks, whereas the rewards include income streams associated with the financial assets. As such, those financial assets are not derecognized and the transactions are treated as collateralized or secured borrowings. The nature of those transactions is described below. SSeeccuurriittiieess SSoolldd UUnnddeerr RReeppuurrcchhaassee AAggrreeeemmeennttss aanndd SSeeccuurriittiieess LLooaanneedd When securities are sold under repurchase agreements and securities loaned under securities lending agreements, the Bank transfers financial assets to third parties in accordance with the standard terms for such transactions. These third parties may have an unlimited right to resell or repledge the financial assets received. If cash collateral is received, the Bank records the cash along with an obligation to return the cash, which is included in Obligations related to securities sold under repurchase agreements and securities loaned on the Consolidated Balance Sheet. Where securities are received as collateral, the Bank does not record the collateral on the Consolidated Balance Sheet. FFiinnaanncciiaall AAsssseettss TTrraannssffeerrrreedd ttoo SSttrruuccttuurreedd EEnnttiittiieess Under the Canada Mortgage Bond (CMB) program, the Bank sells securities backed by insured residential mortgages and other securities to Canada Housing Trust (CHT), which finances the purchase through the issuance of insured mortgage bonds. Third-party CMB investors have legal recourse only to the transferred assets. The cash received for these transferred assets is treated as a secured borrowing, and a corresponding liability is recorded in Liabilities related to transferred receivables on the Consolidated Balance Sheet. The following table provides additional information about the nature of the transferred financial assets that do not qualify for derecognition and the associated liabilities. As at October 31 22001199 2018 CCaarrrryyiinngg vvaalluuee ooff ffiinnaanncciiaall aasssseettss ttrraannssffeerrrreedd bbuutt nnoott ddeerreeccooggnniizzeedd Securities(1) Residential mortgages CCaarrrryyiinngg vvaalluuee ooff aassssoocciiaatteedd lliiaabbiilliittiieess(2) FFaaiirr vvaalluuee ooff ffiinnaanncciiaall aasssseettss ttrraannssffeerrrreedd bbuutt nnoott ddeerreeccooggnniizzeedd Securities(1) Residential mortgages FFaaiirr vvaalluuee ooff aassssoocciiaatteedd lliiaabbiilliittiieess(2) 4477,,229977 2200,,114422 6677,,443399 3366,,662255 4477,,229977 2200,,330088 6677,,660055 3366,,771144 44,125 20,064 64,189 32,834 44,125 19,993 64,118 32,809 (1) (2) The amount related to the securities loaned is the maximum amount of Bank securities that can be lent. For the obligations related to securities sold under repurchase agreements, the amount includes the Bank’s own financial assets as well as those of third parties. Associated liabilities include obligations related to securities sold under repurchase agreements before the offsetting impact of $3,166 million as at October 31, 2019 ($287 million as at October 31, 2018) and liabilities related to transferred receivables. Liabilities related to securities loaned are not included, as the Bank can lend its own financial assets and those of third parties. The carrying value and fair value of liabilities related to securities loaned were $9,753 million as at October 31, 2019 ($7,550 million as at October 31, 2018). The following table specifies the nature of the transactions related to financial assets transferred but not derecognized. As at October 31 CCaarrrryyiinngg vvaalluuee ooff ffiinnaanncciiaall aasssseettss ttrraannssffeerrrreedd bbuutt nnoott ddeerreeccooggnniizzeedd Securities backed by insured residential mortgages and other securities sold to CHT Securities sold under repurchase agreements Securities loaned 22001199 2018 2211,,003355 1166,,229944 3300,,111100 6677,,443399 20,576 12,927 30,686 64,189 164 164 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 99 –– IInnvveessttmmeennttss iinn AAssssoocciiaatteess aanndd JJooiinntt VVeennttuurreess As at October 31 LLiisstteedd aassssoocciiaatteess(2) TMX Group Limited(3) Fiera Capital Corporation(4) UUnnlliisstteedd aassssoocciiaatteess NSIA Participations(5) Other Business segment Other Wealth Management USSF&I 22001199 CCaarrrryyiinngg vvaalluuee 2018 (1) Carrying value 227733 −− 227733 −− 111122 111122 338855 264 140 404 140 101 241 645 (1) (2) (3) During fiscal 2018, the Bank had disposed of its entire interest in an unlisted joint venture. The fair value of investments in associates based on quoted prices in active markets was $544 million as at October 31, 2019 ($611 million as at October 31, 2018). The Bank exercises significant influence over TMX Group Limited mainly through its equity interest, debt financing, and presence on TMX Group Limited’s board of directors. As at October 31, 2019, the Bank’s ownership interest in TMX Group Limited was 8.5%. (4) On May 9, 2019, through one of its subsidiaries, the Bank disposed of 10,680,000 Class A subordinate voting shares of Fiera Capital Corporation (Fiera Capital) at a per-share price of $12.00 for gross proceeds of $128 million. Before the transaction, the Bank’s investment in Fiera Capital stood at 18% and was accounted for using the equity method. After the transaction, the Bank’s ownership percentage was 7%. A gain on disposal of Fiera Capital shares of $79 million, including a $31 million gain on remeasurement at fair value of the retained interest was recognized in the Non-interest income – Other item of the Consolidated Statement of Income for the year ended October 31, 2019 and reported in the Other heading of segment results. After the transaction, the Bank designated the 7% retained interest as a financial asset measured at fair value through other comprehensive income. As at October 31, 2019, the Bank’s ownership interest in Fiera Capital was 5.0%. (5) On June 30, 2019, the Bank concluded that it had lost significant influence over NSIA Participations (NSIA), an associate entity in the Ivory Coast, and therefore ceased using the equity method to account for this investment. The Bank designated its investment in NSIA as a financial asset measured at fair value through other comprehensive income in an amount of $128 million. Following the fair value measurement, a $33 million loss was recorded in the Non-interest income – Other item of the Consolidated Statement of Income and reported in the Other heading of segment results. As at October 31, 2019, the Bank’s ownership interest in NSIA was 22.1%. As at October 31, 2019 and 2018, there were no significant restrictions limiting the ability of associates and joint ventures to transfer funds to the Bank in the form of dividends or to repay any loans or advances. Furthermore, the Bank has not made any specific commitment or contracted any contingent liability with respect to associates or joint ventures. TMX Group Limited TMX Group Limited is a Canadian corporation that directly or indirectly controls a number of entities that operate stock exchanges and clearing houses and provide clearing and settlement services. During the year ended October 31, 2019, TMX Group Limited paid $12 million in dividends to the Bank ($10 million for the year ended October 31, 2018). Fiera Capital Corporation (Fiera Capital) Fiera Capital is an independent Canadian investment management firm. During the year ended October 31, 2019, Fiera Capital paid $10 million in dividends to the Bank, of which $7 million as dividends from an investment in an associate ($13 million for the year ended October 31, 2018). NSIA Participations NSIA Participations is a financial group headquartered in Abidjan, Ivory Coast. During the fiscal years ended October 31, 2019 and 2018, NSIA Participations did not pay any dividends to the Bank. National Bank of Canada 165 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 9 – Investments in Associates and Joint Ventures (cont.) The following table provides summarized financial information on the Bank’s listed associates. As at October 31 BBaallaannccee sshheeeett Current assets Non-current assets Current liabilities Non-current liabilities IInnccoommee ssttaatteemmeenntt Total revenues Net income Other comprehensive income (loss) Comprehensive income 22001199(1) TTMMXX GGrroouupp LLiimmiitteedd 3311,,009999 55,,221155 3311,,116644 11,,771111 881122 227700 ((3388)) 223322 TMX Group Limited Fiera Capital Corporation 20,433 5,160 20,653 1,624 780 419 (23) 396 210 1,201 138 634 524 (2) 21 19 2018(1) Total 20,643 6,361 20,791 2,258 1,304 417 (2) 415 (1) The balance sheet amounts are the balances reported in the unaudited financial statements as at September 30, 2019 and 2018, which are the most recent available, and the income statement amounts are based on the cumulative balances for the 12-month periods ended September 30, 2019 and 2018. The table below provides summarized financial information related to the Bank’s proportionate share in unlisted associates that are not individually significant. Year ended October 31 Net income Other comprehensive income Comprehensive income (1) The amounts are based on the cumulative balances for the 12-month periods ended September 30, 2019 and 2018. 22001199(1) 2018(1) 1122 11 1133 6 − 6 166 6 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 1100 –– PPrreemmiisseess aanndd EEqquuiippmmeenntt HHeeaadd ooffffiiccee bbuuiillddiinngg uunnddeerr ccoonnssttrruuccttiioonn(1) LLaanndd BBuuiillddiinnggss CCoommppuutteerr eeqquuiippmmeenntt EEqquuiippmmeenntt aanndd ffuurrnniittuurree LLeeaasseehhoolldd iimmpprroovveemmeennttss 17 66 (4) 79 11 ((1100)) −− 7700 − 4488 −− −− 4488 CCoosstt As at October 31, 2017 Acquisitions Disposals Fully amortized assets As at October 31, 2018 Acquisitions Disposals(2) Impairment losses(3) AAss aatt OOccttoobbeerr 3311,, 22001199 AAccccuummuullaatteedd aammoorrttiizzaattiioonn As at October 31, 2017 Amortization for the year Disposals Fully amortized assets As at October 31, 2018 Amortization for the year Disposals(2) Impairment losses(3) AAss aatt OOccttoobbeerr 3311,, 22001199 Carrying value as at October 31, 2018 CCaarrrryyiinngg vvaalluuee aass aatt OOccttoobbeerr 3311,, 22001199 79 7700 − 4488 255 6 (2) (3) 256 44 ((118855)) −− 7755 154 5 (1) (3) 155 66 ((110033)) −− 5588 101 1177 235 90 (4) (1) 320 3399 −− ((3366)) 332233 92 74 (5) (1) 160 5577 −− ((2233)) 119944 160 112299 278 18 (170) (8) 118 1188 ((2266)) −− 111100 146 16 (99) (8) 55 1155 ((1133)) −− 5577 63 5533 292 59 (1) (10) 340 3344 ((5522)) −− 332222 127 26 (1) (10) 142 2277 ((2200)) −− 114499 198 117733 TToottaall 1,077 239 (181) (22) 1,113 114444 ((227733)) ((3366)) 994488 519 121 (106) (22) 512 110055 ((113366)) ((2233)) 445588 601 449900 As at October 31, 2019, contractual commitments related to the head office building under construction stood at $312 million and cover a period up to 2023. (1) (2) On July 30, 2019, the Bank completed the sale of its head office land and building located at 600 De La Gauchetière Street West, Montreal, Quebec, Canada, for gross proceeds of $187 million. At the same time, the Bank entered into a four-year operating lease with the purchaser. This sale-leaseback transaction resulted in a gain of $50 million, which was recognized in the Non- Interest Income – Other item of the Consolidated Statement of Income and reported in the Other heading of segment results. During the year ended October 31, 2019, the Bank decided to stop using certain computer equipment. Consequently, an amount of $13 million in impairment losses related to this equipment was recognized in the Non-interest expenses – Technology item of the Consolidated Statement of Income and reported in the Other heading of segment results. (3) AAsssseettss LLeeaasseedd UUnnddeerr OOppeerraattiinngg LLeeaasseess The Bank is a lessor under operating lease agreements for certain buildings. These leases have terms varying from one year to five years and do not contain any bargain purchase options or contingent rent. The following table breaks down the future minimum payments receivable under these operating leases. 1 year or less Over 1 year to 5 years Over 5 years AAss aatt OOccttoobbeerr 3311,, 22001199 22 66 11 99 National Bank of Canada 167 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 1111 –– GGooooddwwiillll aanndd IInnttaannggiibbllee AAsssseettss GGooooddwwiillll The following table presents changes in the carrying amounts of goodwill by cash-generating unit (CGU) and by business segment for the years ended October 31, 2019 and 2018. PPeerrssoonnaall aanndd CCoommmmeerrcciiaall(1) WWeeaalltthh MMaannaaggeemmeenntt FFiinnaanncciiaall MMaarrkkeettss(1) TThhiirrdd--PPaarrttyy SSoolluuttiioonnss(1) SSeeccuurriittiieess BBrrookkeerraaggee(1) MMaannaaggeedd SSoolluuttiioonnss(1) Balance as at October 31, 2017 Impact of foreign currency translation Balance as at October 31, 2018 Impact of foreign currency translation BBaallaannccee aass aatt OOccttoobbeerr 3311,, 22001199 54 −− 54 −− 5544 256 −− 256 −− 225566 434 −− 434 −− 443344 269 −− 269 −− 226699 (1) Constitutes a CGU. CCrreeddiiggyy LLttdd..(1) AAddvvaanncceedd BBaannkk ooff AAssiiaa LLiimmiitteedd(1) 235 − 235 −− 223355 32 1 33 −− 3333 129 2 131 −− 113311 TToottaall 959 −− 959 −− 995599 UUSSSSFF&&II TToottaall TToottaall 161 3 164 −− 116644 1,409 3 1,412 −− 11,,441122 GGooooddwwiillll IImmppaaiirrmmeenntt TTeessttiinngg aanndd SSiiggnniiffiiccaanntt AAssssuummppttiioonnss For impairment testing purposes, goodwill resulting from a business combination must be allocated, as of the acquisition date, to a CGU or a group of CGUs expected to benefit from the synergies of the business combination. Goodwill is tested for impairment annually or more frequently if events or circumstances indicate that the recoverable value of the CGU or group of CGUs may have fallen below its carrying amount. Goodwill was tested for impairment during the years ended October 31, 2019 and 2018, and no impairment loss was recognized. The recoverable value of a CGU or group of CGUs is based on the value in use that is calculated based on discounted pre-tax cash flows. Future pre-tax cash flows are estimated based on a five-year period, which is the reference period used for the most recent financial forecasts approved by management. Cash flows beyond that period are extrapolated using a long-term growth rate. The discount rate used for each CGU or group of CGUs is calculated using the cost of debt financing and the cost related to the Bank’s equity. This rate corresponds to the Bank’s weighted average cost of capital and reflects the risk specific to the CGU. The long-term growth rate used in calculating discounted cash flow estimates is based on the forecasted growth rate plus a risk premium. The rate is constant over the entire five-year period for which the cash flows were determined. Growth rates are determined, among other factors, based on past growth rates, economic trends, inflation, competition and the impact of the Bank’s strategic initiatives. As at October 31, 2019, for each CGU or CGU group, the discount rate used was 12.9% (12.8% as at October 31, 2018) and the long-term growth rate was between 2% and 5%, depending on the CGU, as at October 31, 2019 and 2018. Estimating a CGU’s value in use requires significant judgment regarding the inputs used in applying the discounted cash flow method. The Bank conducts sensitivity analyses by varying the after-tax discount rate upward by 1% and the terminal growth rates down by 1%. Such sensitivity analyses demonstrate that a reasonable change in assumptions would not result in a CGU’s carrying value exceeding its value in use. 168 168 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) IInnttaannggiibbllee AAsssseettss IInnddeeffiinniittee uusseeffuull lliiffee FFiinniittee uusseeffuull lliiffee TToottaall MMaannaaggeemmeenntt ccoonnttrraaccttss(1) TTrraaddeemmaarrkk TToottaall IInntteerrnnaallllyy-- ggeenneerraatteedd ssooffttwwaarree(2) OOtthheerr ssooffttwwaarree OOtthheerr iinnttaannggiibbllee aasssseettss CCoosstt As at October 31, 2017 Acquisitions Fully amortized intangible assets As at October 31, 2018 Acquisitions Impairment losses(3) Fully amortized intangible assets AAss aatt OOccttoobbeerr 3311,, 22001199 AAccccuummuullaatteedd aammoorrttiizzaattiioonn As at October 31, 2017 Amortization for the year Fully amortized intangible assets As at October 31, 2018 Amortization for the year Impairment losses(3) Fully amortized intangible assets AAss aatt OOccttoobbeerr 3311,, 22001199 161 − 161 −− −− 116611 11 − 11 −− −− 1111 172 − 172 −− −− 117722 1,267 242 − 1,509 332299 ((8855)) ((5500)) 11,,770033 295 149 − 444 119944 ((4411)) ((5500)) 554477 Carrying value as at October 31, 2018 CCaarrrryyiinngg vvaalluuee aass aatt OOccttoobbeerr 3311,, 22001199 161 116611 11 1111 172 117722 1,065 11,,115566 115 13 (2) 126 3300 −− −− 115566 61 23 (2) 82 2233 −− −− 110055 44 5511 108 1 (6) 103 −− −− −− 110033 67 9 (6) 70 66 −− −− 7766 33 2277 TToottaall 1,490 256 (8) 1,738 335599 ((8855)) ((5500)) 11,,996622 423 181 (8) 596 222233 ((4411)) ((5500)) 772288 1,662 256 (8) 1,910 335599 ((8855)) ((5500)) 22,,113344 423 181 (8) 596 222233 ((4411)) ((5500)) 772288 1,142 11,,223344 1,314 11,,440066 (1) (2) (3) For annual impairment testing purposes, management contracts are allocated to the Managed Solutions CGU. The remaining amortization period for significant internally-generated software is four years. The Bank wrote off certain technology developments due to obsolescence and decided to discontinue them. The recoverable amount of those technology developments was estimated to be nil. During the year ended October 31, 2019, an amount of $44 million in impairment losses was recognized in the Non-interest expenses – Technology item of the Consolidated Statement of Income and reported in the Other heading of segment results. NNoottee 1122 –– OOtthheerr AAsssseettss As at October 31 Receivables, prepaid expenses and other items Interest and dividends receivable Due from clients, dealers and brokers Defined benefit asset (Note 23) Deferred tax assets (Note 24) Current tax assets Reinsurance assets 22001199 2018 669966 662233 557700 3388 556622 221166 3333 22,,773388 775 549 1,255 64 324 113 31 3,111 National Bank of Canada 169 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 1133 –– DDeeppoossiittss As at October 31 Personal Business and government Deposit-taking institutions OOnn ddeemmaanndd(1) AAfftteerr nnoottiiccee(2) FFiixxeedd tteerrmm(3) 44,,332255 3388,,668800 11,,770077 4444,,771122 2277,,227711 2211,,882233 11,,331144 5500,,440088 2288,,446699 6644,,776633 11,,221144 9944,,444466 22001199 TToottaall 6600,,006655 112255,,226666 44,,223355 118899,,556666 2018 Total 55,688 110,321 4,821 170,830 (1) (2) (3) Demand deposits are deposits for which the Bank does not have the right to require notice of withdrawal and consist essentially of deposits in chequing accounts. Notice deposits are deposits for which the Bank may legally require a notice of withdrawal and consist mainly of deposits in savings accounts. Fixed-term deposits are deposits that can be withdrawn by the holder on a specified date and include term deposits, guaranteed investment certificates, savings accounts and plans, covered bonds, and similar instruments. The Deposits – Business and government item includes, among other items, covered bonds, as described below and includes a $3.5 billion amount of deposits as at October 31, 2019 that are subject to the bank bail-in conversion regulations issued by the Government of Canada. These regulations provide certain powers to the Canada Deposit Insurance Corporation (CDIC), notably the power to convert certain eligible Bank shares and liabilities into common shares should the Bank become non-viable. CCoovveerreedd BBoonnddss NBC Covered Bond Guarantor (Legislative) Limited Partnership In December 2013, the Bank established the covered bond legislative program under which covered bonds are issued. It therefore created NBC Covered Bond Guarantor (Legislative) Limited Partnership (the Guarantor) to guarantee payment of the principal and interest owed to the bondholders. The Bank sold uninsured residential mortgages to the Guarantor and granted it loans to facilitate the acquisition of these assets. During the year ended October 31, 2019, an amount of 1.0 billion euros in covered bonds matured, and the Bank issued covered bonds in amounts of US$1.3 billion and 750 million euros (US$750 million in covered bonds matured, and the Bank issued covered bonds in an amount of 1.5 billion euros during the year ended October 31, 2018). The covered bonds totalled $9.5 billion as at October 31, 2019 ($8.3 billion as at October 31, 2018). For additional information, see Note 27 to these consolidated financial statements. The Bank has limited access to the assets owned by this structured entity according to the terms of the agreements that apply to this transaction. The assets owned by this entity totalled $16.5 billion as at October 31, 2019 ($13.2 billion as at October 31, 2018), of which $16.2 billion ($12.9 billion as at October 31, 2018) is presented in Residential mortgage loans on the Bank’s Consolidated Balance Sheet. NNoottee 1144 –– OOtthheerr LLiiaabbiilliittiieess As at October 31 Accounts payable and accrued expenses Subsidiaries’ debts to third parties Interest and dividends payable Due to clients, dealers and brokers Defined benefit liability (Note 23) Allowances for credit losses — Off-balance-sheet commitments (Note 7) Deferred tax liabilities (Note 24) Current tax liabilities Insurance liabilities Other items(1)(2)(3) 22001199 11,,888833 11,,222255 11,,006611 554488 337744 7744 55 114444 2244 883399 66,,117777 2018 1,790 1,033 1,012 796 186 54 25 48 50 830 5,824 (1) (2) (3) As at October 31, 2019, Other items included $6 million in restructuring provisions ($14 million as at October 31, 2018). As at October 31, 2019, Other items included $19 million in litigation provisions ($9 million as at October 31, 2018). During the year ended October 31, 2019, the Bank reviewed all of the leases for its corporate buildings and recorded $45 million in provisions for onerous contracts in the Non-interest expenses – Occupancy item of the Consolidated Statement of Income and reported in the Other heading of segment results. As at October 31, 2019, other items included $48 million in provisions for onerous contracts ($3 million as at October 31, 2018). 170 0 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 1155 –– SSuubboorrddiinnaatteedd DDeebbtt The subordinated debt represents direct unsecured obligations, in the form of notes and debentures, to the Bank’s debt holders. The rights of the Bank’s note and debenture holders are subordinate to the claims of depositors and certain other creditors. Approval from OSFI is required before the Bank can redeem its subordinated notes and debentures in whole or in part. On February 1, 2018, the Bank had issued medium-term notes for a total amount of $750 million, bearing interest at 3.183% and maturing on February 1, 2028. As at October 31 22001199 2018 MMaattuurriittyy ddaattee IInntteerreesstt rraattee CChhaarraacctteerriissttiiccss February February 2028 2087 3.183%(1) Redeemable(2) Variable(3) Redeemable at the Bank’s option since February 28, 1993 Fair value hedge adjustment Unamortized issuance costs(4) TToottaall 775500 99 775599 1155 ((11)) 777733 750 9 759 (10) (2) 747 (1) Bearing interest at a rate of 3.183%, payable semi-annually until February 1, 2023, and thereafter bearing interest at a floating rate equal to the rate on three-month CDOR plus 0.72%, payable quarterly. (2) With the prior approval of OSFI, the Bank may, at its option, redeem these notes as of February 1, 2023, in whole or in part, at their nominal value plus accrued and unpaid interest. These notes contain non-viability contingent capital (NVCC) provisions and qualify for the purposes of calculating regulatory capital under Basel III. In the case of a trigger event as defined by OSFI, each note will be automatically and immediately converted, on a full and permanent basis, without the consent of the holder, into a specified number of common shares of the Bank as determined using an automatic conversion formula with a multiplier of 1.5 and a conversion price based on the greater of: (i) a floor price of $5.00; (ii) the current market price of common shares, which represents the volume weighted average price of common shares for the ten trading days ending on the trading day preceding the date of the trigger event. If the common shares are not listed on an exchange when this price is being established, the price will be the fair value reasonably determined by the Bank’s Board. The number of shares issued is determined by dividing the par value of the note (plus accrued and unpaid interest on such note) by the conversion price and then applying the multiplier. Debentures denominated in foreign currency totalling US$7 million as at October 31, 2019 (2018: US$7 million) and bearing interest at a rate of 1/8% above six-month LIBOR. The unamortized costs related to the issuance of the subordinated debt represent the initial cost, net of accumulated amortization, calculated using the effective interest rate method. (3) (4) NNoottee 1166 –– DDeerriivvaattiivvee FFiinnaanncciiaall IInnssttrruummeennttss Derivative financial instruments are financial contracts whose value is derived from an underlying interest rate, exchange rate, equity price, commodity price, credit spread or index. The main types of derivative financial instruments used are presented below. FFoorrwwaarrddss aanndd FFuuttuurreess Forwards and futures are contractual obligations to buy or deliver a specified amount of currency, interest rate, commodity, or financial instrument on a specified future date at a specified price. Forwards are tailor-made agreements transacted in the over-the-counter market. Futures are traded on organized exchanges and are subject to cash margining calculated daily by clearing houses. SSwwaappss Swaps are over-the-counter contracts in which two parties agree to exchange cash flows. The Bank uses the following types of swap contracts:  Cross-currency swaps are transactions in which counterparties exchange fixed-rate interest payments and principal payments in different currencies.  Interest rate swaps are transactions in which counterparties exchange fixed and floating rate interest payments based on the notional principal value in the same currency.  Commodity swaps are transactions in which counterparties exchange fixed and floating rate payments based on the notional principal value of a commodity. Equity swaps are transactions in which counterparties agree to exchange the return on one equity or group of equities for a payment based on a benchmark  interest rate.  Credit default swaps are transactions in which one of the parties agrees to pay returns to the other party so that the latter can make a payment if a credit event occurs. OOppttiioonnss Options are agreements between two parties in which the writer of the option grants the buyer the right, but not the obligation, to buy or sell, either at a specified date or dates or at any time prior to a predetermined expiry date, a specific amount of currency, commodity, or financial instrument at an agreed-upon price upon the sale of the option. The writer receives a premium for the sale of this instrument. National Bank of Canada 171 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 16 –– Derivative Financial Instruments (cont.) NNoottiioonnaall AAmmoouunnttss(1) As at October 31 IInntteerreesstt rraattee ccoonnttrraaccttss OOTTCC ccoonnttrraaccttss Forward rate agreements Not settled by central counterparties Settled by central counterparties Swaps Not settled by central counterparties Settled by central counterparties Options purchased Options written EExxcchhaannggee--ttrraaddeedd ccoonnttrraaccttss Futures Long positions Short positions Options purchased Options written FFoorreeiiggnn eexxcchhaannggee ccoonnttrraaccttss OOTTCC ccoonnttrraaccttss Forwards Swaps Options purchased Options written EExxcchhaannggee--ttrraaddeedd ccoonnttrraaccttss Futures Long positions Short positions EEqquuiittyy,, ccoommmmooddiittyy aanndd ccrreeddiitt ddeerriivvaattiivvee ccoonnttrraaccttss(2) OOTTCC ccoonnttrraaccttss Forwards Swaps Not settled by central counterparties Settled by central counterparties Options purchased Options written EExxcchhaannggee--ttrraaddeedd ccoonnttrraaccttss Futures Long positions Short positions Options purchased Options written 33 mmoonntthhss oorr lleessss OOvveerr 33 mmoonntthhss ttoo 1122 mmoonntthhss OOvveerr 11 yyeeaarr ttoo 55 yyeeaarrss OOvveerr 55 yyeeaarrss TToottaall ccoonnttrraaccttss CCoonnttrraaccttss hheelldd ffoorr ttrraaddiinngg ppuurrppoosseess CCoonnttrraaccttss ddeessiiggnnaatteedd aass hheeddggeess Total contracts TTeerrmm ttoo mmaattuurriittyy 22001199 2018 44,,224411 −− 88,,883311 115577,,775533 2288 111144 117700,,996677 2255,,557766 99,,002200 1155,,440000 116655 5500,,116611 1122,,996600 114499,,881111 66,,007755 66,,001188 117744,,886644 8800 3355 111155 2244 4455,,995555 222200 226699 8833 4466,,555511 55,,115533 1111,,886655 22,,990022 22,,222244 2222,,114444 446644,,880022 11,,002288 117744 1155,,331155 115577,,663388 11,,777777 220077 117766,,113399 88,,117799 77,,775500 22,,669988 11,,669988 2200,,332255 88,,773311 6611,,666600 66,,006655 66,,443344 8822,,889900 −− −− −− −− 558800 6600,,776655 220077,,882244 33,,666688 11,,225533 227744,,009900 778855 44,,447799 −− −− 55,,226644 66,,009900 7755,,779911 11,,551111 11,,111144 8844,,550066 −− −− −− −− −− 4422,,446622 6666,,661122 22,,998899 44,,002211 111166,,008844 −− −− −− −− −− 11,,116677 2255,,662222 −− −− 2266,,778899 55,,226699 775544 112277,,337733 558899,,882277 88,,446622 55,,559955 773377,,228800 3344,,554400 2211,,224499 1188,,009988 11,,886633 7755,,775500 2288,,994488 331122,,888844 1133,,665511 1133,,556666 336699,,004499 −− −− −− 8800 3355 111155 6611 11,,555511 119977 11,,883333 334422 22,,002266 22 111177 22,,668844 7744,,440066 66,,445544 11,,110088 11,,335588 8855,,115599 2200,,885599 115544 4400 117744 2211,,228888 331144 11,,660055 330055 770033 22,,992277 330033,,556699 77,,225500 44,,005544 779977 998844 1144,,663366 339900 777777 222200 994422 22,,332299 338800,,882255 55,,226699 775544 112244,,883322 555522,,777744 88,,225522 44,,550066 669966,,338877 3344,,554400 2211,,224499 1188,,009988 11,,886633 7755,,775500 2288,,994488 229955,,111100 1133,,665511 1133,,556666 335511,,227755 8800 3355 111155 11,,883333 7744,,440066 66,,445544 11,,110088 11,,335588 8855,,115599 −− −− 22,,554411 3377,,005533 221100 11,,008899 4400,,889933 −− −− −− −− −− −− 1177,,777744 −− −− 1177,,777744 −− −− −− −− −− −− −− −− −− 1,680 2,172 129,201 408,729 5,438 2,018 549,238 27,498 26,556 26,189 − 80,243 32,178 199,911 12,322 11,115 255,526 59 238 297 1,976 46,874 2,438 1,523 1,436 54,247 7,699 11,691 2,243 3,468 25,101 964,652 115588 −− −− 44 116622 114455,,771199 66,,001155 1144,,224477 33,,442277 33,,887733 2277,,556622 11,,229944,,991155 66,,001155 1144,,224477 33,,442277 33,,887733 2277,,556622 11,,223366,,224488 −− −− −− −− −− 5588,,666677 (1) (2) Notional amounts are not presented in assets or liabilities on the Consolidated Balance Sheet. They represent the reference amount of the contract to which a rate or price is applied to determine the amount of cash flows to be exchanged. Includes precious metal contracts. 172 2 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) CCrreeddiitt RRiisskk Credit risk on derivative financial instruments is the risk of financial loss that the Bank will have to assume if a counterparty fails to honour its contractual obligations. Credit risk related to derivative financial instruments is subject to the same credit approval, credit limit and credit monitoring standards as those applied to the Bank’s other credit transactions. Consequently, the Bank evaluates the creditworthiness of counterparties and manages the size of the portfolios as well as the diversification and maturity profiles of these financial instruments. The Bank limits the credit risk of over-the-counter contracts by dealing with creditworthy counterparties and entering into contracts that provide for the exchange of collateral between parties where the fair value of the outstanding transactions exceeds an agreed threshold. The Bank also negotiates master netting agreements that provide for the simultaneous close-out and settling of all transactions with a given counterparty in the event of default, insolvency, or bankruptcy. However, overall exposure to credit risk, reduced through master netting agreements, may change substantially after the balance sheet date because it is affected by all transactions subject to a contract as well as by changes in the market rates of the underlying instruments. The Bank also uses financial intermediaries to have access to established clearing houses in order to minimize the settlement risk arising from financial derivative transactions. In some cases, the Bank has direct access to clearing houses for settling derivative financial instruments. In addition, certain derivative financial instruments traded over the counter are settled directly or indirectly by central counterparties. In the case of exchange-traded contracts, exposure to credit risk is limited because these transactions are standardized contracts executed on established exchanges, each of which is associated with a well-capitalized clearing house that assumes the obligations of both counterparties and guarantees their performance obligations. All exchange-traded contracts are subject to initial margins and daily settlement. TTeerrmmss UUsseedd Replacement Cost Replacement cost is the Bank’s maximum credit risk associated with derivative financial instruments as at the Consolidated Balance Sheet date. This amount is the positive fair value of all derivative financial instruments, before all master netting agreements and collateral held. Credit Risk Equivalent The credit risk equivalent amount is the total replacement cost plus an amount representing the potential future credit risk exposure, as outlined in OSFI’s Capital Adequacy Requirements Guideline. Risk-Weighted Amount The risk-weighted amount is determined by applying the OSFI guidance to the credit risk equivalent. CCrreeddiitt RRiisskk EExxppoossuurree ooff tthhee DDeerriivvaattiivvee FFiinnaanncciiaall IInnssttrruummeenntt PPoorrttffoolliioo As at October 31 Interest rate contracts Foreign exchange contracts Equity, commodity and credit derivative contracts Impact of master netting agreements RReeppllaacceemmeenntt ccoosstt CCrreeddiitt rriisskk eeqquuiivvaalleenntt(1) 22,,660033 33,,110033 22,,442233 88,,112299 ((33,,441155)) 44,,771144 66,,668855 44,,557700 22,,991177 1144,,117722 1144,,117722 22001199 RRiisskk-- wweeiigghhtteedd aammoouunntt(1) 996688 11,,551155 11,,111199 33,,660022 33,,660022 Replacement cost(2) Credit risk equivalent 1,943 3,533 3,034 8,510 (3,151) 5,359 7,961 11,043 6,919 25,923 (8,300) 17,623 2018 Risk- weighted amount 649 1,853 673 3,175 (863) 2,312 (1) (2) After application of the Standardized Approach for Measuring Counterparty Credit Risk on November 1, 2018, the amounts are presented net of the Impact of master netting agreements. As at October 31, 2018, the total positive fair value of exchange-traded contracts amounting to $98 million was excluded. CCrreeddiitt RRiisskk EExxppoossuurree ooff tthhee DDeerriivvaattiivvee FFiinnaanncciiaall IInnssttrruummeenntt PPoorrttffoolliioo bbyy CCoouunntteerrppaarrttyy As at October 31 OECD(1) governments Banks of OECD member countries Other (1) Organisation for Economic Co-operation and Development. RReeppllaacceemmeenntt ccoosstt 11,,004488 667700 22,,999966 44,,771144 22001199 CCrreeddiitt rriisskk eeqquuiivvaalleenntt 22,,007777 33,,772200 88,,337755 1144,,117722 Replacement cost 1,051 816 3,492 5,359 2018 Credit risk equivalent 1,855 4,197 11,571 17,623 National Bank of Canada 173 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 16 –– Derivative Financial Instruments (cont.) FFaaiirr VVaalluuee ooff DDeerriivvaattiivvee FFiinnaanncciiaall IInnssttrruummeennttss As at October 31 CCoonnttrraaccttss hheelldd ffoorr ttrraaddiinngg ppuurrppoosseess IInntteerreesstt rraattee ccoonnttrraaccttss Forwards Swaps Options FFoorreeiiggnn eexxcchhaannggee ccoonnttrraaccttss Forwards Swaps Options EEqquuiittyy,, ccoommmmooddiittyy aanndd ccrreeddiitt ddeerriivvaattiivvee ccoonnttrraaccttss Forwards Swaps Options Total – Contracts held for trading purposes CCoonnttrraaccttss ddeessiiggnnaatteedd aass hheeddggeess IInntteerreesstt rraattee ccoonnttrraaccttss Forwards Swaps Options FFoorreeiiggnn eexxcchhaannggee ccoonnttrraaccttss Forwards Swaps Options EEqquuiittyy,, ccoommmmooddiittyy aanndd ccrreeddiitt ddeerriivvaattiivvee ccoonnttrraaccttss Forwards Swaps Options Total – Contracts designated as hedges Designated as fair value hedges Designated as cash flow hedges Designated as a hedge of a net investment in a foreign operation TToottaall ffaaiirr vvaalluuee Impact of master netting agreements NNoottee 1177 –– HHeeddggiinngg AAccttiivviittiieess PPoossiittiivvee NNeeggaattiivvee 3366 11,,880088 9977 11,,994411 229988 22,,661188 112277 33,,004433 11,,005500 11,,003300 334433 22,,442233 77,,440077 −− 666622 −− 666622 −− 6600 −− 6600 −− −− −− −− 772222 446611 226611 5599 11,,774422 7700 11,,887711 118800 22,,226633 110099 22,,555522 7722 11,,443399 440055 11,,991166 66,,333399 −− 225522 220066 445588 −− 5555 −− 5555 −− −− −− −− 551133 332200 119933 −− 88,,112299 ((33,,441155)) 44,,771144 −− 66,,885522 ((33,,441155)) 33,,443377 22001199 NNeett ((2233)) 6666 2277 7700 111188 335555 1188 449911 997788 ((440099)) ((6622)) 550077 11,,006688 −− 441100 ((220066)) 220044 −− 55 −− 55 −− −− −− −− 220099 114411 6688 −− 11,,227777 −− 11,,227777 Positive Negative 16 1,392 61 1,469 428 2,892 157 3,477 854 1,929 336 3,119 8,065 − 487 − 487 − 56 − 56 − − − − 543 197 346 10 1,486 41 1,537 243 1,956 139 2,338 62 997 431 1,490 5,365 − 403 81 484 − 187 − 187 − − − − 671 476 195 − 8,608 (3,151) 5,457 − 6,036 (3,151) 2,885 2018 Net 6 (94) 20 (68) 185 936 18 1,139 792 932 (95) 1,629 2,700 − 84 (81) 3 − (131) − (131) − − − − (128) (279) 151 − 2,572 − 2,572 The Bank’s market risk exposure, risk management objectives, policies and procedures, and risk measurement methods are presented in the Risk Management section of the MD&A for the year ended October 31, 2019. The Bank has elected, as permitted under IFRS 9, to continue applying the hedge accounting requirements of IAS 39. Some of the tables present information on currencies, specifically, the Canadian dollar (CAD), the Chinese yuan renminbi (CNH), the Hong Kong dollar (HKD), the U.S. dollar (USD), the euro (EUR), the pound sterling (GBP) and the Brazilian real (BRL). 174 4 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) The following table shows the notional amounts and the weighted average rates by term to maturity of the designated derivative instruments and their fair value by type of hedging relationship. As at October 31 OOvveerr 11 yyeeaarr ttoo 22 yyeeaarrss 11 yyeeaarr oorr lleessss TTeerrmm ttoo mmaattuurriittyy OOvveerr 22 yyeeaarrss ttoo 55 yyeeaarrss OOvveerr 55 yyeeaarrss 22001199 FFaaiirr vvaalluuee 2018 Fair value TToottaall AAsssseettss LLiiaabbiilliittiieess Total Assets Liabilities FFaaiirr vvaalluuee hheeddggeess IInntteerreesstt rraattee rriisskk Interest rate swaps Notional amount – LIBOR reform(1) Notional amount – Other Average fixed interest rate – Pay fixed Average fixed interest rate – Receive fixed Cross-currency swaps Notional amount – LIBOR reform(1) Notional amount – Other Average CAD-CNH exchange rate Average CAD-HKD exchange rate Options Notional amount – LIBOR reform(1) Notional amount – Other Average fixed interest rate – Purchased Average fixed interest rate – Written CCaasshh ffllooww hheeddggeess IInntteerreesstt rraattee rriisskk Interest rate swaps Notional amount – LIBOR reform(1) Notional amount – Other Average fixed interest rate – Pay fixed Average fixed interest rate – Receive fixed Cross-currency swaps Notional amount – LIBOR reform(1) Notional amount – Other Average CAD-USD exchange rate Average USD-EUR exchange rate Average USD-GBP exchange rate EEqquuiittyy pprriiccee rriisskk Equity swaps Notional amount Average price HHeeddggeess ooff nneett iinnvveessttmmeennttss iinn ffoorreeiiggnn ooppeerraattiioonnss(2) FFoorreeiiggnn eexxcchhaannggee rriisskk Cross-currency swaps Notional amount Average CAD-USD exchange rate Average USD-BRL exchange rate Average USD-HKD exchange rate 11,,006611 33,,338811 555544 66,,554411 11,,776688 33,,660000 22,,332222 1144,,558833 −− %% 00..88 %% 11..77 %% 00..88 %% 22..00 %% 22..22 %% 11..99 %% 22..66 %% 11..99 %% 22..11 %% 111122 $$ 00..11886644 −− 331144 00..11 %% 22..44 %% 11,,448877 −− 111166 −− $$ 00..11662211 −− −− −− −− −− −− −− −− 222288 $$ 00..11886644 $$ 00..11662211 3355 00..11 %% 22..44 %% 4400 2222 ((00..88)) %% 22..77 %% 339955 449933 −− %% 22..88 %% 443355 886644 00..11 %% 22..77 %% 445511 111144 14,019 193 357 1.8 % 2.2 % 1100 −− 888 4 38 $ 0.1955 $ 0.1621 −− 220066 1,454 − 81 − % 2.7 % 33,,441166 77,,227733 66,,225566 1188,,443322 446611 332200 16,361 197 476 22,,774400 22..11 %% 11..99 %% 771177 22..11 %% −− %% 11,,118855 1144,,886600 −− 33,,118877 11,,118855 2211,,550044 22..00 %% 00..77 %% 22..22 %% 00..77 %% 22..00 %% 00..88 %% 221111 113388 17,419 294 46 2.1 % 0.8 % 5500 5555 12,144 52 149 11,,443355 33,,003344 22,,330022 −− $$ 11..33007766 $$ 11..33224433 $$ 11..33110011 $$ 11..22883388 $$ 11..22227788 $$ 11..11113311 $$ 11..11335511 $$ 11..22229955 −− 1100,,776655 −− $$ 11..22992211 −− −− 1133,,006677 44,,446699 $$ 11..33007744 $$ 11..11662266 $$ 11..22992211 $ 1.2976 $ 1.1742 $ 1.3012 −− −− 55,,777744 −− −− −− −− −− −− −− −− −− −− 109 $ 62.42 − − 22,,115522 2266,,881100 55,,448899 4400,,222255 226611 119933 29,672 346 195 1100 $$ 11..33228866 −− $$ 00..11227777 1100 77,,227711 −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− 1100 $$ 11..33228866 −− $$ 00..11227777 1100 55,,556688 3344,,008833 1111,,774455 5588,,666677 −− −− 772222 −− 15 $ 1.2929 $ 0.2508 $ 0.1281 15 −− 551133 46,048 − − − 543 − 671 (1) (2) The benchmark interest rate reform is a global initiative led and coordinated by central banks and governments around the world, including those in Canada. In July 2017, the UK Financial Conduct Committee (FCA) stated that, after 2021, it will no longer compel banks to submit rates used for the calculation of the London Interbank Offered Rate (LIBOR). The Bank has formed a team that is conducting a Bank-wide impact analysis. It is currently inventorying all of the Bank’s contractual arrangements linked to LIBOR, assessing the Bank’s exposures to LIBOR instruments and identifying impacts on the Bank’s products, systems and processes with the intention of minimizing the impacts through appropriate mitigating actions. The Bank is also actively involved in industry working groups and will continue to monitor industry progress. As at October 31, 2019, the Bank also designated $958 million in foreign currency deposits denominated in U.S. dollars as net investment hedging instruments ($1,035 million in foreign currency deposits denominated in U.S. dollars and euros as net investment hedging instruments as at October 31, 2018). National Bank of Canada 175 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 17 – Hedging Activities (cont.) FFaaiirr VVaalluuee HHeeddggeess Fair value hedge transactions consist of using derivative financial instruments (interest rate swaps and options) to hedge changes in the fair value of a financial asset or financial liability caused by interest rate fluctuations. Changes in the fair values of the derivative financial instruments used as hedging instruments offset changes in the fair value of the hedged items. The Bank applies this strategy mainly to portfolios of securities measured at fair value through other comprehensive income, fixed-rate deposits, liabilities related to transferred receivables, and subordinated debt. In addition, when a fixed-rate asset or liability is denominated in a foreign currency, the Bank sometimes uses cross-currency swaps to hedge the associated foreign exchange risk. The Bank may designate a cross-currency swap to exchange the fixed-rate foreign currency for the functional currency at a floating rate in a single hedging relationship addressing both interest rate risk and foreign exchange risk. In certain cases, given that interest rate risk and foreign exchange risk are hedged in a single hedging relationship, the information below does not distinguish between interest rate risk and the combination of interest rate risk and foreign exchange risk as two separate risk categories. The Bank applies this strategy mainly to foreign currency fixed-rate deposits. Regression analysis is used to test hedge effectiveness and determine the hedge ratio. For fair value hedges, the main source of potential hedge ineffectiveness is a circumstance where the critical terms of the hedging instrument and the hedged item are not closely aligned. The following tables show amounts related to hedged items as well as the results of the fair value hedges. CCaarrrryyiinngg vvaalluuee ooff hheeddggeedd iitteemmss 88,,334444 44,,666677 33,,666633 775522 Carrying value of hedged items 3,315 6,367 4,482 737 AAss aatt OOccttoobbeerr 3311,, 22001199 CCuummuullaattiivvee aaddjjuussttmmeennttss ffrroomm ddiissccoonnttiinnuueedd hheeddggeess CCuummuullaattiivvee hheeddggee aaddjjuussttmmeennttss ffrroomm aaccttiivvee hheeddggeess YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 GGaaiinnss ((lloosssseess)) oonn tthhee hheeddggeedd iitteemmss ffoorr iinneeffffeeccttiivveenneessss mmeeaassuurreemmeenntt(1) GGaaiinnss ((lloosssseess)) oonn tthhee hheeddggiinngg iinnssttrruummeennttss ffoorr iinneeffffeeccttiivveenneessss mmeeaassuurreemmeenntt(1) HHeeddggee iinneeffffeeccttiivveenneessss(1) 7788 111122 5599 1155 99 4488 7799 −− 221100 ((339966)) ((119988)) ((2255)) ((440099)) ((220088)) 339955 119977 2266 441100 22 ((11)) ((11)) 11 11 As at October 31, 2018 Cumulative adjustments from discontinued hedges Cumulative hedge adjustments from active hedges Year ended October 31, 2018 Gains (losses) on the hedged items for ineffectiveness measurement(1) Gains (losses) on the hedging instruments for ineffectiveness measurement(1) Hedge ineffectiveness(1) (78) (258) (89) (10) (11) 20 50 − (144) 264 123 10 253 144 (262) (122) (10) (250) − 2 1 − 3 Securities at fair value through other comprehensive income Deposits Liabilities related to transferred receivables Subordinated debt Securities at fair value through other comprehensive income Deposits Liabilities related to transferred receivables Subordinated debt (1) Amounts are presented on a pre-tax basis. 176 6 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) CCaasshh FFllooww HHeeddggeess Cash flow hedge transactions consist of using interest rate swaps to hedge the risk of changes in future cash flows caused by floating-rate assets or liabilities. In addition, the Bank sometimes uses cross-currency swaps to hedge the foreign exchange risk caused by assets or liabilities denominated in foreign currencies. In certain cases, given that interest rate risk and foreign exchange risk are hedged in a single hedging relationship, the information below does not distinguish between interest rate risk and the combination of interest rate risk and foreign exchange risk as two separate risk categories. The Bank applies this strategy mainly to its loan, personal credit line, acceptance, and deposit portfolios. The Bank also uses total return swaps to hedge the risk of changes in future cash flows related to the Restricted Stock Unit (RSU) Plan. Some of these swaps are designated as part of a cash flow hedge against a portion of the unrecognized obligation of the RSU Plan. In cash flow hedges, the derivative financial instruments used as hedging instruments reduce the variability of the future cash flows related to the hedged items. Regression analysis is used to assess hedge effectiveness and to determine the hedge ratio. For cash flow hedges, the main source of potential hedge ineffectiveness is a circumstance where the critical terms of the hedging instrument and the hedged item are not closely aligned. The following tables show the amounts related to hedged items as well as the results of the cash flow hedges. AAss aatt OOccttoobbeerr 3311,, 22001199 YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 AAccccuummuullaatteedd ootthheerr ccoommpprreehheennssiivvee iinnccoommee ffrroomm aaccttiivvee hheeddggeess AAccccuummuullaatteedd ootthheerr ccoommpprreehheennssiivvee iinnccoommee ffrroomm ddiissccoonnttiinnuueedd hheeddggeess GGaaiinnss ((lloosssseess)) oonn hheeddggeedd iitteemmss ffoorr iinneeffffeeccttiivveenneessss mmeeaassuurreemmeenntt(1) GGaaiinnss ((lloosssseess)) oonn hheeddggiinngg iinnssttrruummeennttss ffoorr iinneeffffeeccttiivveenneessss mmeeaassuurreemmeenntt(1) HHeeddggee iinneeffffeeccttiivveenneessss(1) UUnnrreeaalliizzeedd ggaaiinnss ((lloosssseess)) iinncclluuddeedd iinn OOtthheerr ccoommpprreehheennssiivvee iinnccoommee aass tthhee eeffffeeccttiivvee ppoorrttiioonn ooff tthhee hheeddggiinngg iinnssttrruummeenntt(1) LLoosssseess ((ggaaiinnss)) rreeccllaassssiiffiieedd ttoo NNeett iinntteerreesstt iinnccoommee(1) −− 3300 44 3344 −− 3344 ((1144)) 99 ((4444)) ((4499)) 1100 ((3399)) ((4455)) 115544 113333 224422 ((66)) 223366 4455 ((115544)) ((113355)) ((224444)) 66 ((223388)) −− −− ((22)) ((22)) −− ((22)) 4455 ((110088)) ((113333)) ((119966)) 99 ((118877)) ((1166)) ((1100)) 22 ((2244)) ((33)) ((2277)) As at October 31, 2018 Year ended October 31, 2018 Accumulated other comprehensive income from active hedges Accumulated other comprehensive income from discontinued hedges Gains (losses) on hedged items for ineffectiveness measurement(1) Gains (losses) on hedging instruments for ineffectiveness measurement(1) Hedge ineffectiveness(1) Unrealized gains (losses) included in Other comprehensive income as the effective portion of the hedging instrument(1) Losses (gains) reclassified to Net interest income(1) (16) 138 54 176 (3) 173 (26) 19 37 30 7 37 54 (84) (70) (100) 23 (77) (53) 86 68 101 (23) 78 − − 1 1 − 1 (53) 78 68 93 (23) 70 (36) (10) (17) (63) − (63) IInntteerreesstt rraattee rriisskk Loans Deposits Acceptances EEqquuiittyy pprriiccee rriisskk Other liabilities IInntteerreesstt rraattee rriisskk Loans Deposits Acceptances EEqquuiittyy pprriiccee rriisskk Other liabilities (1) Amounts are presented on a pre-tax basis. National Bank of Canada 177 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 17 – Hedging Activities (cont.) HHeeddggeess ooff NNeett IInnvveessttmmeennttss iinn FFoorreeiiggnn OOppeerraattiioonnss The Bank’s structural foreign exchange risk arises from investments in foreign operations denominated in currencies other than the Canadian dollar. The Bank measures this risk by assessing the impact of foreign currency fluctuations and hedges it using derivative and non-derivative financial instruments (cross- currency swaps and deposits). In a hedge of a net investment in a foreign operation (net investment hedge), the financial instruments used offset the foreign exchange gains and losses on the investments. When non-derivative financial instruments are designated as foreign exchange risk hedges, only the changes in fair value that are attributable to foreign exchange risk are taken into account when assessing and calculating the effectiveness of the hedge. Assessing the effectiveness of net investment hedges consists of comparing changes in the carrying value of the deposits or the fair value of the derivative attributable to exchange rate fluctuations with changes in the net investment in a foreign operation attributable to exchange rate fluctuations. Inasmuch as the notional amount of the hedging instruments and the hedged net investments are aligned, no ineffectiveness is expected. The following tables present the amounts related to hedged items as well as the results of the net investment hedges. NNeett iinnvveessttmmeennttss iinn ffoorreeiiggnn ooppeerraattiioonnss ddeennoommiinnaatteedd iinn:: USD EUR BRL Other currencies AAss aatt OOccttoobbeerr 3311,, 22001199 YYeeaarr eennddeedd OOccttoobbeerr 3311,, 22001199 AAccccuummuullaatteedd ootthheerr ccoommpprreehheennssiivvee iinnccoommee ffrroomm aaccttiivvee hheeddggeess AAccccuummuullaatteedd ootthheerr ccoommpprreehheennssiivvee iinnccoommee ffrroomm ddiissccoonnttiinnuueedd hheeddggeess GGaaiinnss ((lloosssseess)) oonn hheeddggeedd iitteemmss ffoorr iinneeffffeeccttiivveenneessss mmeeaassuurreemmeenntt(1) GGaaiinnss ((lloosssseess)) oonn hheeddggiinngg iinnssttrruummeennttss ffoorr iinneeffffeeccttiivveenneessss mmeeaassuurreemmeenntt(1) HHeeddggee iinneeffffeeccttiivveenneessss(1) UUnnrreeaalliizzeedd ggaaiinnss ((lloosssseess)) iinncclluuddeedd iinn OOtthheerr ccoommpprreehheennssiivvee iinnccoommee aass tthhee eeffffeeccttiivvee ppoorrttiioonn ooff tthhee hheeddggiinngg iinnssttrruummeenntt(1) LLoosssseess ((ggaaiinnss)) rreeccllaassssiiffiieedd ttoo tthhee NNoonn--iinntteerreesstt iinnccoommee iitteemm(1) 77 −− −− −− 77 ((119911)) −− 3366 −− ((115555)) ((55)) −− −− ((11)) ((66)) 55 −− −− 11 66 −− −− −− −− −− 55 −− −− 11 66 −− 33 −− ((11)) 22 As at October 31, 2018 Year ended October 31, 2018 Accumulated other comprehensive income from active hedges Accumulated other comprehensive income from discontinued hedges Gains (losses) on hedged items for ineffectiveness measurement(1) Gains (losses) on hedging instruments for ineffectiveness measurement(1) Hedge ineffectiveness(1) Unrealized gains (losses) included in Other comprehensive income as the effective portion of the hedging instrument(1) Losses (gains) reclassified to the Non-interest income item(1) NNeett iinnvveessttmmeennttss iinn ffoorreeiiggnn ooppeerraattiioonnss ddeennoommiinnaatteedd iinn:: USD EUR BRL Other currencies (1) Amounts are presented on a pre-tax basis. (2) 1 (1) − (2) (187) (4) 37 − (154) 17 (1) (3) − 13 (17) 1 3 − (13) − − − − − (17) 1 3 − (13) − − − − − 178 8 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) RReeccoonncciilliiaattiioonn ooff EEqquuiittyy CCoommppoonneennttss The following table presents a reconciliation by risk category of Accumulated other comprehensive income attributable to hedge accounting. As at October 31 Balance at beginning HHeeddggeess ooff nneett iinnvveessttmmeennttss iinn ffoorreeiiggnn ooppeerraattiioonnss(1) Gains (losses) included as the effective portion Losses (gains) reclassified to Non-interest income Foreign currency translation gains (losses) on investments in foreign operations CCaasshh ffllooww hheeddggeess(1) Gains (losses) included as the effective portion Interest rate risk Equity price risk Losses (gains) reclassified to Net interest income Interest rate risk Equity price risk Other comprehensive income attributable to non-controlling interests Income taxes BBaallaannccee aatt eenndd (1) Amounts are presented on a pre-tax basis. NNeett ggaaiinnss ((lloosssseess)) oonn ccaasshh ffllooww hheeddggeess 115511 ((119966)) 99 ((2244)) ((33)) −− 5577 ((66)) 22001199 NNeett ffoorreeiiggnn ccuurrrreennccyy ttrraannssllaattiioonn aaddjjuussttmmeennttss 1144 66 22 ((99)) 11 ((66)) 88 Net gains (losses) on cash flow hedges 146 93 (23) (63) − − (2) 151 2018 Net foreign currency translation adjustments (13) (13) − 42 (1) (1) 14 National Bank of Canada 179 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 1188 –– SShhaarree CCaappiittaall AAuutthhoorriizzeedd Common Shares An unlimited number of shares without par value. First Preferred Shares An unlimited number of shares, without par value, issuable for a maximum aggregate consideration of $5 billion. FFiirrsstt PPrreeffeerrrreedd SShhaarreess Redemption and conversion date(1)(2) Redemption price per share ($)(1) Convertible into preferred shares(2) Dividend per share ($)(3) Reset premium As at October 31, 2019 May 15, 2024 (5)(6) February 15, 2020 (5)(6) May 15, 2021 (5)(6) August 15, 2021 (5)(6) November 15, 2022 (5)(6) May 15, 2023 (5)(6) November 15, 2023 (5)(6) July 31, 2013 May 15, 2024 (5) February 15, 2020 (5) May 15, 2021 (5) August 15, 2021 (5) November 15, 2022 (5) May 15, 2023 (5) November 15, 2023 (5) 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 (10) 25.50 (12) 25.50 (12) 25.50 (12) 25.50 (12) 25.50 (12) 25.50 (12) Series 31 Series 33 Series 35 Series 37 Series 39 Series 41 Series 43 0.25156 (7) 0.24375 (8) 0.35000 (8) 0.33750 (8) 0.27813 (8) 0.28750 (8) 0.30938 (8) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 0.75000 Floating rate (11) Floating rate (11) Floating rate (11) Floating rate (11) Floating rate (11) Floating rate (11) Floating rate (11) 2.40 % 2.25 % 4.90 % 4.66 % 3.43 % 2.58 % 2.77 % n.a. 2.40 % 2.25 % 4.90 % 4.66 % 3.43 % 2.58 % 2.77 % FFiirrsstt pprreeffeerrrreedd sshhaarreess iissssuueedd aanndd oouuttssttaannddiinngg Series 30(4) Series 32(4) Series 34(4) Series 36(4) Series 38(4) Series 40(4) Series 42(4) FFiirrsstt pprreeffeerrrreedd sshhaarreess aauutthhoorriizzeedd bbuutt nnoott iissssuueedd Series 23(9) Series 31(4) Series 33(4) Series 35(4) Series 37(4) Series 39(4) Series 41(4) Series 43(4) n.a. (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) Not applicable Redeemable in cash at the Bank’s option, in whole or in part, subject to the provisions of the Bank Act (Canada) and to OSFI approval. Redemption prices are increased by all the declared and unpaid dividends on the preferred shares to the date fixed for redemption. Convertible at the option of the holders of first preferred shares, subject to certain conditions. The dividends are non-cumulative and payable quarterly, except for Series 23, for which the dividends are payable semi-annually. Upon the occurrence of a trigger event as defined by OSFI, each outstanding preferred share will be automatically and immediately converted, on a full and permanent basis, without the consent of the holder, into a number of common shares of the Bank determined pursuant to an automatic conversion formula. This conversion will be calculated by dividing the value of the preferred shares, i.e., $25.00 per share, plus all declared and unpaid dividends as at the date of the trigger event, by the value of the common shares. The value of the common shares will be the greater of a $5.00 floor price or the current market price of the common shares. Current market price means the volume weighted average trading price of common shares for the ten consecutive trading days ending on the trading day preceding the date of the trigger event. If the common shares are not listed on an exchange when this price is being established, the price will be the fair value reasonably determined by the Bank’s Board. Redeemable on the date fixed for redemption and on the same date every five years thereafter. Convertible on the date fixed for conversion and on the same date every five years thereafter, subject to certain conditions. The dividend amount is set for the five-year period commencing on May 16, 2019 and ending on the date fixed for redemption. Thereafter, these shares carry a non-cumulative quarterly fixed dividend in an amount per share determined by multiplying the rate of interest equal to the sum of the 5-year Government of Canada bond yield on the applicable fixed-rate calculation date by $25.00, plus the reset premium. The dividend amount is set for the initial period ending on the date fixed for redemption. Thereafter, these shares carry a non-cumulative quarterly fixed dividend in an amount per share determined by multiplying the rate of interest equal to the sum of the 5-year Government of Canada bond yield on the applicable fixed-rate calculation date by $25.00, plus the reset premium. For additional information, see Note 19 to these consolidated financial statements. As of the date fixed for redemption, and every five years thereafter, the redemption price will be $25.00 per share. The dividend period begins as of the date fixed for redemption. The amount of the floating quarterly non-cumulative dividend is determined by multiplying the rate of interest equal to the sum of the 90-day Government of Canada treasury bill yield on the floating rate calculation date by $25.00, plus the reset premium. As of the date fixed for redemption, the redemption price will be $25.50 per share. Thereafter, on the same date every five years, the redemption price will be $25.00 per share. Second Preferred Shares 15 million shares without par value, issuable for a total maximum consideration of $300 million. As at October 31, 2019, no shares had been issued or traded. 180 180 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) SShhaarreess OOuuttssttaannddiinngg As at October 31 First Preferred Shares Series 30 Series 32 Series 34 Series 36 Series 38 Series 40 Series 42 Common shares at beginning of the fiscal year Issued pursuant to the Stock Option Plan Repurchase of common shares for cancellation Impact of shares purchased or sold for trading(1) Other Common shares at end of year NNuummbbeerr ooff sshhaarreess 1144,,000000,,000000 1122,,000000,,000000 1166,,000000,,000000 1166,,000000,,000000 1166,,000000,,000000 1122,,000000,,000000 1122,,000000,,000000 9988,,000000,,000000 333355,,007700,,664422 22,,995500,,992222 ((44,,554477,,220000)) 669999,,556644 ((11,,551177)) 333344,,117722,,441111 22001199 SShhaarreess $$ 335500 330000 440000 440000 440000 330000 330000 22,,445500 22,,882222 112222 ((4400)) 4455 −− 22,,994499 Number of shares 14,000,000 12,000,000 16,000,000 16,000,000 16,000,000 12,000,000 12,000,000 98,000,000 339,591,965 3,129,313 (7,500,000) (149,430) (1,206) 335,070,642 2018 Shares $ 350 300 400 400 400 300 300 2,450 2,768 128 (64) (10) − 2,822 (1) As at October 31, 2019, there were 3,846 shares held for trading, representing a negligible amount (703,410 shares held for trading representing $45 million as at October 31, 2018). DDiivviiddeennddss DDeeccllaarreedd Year ended October 31 First Preferred Shares Series 30 Series 32 Series 34 Series 36 Series 38 Series 40 Series 42 Common shares DDiivviiddeennddss $$ 1144 1122 2222 2222 1188 1144 1144 111166 889922 11,,000088 22001199 DDiivviiddeennddss ppeerr sshhaarree 11..00115566 00..99775500 11..44000000 11..33550000 11..11112255 11..11550000 11..22337755 22..66660000 Dividends $ 14 12 22 22 18 11 6 105 829 934 2018 Dividends per share 1.0250 0.9750 1.4000 1.3500 1.1125 0.9310 0.5323 2.4400 IIssssuuaanncceess ooff PPrreeffeerrrreedd SShhaarreess On June 11, 2018, the Bank had issued 12,000,000 Non-Cumulative 5-Year Rate-Reset Series 42 First Preferred Shares at a price equal to $25.00 per share for gross proceeds of $300 million. Given that the Series 42 preferred shares satisfy the non-viability contingent capital requirements, they qualify for the purposes of calculating regulatory capital under Basel III. On January 22, 2018, the Bank had issued 12,000,000 Non-Cumulative 5-Year Rate-Reset Series 40 First Preferred Shares at a price equal to $25.00 per share for gross proceeds of $300 million. Given that the Series 40 preferred shares satisfy the non-viability contingent capital requirements, they qualify for the purposes of calculating regulatory capital under Basel III. National Bank of Canada 181 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 18 –– Share Capital (cont.) RReeppuurrcchhaasseess ooff CCoommmmoonn SShhaarreess On June 10, 2019, the Bank began a normal course issuer bid to repurchase for cancellation up to 6,000,000 common shares (representing approximately 1.80% of its outstanding common shares) over the 12-month period ending no later than June 9, 2020. On June 6, 2018, the Bank had begun a normal course issuer bid to repurchase for cancellation up to 8,000,000 common shares (representing approximately 2.36% of its outstanding common shares) over the 12-month period ended June 5, 2019. Any repurchase through the Toronto Stock Exchange will be done at market prices. The common shares may also be repurchased through other means authorized by the Toronto Stock Exchange and applicable regulations, including private agreements or share repurchase programs under issuer bid exemption orders issued by the securities regulators. A private purchase made under an exemption order issued by a securities regulator will be done at a discount to the prevailing market price. The amounts that are paid above the average book value of the common shares are charged to Retained earnings. During the year ended October 31, 2019, the Bank repurchased 4,547,200 common shares for $281 million, which reduced Common share capital by $40 million and Retained earnings by $241 million. During the year ended October 31, 2018, the Bank had repurchased 7,500,000 common shares for $467 million, which had reduced Common share capital by $64 million and Retained earnings by $403 million. RReesseerrvveedd CCoommmmoonn SShhaarreess As at October 31, 2019 and 2018, there were 15,507,568 common shares reserved under the Dividend Reinvestment and Share Purchase Plan. As at October 31, 2019, there were 20,377,278 common shares (22,894,802 as at October 31, 2018) reserved under the Stock Option Plan. CCoommmmoonn SShhaarreess HHeelldd iinn EEssccrrooww As part of the acquisition of Wellington West Holdings Inc. in 2011, the Bank had issued common shares held in escrow. In December 2016, a total of 799,563 of these shares were released to shareholders, and 108,341 shares were cancelled, mainly upon the settlement of certain indemnifications guaranteed by those shares. During the year ended October 31, 2019, a total of 870 of these shares were released to shareholders, and 1,517 shares were cancelled (during the year ended October 31, 2018, a total of 3,778 of these shares were released, and 1,206 shares were cancelled). As at October 31, 2019, the number of common shares held in escrow was 21,510 (23,897 as at October 31, 2018). The Bank expects that the remaining shares in escrow will be settled by the end of calendar year 2020. RReessttrriiccttiioonn oonn tthhee PPaayymmeenntt ooff DDiivviiddeennddss The Bank is prohibited from declaring dividends on its common or preferred shares if there are reasonable grounds for believing that the Bank would, by so doing, be in contravention of the regulations of the Bank Act (Canada) or OSFI’s capital adequacy and liquidity guidelines. In addition, the ability to pay common share dividends is restricted by the terms of the outstanding preferred shares pursuant to which the Bank may not pay dividends on its common shares without the approval of the holders of the outstanding preferred shares, unless all preferred share dividends have been declared and paid or set aside for payment. Moreover, if NBC Asset Trust were unable to pay the full amount of distributions on the trust units, the Bank would withhold from declaring dividends on any of its preferred and common shares during a determined period. For additional information, see Notes 19 and 27 to these consolidated financial statements. DDiivviiddeenndd RReeiinnvveessttmmeenntt PPllaann The Bank has a dividend reinvestment plan for common and preferred shareholders. Participation in the plan is optional. Under the terms and conditions of the plan, participants acquire shares through the reinvestment of cash dividends paid on the shares they hold or through optional cash payments. Common shares subscribed by participants are purchased on their behalf in the secondary market through the Bank’s transfer agent, Computershare Trust Company of Canada, at a price equal to the average purchase price of the common shares during the ten business days immediately following the dividend payment date. 182 182 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 1199 –– NNoonn--CCoonnttrroolllliinngg IInntteerreessttss As at October 31 Trust units issued by NBC Asset Trust (NBC CapS II) – Series 2(1) Other(2) 22001199 335599 ((11)) 335588 2018 359 20 379 (1) (2) Includes $9 million in accrued interest as at October 31, 2019 ($9 million as at October 31, 2018). During the year ended October 31, 2019, the Bank acquired the entire remaining non-controlling interest in the Cambodian subsidiary Advanced Bank of Asia Limited. For additional information, see Note 31 to these consolidated financial statements. TTrruusstt UUnniittss IIssssuueedd bbyy NNBBCC AAsssseett TTrruusstt Through structured entity NBC Asset Trust (the Trust), a closed-end trust established under the laws of the Province of Ontario, the Bank issued transferable non- voting trust units called “Trust Capital Securities” or “NBC CapS II.” These securities are not redeemable or exchangeable for Bank preferred shares at the option of the holder. The gross proceeds from the issuance were used by the Trust to finance the acquisition of mortgage loans from the Bank. For additional information, see Note 27 to these consolidated financial statements. The main terms and characteristics of the NBC CapS II trust units outstanding as at October 31, 2019 are presented below. Number Issuance date Annual yield Distribution dates Semi-annual distribution by NBC CapS II(1) Series 2 350,000 June 30, 2008 7.447 % June 30, December 31 $37.235(2) (1) (2) For each unit with a face value of $1,000. For each distribution date after June 30, 2020, the distribution will be paid at a rate equal to one-half the sum of the 180-day bankers’ acceptance rate in effect plus 4.09%. Distribution No cash distributions will be payable by the Trust on NBC CapS II if the Bank fails to declare regular dividends on its preferred shares or, if no preferred shares are then outstanding, on its outstanding common shares. In this case, the net distributable funds of the Trust will be paid to the Bank as the sole holder of the special trust securities, representing the residual interest in the Trust. Should the Trust fail to pay the semi-annual distributions in full on the NBC CapS II, the Bank will withhold from declaring dividends on any of its preferred and common shares during a determined period. Automatic Exchange Each NBC CapS II – Series 2 can be exchanged automatically, without the consent of the holders, for 40 Series 23 First Preferred Shares of the Bank upon the occurrence of one of the following events: (i) proceedings are commenced for the winding-up of the Bank; (ii) OSFI takes control of the Bank; (iii) the Bank posts a Tier 1 capital ratio of less than 5% or a Total capital ratio of less than 8%; or (iv) OSFI has directed the Bank to increase its capital or to provide additional liquidity and the Bank elects such automatic exchange or the Bank fails to comply with such direction to the satisfaction of OSFI. On an automatic exchange, the Bank will hold all outstanding trust capital securities of the Trust. Redemption at the Option of the Trust On any distribution date, the Trust may, subject to prior written notice and OSFI approval, redeem, at its option, the NBC CapS II – Series 2, in whole but not in part, without the consent of the holders. Purchase for Cancellation The Trust may, with OSFI approval, purchase NBC CapS II – Series 2, in whole or in part, on the open market or by tender or private contract at any price. The NBC CapS II purchased by the Trust, if any, will be cancelled and will not be reissued. Regulatory Capital The NBC CapS II – Series 2 qualify as innovative capital instruments and are eligible as additional Tier 1 capital, but because these instruments do not satisfy the non-viability contingent capital requirements, they are to be phased out at a rate of 10% per year between 2013 and 2022. National Bank of Canada 183 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 2200 –– CCaappiittaall DDiisscclloossuurree CCaappiittaall MMaannaaggeemmeenntt OObbjjeeccttiivveess,, PPoolliicciieess aanndd PPrroocceedduurreess Capital management has a dual role of ensuring a competitive return to the Bank’s shareholders while maintaining a solid capital foundation that covers the risks inherent to the Bank’s business, supports its business segments and protects its clients. The Bank’s capital management policy defines the guiding principles as well as the roles and responsibilities regarding its internal capital adequacy assessment process. This process is a key tool in establishing the Bank’s capital strategy and is subject to quarterly reviews and periodic amendments. CCaappiittaall MMaannaaggeemmeenntt Capital ratios are obtained by dividing regulatory capital by risk-weighted assets and are expressed as a percentage. Risk-weighted assets are calculated in accordance with the rules established by OSFI for on- and off-balance-sheet risks. Credit, market and operational risks are factored into the risk-weighted assets calculation for regulatory purposes. The definition adopted by the Basel Committee on Banking Supervision (BCBS) distinguishes between three types of capital. Common Equity Tier 1 (CET1) capital consists of common shareholders’ equity less goodwill, intangible assets and other capital deductions. The Additional Tier 1 instruments comprise eligible non-cumulative preferred shares and the eligible amount of innovative instruments. The sum of CET1 and Additional Tier 1 capital forms what is known as Tier 1 capital. Tier 2 capital consists of the eligible portion of subordinated debt and certain allowances for credit losses. Total regulatory capital is the sum of Tier 1 and Tier 2 capital. The Bank and all other major Canadian banks have to maintain minimum capital ratios established by OSFI: a CET1 capital ratio of at least 10.0%, a Tier 1 capital ratio of at least 11.5%, and a Total capital ratio of at least 13.5%. All of these ratios are to include a capital conservation buffer of 2.5%, a 1% surcharge applicable solely to D-SIBs, and a 2.0% domestic stability buffer. The domestic stability buffer, which can vary from 0% to 2.5% of risk-weighted assets, consists exclusively of CET1 capital. A D-SIB that fails to meet this buffer requirement will not be subject to automatic constraints to reduce capital distributions but will have to provide a remediation plan to OSFI. The banks also have to meet the capital floor that sets the regulatory capital level according to the Basel II standardized approach. If the capital requirement under Basel III is less than 75% of the capital requirements as calculated under Basel II, the difference is added to risk- weighted assets. OSFI requires Canadian banks to meet a Basel III leverage ratio of at least 3.0%. The leverage ratio is a measure independent of risk that is calculated by dividing the amount of Tier 1 capital by total exposure. Total exposure is defined as the sum of on-balance-sheet assets (including derivative exposures and securities financing transaction exposures) and off-balance-sheet items. The assets deducted from Tier 1 capital are also deducted from total exposure. During the years ended October 31, 2019 and 2018, the Bank was in compliance with all of OSFI’s regulatory capital requirements. 184 184 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) RReegguullaattoorryy CCaappiittaall aanndd RRaattiiooss UUnnddeerr BBaasseell IIIIII As at October 31 CCaappiittaall CET1 Tier 1 Total RRiisskk--wweeiigghhtteedd aasssseettss CET1 capital Tier 1 capital Total capital TToottaall eexxppoossuurree CCaappiittaall rraattiiooss CET1 Tier 1 Total LLeevveerraaggee rraattiioo 22001199 2018 99,,669922 1122,,449922 1133,,336666 8833,,003399 8833,,003399 8833,,003399 8,608 11,410 12,352 73,654 73,670 73,685 330088,,990022 284,337 1111..77 %% 1155..00 %% 1166..11 %% 44..00 %% 11.7 % 15.5 % 16.8 % 4.0 % NNoottee 2211 –– TTrraaddiinngg AAccttiivviittyy RReevveennuueess Trading activity revenues consist of the net interest income from trading activities and of trading revenues recognized in Non-interest income in the Consolidated Statement of Income. Net interest income comprises dividends related to financial assets and liabilities associated with trading activities, net of interest expenses and interest income related to the financing of these financial assets and liabilities. Non-interest income consists of realized and unrealized gains and losses as well as interest income on securities measured at fair value through profit or loss, income from held-for-trading derivative financial instruments, changes in the fair value of loans at fair value through profit or loss, changes in the fair value of financial instruments designated at fair value through profit or loss, and transaction costs if applicable. Year ended October 31 Net interest income Non-interest income 22001199 4477 882299 887766 2018 70 840 910 National Bank of Canada 185 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 2222 –– SShhaarree--BBaasseedd PPaayymmeennttss The compensation expense information provided below excludes the impact of hedging. SSttoocckk OOppttiioonn PPllaann The Bank’s Stock Option Plan is for officers and other designated persons of the Bank and its subsidiaries. Under this plan, options are awarded annually and provide participants with the right to purchase common shares at an exercise price equal to the closing price of the Bank’s common share on the Toronto Stock Exchange on the day preceding the award. The options vest evenly over a four-year period and expire ten years from the award date or, in certain circumstances set out in the plan, within specified time limits. The Stock Option Plan contains provisions for retiring employees that allow the participant’s rights to continue vesting in accordance with the stated terms of the grant agreement. The maximum number of common shares that may be issued under the Stock Option Plan was 20,377,278 as at October 31, 2019 (22,894,802 as at October 31, 2018). The number of common shares reserved for a participant may not exceed 5% of the total number of Bank shares issued and outstanding. As at October 31 SSttoocckk OOppttiioonn PPllaann Outstanding at beginning Awarded Exercised Cancelled(1) Outstanding at end Exercisable at end NNuummbbeerr ooff ooppttiioonnss 1133,,006644,,774466 22,,111166,,889922 ((22,,995500,,992222)) ((112277,,009900)) 1122,,110033,,662266 77,,442211,,666622 22001199 WWeeiigghhtteedd aavveerraaggee eexxeerrcciissee pprriiccee $$ $$ $$ $$ $$ $$ 4444..7788 5588..7799 3366..4400 5566..8866 4499..1155 4433..5599 Number of options 14,575,894 1,836,348 (3,129,313) (218,183) 13,064,746 8,378,530 (1) Includes 13,662 expired options during the year ended October 31, 2019 (13,784 expired options during the year ended October 31, 2018). Exercise price $29.25 $34.34 $34.09 $38.36 $44.96 $47.93 $42.17 $54.69 $64.14 $58.79 Options outstanding 373,908 580,874 778,732 965,378 1,213,605 1,529,319 1,339,479 1,493,427 1,734,064 2,094,840 12,103,626 Options exercisable 373,908 580,874 778,732 965,378 1,213,605 1,529,319 884,759 671,513 423,574 − 7,421,662 2018 Weighted average exercise price $ $ $ $ $ $ 40.46 64.14 35.75 48.85 44.78 39.17 Expiry date December 2019 December 2020 December 2021 December 2022 December 2023 December 2024 December 2025 December 2026 December 2027 December 2028 During the year ended October 31, 2019, the Bank awarded 2,116,892 stock options (1,836,348 stock options during the year ended October 31, 2018) with an average fair value of $6.14 per option ($7.42 for the year ended October 31, 2018). The average fair value of options awarded was estimated on the award date using the Black-Scholes model as well as the following assumptions. Year ended October 31 Risk-free interest rate Expected life of options Expected volatility Expected dividend yield 186 22001199 2018 22..5500%% 77 yyeeaarrss 1188..4400%% 44..3377%% 2.11% 7 years 18.87% 3.80% 186 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) The expected life of the options is based on historical data and is not necessarily representative of how options will be exercised in the future. Expected volatility is extrapolated from the implied volatility of the Bank’s share price and observable market inputs, which are not necessarily representative of actual results. The expected dividend yield represents the annualized dividend divided by the Bank’s share price at the award date. The risk-free interest rate is based on the Canadian dollar swap curve at the award date. The exercise price is equal to the Bank’s share price at the award date. No other market parameter has been included in the fair value measurement of the options. The compensation expense recorded for this plan for the year ended October 31, 2019 was $11 million ($12 million for the year ended October 31, 2018). SSttoocckk AApppprreecciiaattiioonn RRiigghhttss ((SSAARR)) PPllaann The SAR Plan is for officers and other designated persons of the Bank and its subsidiaries. Under this plan, participants receive, upon exercising the right, a cash amount equal to the difference between the closing price of the Bank’s common share on the Toronto Stock Exchange on the day preceding the exercise date and the closing price on the day preceding the award date. SARs vest evenly over a four-year period and expire 10 years after the award date or, in certain circumstances set out in the plan, within specified time limits. The SAR Plan contains provisions for retiring employees that allow the participant’s rights to continue vesting in accordance with the stated terms of the grant agreement. A compensation expense of $2 million was recognized for the year ended October 31, 2019 with respect to this plan ($1 million for the year ended October 31, 2018). As at October 31 SSAARR PPllaann(1) Outstanding at beginning Awarded Exercised Outstanding at end Exercisable at end (1) No SARs cancelled or expired during the years ended October 31, 2019 and 2018. Exercise price $29.25 $34.34 $34.09 $38.36 $44.96 $47.93 $42.17 $54.69 $64.14 $58.79 NNuummbbeerr ooff SSAARRss 333322,,221111 4466,,996688 ((4444,,118822)) 333344,,999977 119900,,669911 22001199 WWeeiigghhtteedd aavveerraaggee eexxeerrcciissee pprriiccee $$ $$ $$ $$ $$ 4466..8866 5588..7799 3388..6699 4499..6611 4433..6655 Number of SARs 395,334 62,820 (125,943) 332,211 163,971 SARs outstanding SARs exercisable 9,320 21,060 24,608 24,216 29,480 31,572 33,356 51,597 62,820 46,968 334,997 9,320 21,060 24,608 24,216 29,480 31,572 14,811 19,919 15,705 − 190,691 2018 Weighted average exercise price $ $ $ $ $ 42.29 64.14 41.13 46.86 38.91 Expiry date December 2019 December 2020 December 2021 December 2022 December 2023 December 2024 December 2025 December 2026 December 2027 December 2028 DDeeffeerrrreedd SSttoocckk UUnniitt ((DDSSUU)) PPllaannss The DSU Plans are for officers and other designated persons of the Bank and its subsidiaries as well as directors. These plans allow the Bank to tie a portion of the value of the compensation of participants to the future value of the Bank’s common shares. A DSU is a right that has a value equal to the closing price of a common share of the Bank on the Toronto Stock Exchange on the day preceding the award. DSUs generally vest evenly over four years. Additional DSUs are credited to the accounts of participants in an amount equal to the dividends declared on Bank common shares and vest evenly over the same period as the reference DSUs. DSUs may only be cashed when participants retire or leave the Bank or, for directors, when their term ends. The DSU Plans contain provisions for retiring employees whereby participants may continue vesting units in accordance with the stated terms of the grant agreement. During the year ended October 31, 2019, the Bank awarded 51,839 DSUs at a weighted average price of $60.33 (44,713 DSUs at a weighted average price of $63.68 for the year ended October 31, 2018). A total of 569,402 DSUs were outstanding as at October 31, 2019 (591,360 DSUs as at October 31, 2018). A compensation expense of $9 million was recognized for the year ended October 31, 2019 with respect to these plans ($7 million for the year ended October 31, 2018). National Bank of Canada 187 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 22 –– Share-Based Payments (cont.) RReessttrriicctteedd SSttoocckk UUnniitt ((RRSSUU)) PPllaann The RSU Plan is for certain officers and other designated persons of the Bank and its subsidiaries. The objective of this plan is to ensure that the compensation of certain officers and other designated persons is competitive and to foster retention. An RSU represents a right that has a value equal to the average closing price of the Bank’s common share, as published by the Toronto Stock Exchange, over the ten trading days preceding the sixth business day in December. RSUs generally vest evenly over three years, although some RSUs vest on the sixth business day of December of the third year following the date of the award, the date on which all RSUs expire. Additional RSUs are credited to the accounts of participants in an amount equal to the dividends declared on the Bank common shares and vest evenly over the same period as the reference RSUs. The RSU Plan contains provisions for retiring employees whereby participants may continue vesting units in accordance with the stated terms of the award agreement. During the year ended October 31, 2019, the Bank awarded 2,396,501 RSUs at a weighted average price of $60.07 (2,158,594 RSUs at a weighted average price of $63.57 for the year ended October 31, 2018). As at October 31, 2019, a total of 4,977,984 RSUs were outstanding (5,072,615 RSUs as at October 31, 2018). A compensation expense of $175 million was recognized for the year ended October 31, 2019 with respect to this plan ($140 million for the year ended October 31, 2018). PPeerrffoorrmmaannccee SSttoocckk UUnniitt ((PPSSUU)) PPllaann The PSU Plan is for officers and other designated persons of the Bank. The objective of this plan is to tie a portion of the value of the compensation of these officers and other designated persons to the future value of the Bank’s common shares. A PSU represents a right that has a value equal to the average closing price of the Bank’s common share, as published by the Toronto Stock Exchange, over the ten trading days preceding the sixth business day in December, adjusted upward or downward according to performance criteria, which is based on the Bank’s total shareholder return (TSR) growth index over three years compared to the average TSR growth index of the comparator group composed of Canadian banks over three years. PSUs vest on the sixth business day of December of the third year following the date of the award, the date on which all PSUs expire. Additional PSUs are credited to the accounts of participants in an amount equal to the dividends declared on the Bank’s common shares and vest evenly over the same period as the reference PSUs. The PSU Plan contains provisions for retiring employees whereby participants may continue vesting units in accordance with the stated terms of the award agreement. During the year ended October 31, 2019, the Bank awarded 351,956 PSUs at a weighted average price of $60.07 (287,206 PSUs at a weighted average price of $63.57 for the year ended October 31, 2018). As at October 31, 2019, a total of 843,250 PSUs were outstanding (969,322 PSUs as at October 31, 2018). A compensation expense of $29 million was recognized for the year ended October 31, 2019 with respect to this plan ($21 million for the year ended October 31, 2018). DDeeffeerrrreedd CCoommppeennssaattiioonn PPllaann ooff NNaattiioonnaall BBaannkk FFiinnaanncciiaall ((NNBBFF)) This plan is exclusively for key employees of NBF Wealth Management. The purpose of this plan is to foster the retention of key employees and promote the growth in income and the continuous improvement in profitability at Wealth Management. Under this plan, participants can defer a portion of their annual compensation, and NBF may pay a contribution to key employees when certain financial objectives are met. Amounts awarded by NBF and the compensation deferred by participants are invested in, among others, Bank common share units. These share units represent a right, the value of which corresponds to the closing price of the Bank’s common share on the Toronto Stock Exchange on the award date. Additional units are paid to the accounts of participants in an amount equal to the dividends declared on Bank common shares. Share units representing the amounts awarded by NBF vest evenly over four years. When a participant retires, or in certain cases when the participant’s employment is terminated, the participant receives a cash amount representing the value of the vested share units. During the year ended October 31, 2019, NBF awarded 147,927 share units at a weighted average price of $59.94 (132,544 share units at a weighted average price of $63.63 for the year ended October 31, 2018). As at October 31, 2019, a total of 1,764,789 share units were outstanding (1,618,166 share units as at October 31, 2018). During the year ended October 31, 2019, a $22 million compensation expense was recognized for this plan (recovery of a $3 million compensation expense related to a decline in share value for the year ended October 31, 2018). EEmmppllooyyeeee SShhaarree OOwwnneerrsshhiipp PPllaann Under the Bank’s Employee Share Ownership Plan, employees who meet the eligibility criteria can contribute up to 8% of their annual gross salary by way of payroll deductions. The Bank matches 25% of the employee contribution up to a maximum of $1,500 per annum. Bank contributions vest to the employee after one year of uninterrupted participation in the plan. Subsequent contributions vest immediately. The Bank’s contributions, amounting to $12 million for the year ended October 31, 2019 ($9 million for the year ended October 31, 2018), were charged to Compensation and employee benefits when paid. As at October 31, 2019, a total of 5,813,172 common shares were held for this plan (5,718,242 common shares as at October 31, 2018). Plan shares are purchased on the open market and are considered to be outstanding for earnings per share calculations. Dividends paid on the Bank’s common shares held for the Employee Share Ownership Plan are used to purchase other common shares on the open market. PPllaann LLiiaabbiilliittiieess aanndd IInnttrriinnssiicc VVaalluuee Total liabilities arising from the Bank’s share-based compensation plans amounted to $549 million as at October 31, 2019 ($494 million as at October 31, 2018). The intrinsic value of these liabilities that had vested as at October 31, 2019 was $217 million ($182 million as at October 31, 2018). 188 188 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 2233 –– EEmmppllooyyeeee BBeenneeffiittss –– PPeennssiioonn PPllaannss aanndd OOtthheerr PPoosstt--EEmmppllooyymmeenntt BBeenneeffiittss The Bank offers defined benefit pension plans and other post-employment benefit plans to eligible employees. The pension plans provide benefits based on years of plan participation and average earnings at retirement. The other post-employment benefit plans include post-retirement medical, dental and life insurance coverage. The pension plans are funded whereas the other plans are not funded. The fair value of plan assets and the present value of the defined benefit obligation are measured as at October 31. The Bank’s most significant pension plan is the Employee Pension Plan of the National Bank of Canada; it is registered with OSFI and the Canada Revenue Agency and subject to the Pension Benefits Standards Act, 1985 and the Income Tax Act. The defined benefit plans expose the Bank to specific risks such as investment performance, changes to the discount rate used to calculate the obligation, the longevity of plan members and future inflation. While management believes that the assumptions used in the actuarial valuation process are reasonable, there remains a degree of risk and uncertainty that may cause future results to differ significantly from these assumptions, which could give rise to gains or losses. According to the Bank’s governance rules, the policies and risk management related to the defined benefit plans are overseen at different levels by the pension committees, the Bank’s management and the Board’s Human Resources Committee. The defined benefit plans are examined on an ongoing basis in order to monitor the funding and investment policies, the plans’ financial status and the Bank’s funding requirements. The Bank’s funding policy for the defined benefit pension plans is to make at least the minimum annual contributions required by pension regulators. For funded plans, the Bank determines whether an economic benefit exists in the form of potential reductions in future contributions and in the form of refunds from the plan surplus, where permitted by applicable regulations and plan provisions. DDeeffiinneedd BBeenneeffiitt OObblliiggaattiioonn,, PPllaann AAsssseettss aanndd FFuunnddeedd SSttaattuuss As at October 31 DDeeffiinneedd bbeenneeffiitt oobblliiggaattiioonn Balance at beginning Current service cost Interest cost Remeasurements Actuarial (gains) losses arising from changes in demographic assumptions Actuarial (gains) losses arising from changes in financial assumptions Actuarial (gains) losses arising from experience adjustments Employee contributions Benefits paid Balance at end PPllaann aasssseettss Fair value at beginning Interest income Administration cost Remeasurements Return on plan assets (excluding interest income) Bank contributions(1) Employee contributions Benefits paid Fair value at end DDeeffiinneedd bbeenneeffiitt aasssseett ((lliiaabbiilliittyy)) aatt eenndd 22001199 33,,886644 9933 115588 ((112211)) 771122 114411 5533 ((119977)) 44,,770033 33,,991188 115577 ((44)) 557755 6677 5533 ((119977)) 44,,556699 ((113344)) Pension plans 2018 Other post-employment benefit plans 2018 22001199 3,984 114 148 37 (276) − 47 (190) 3,864 3,979 144 (4) (116) 58 47 (190) 3,918 54 117766 33 66 88 1188 −− ((99)) 220022 191 5 7 − (16) (1) (10) 176 ((220022)) (176) (1) For fiscal 2020, the Bank expects to pay an employer contribution of $62 million to the defined benefit pension plans. National Bank of Canada 189 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 23 – Employee Benefits – Pension Plans and Other Post-Employment Benefits (cont.) DDeeffiinneedd BBeenneeffiitt AAsssseett ((LLiiaabbiilliittyy)) As at October 31 Defined benefit asset included in Other assets Defined benefit liability included in Other liabilities 22001199 3388 ((117722)) ((113344)) Pension plans 2018 Other post-employment benefit plans 2018 22001199 64 (10) 54 ((220022)) ((220022)) (176) (176) Pension plans 2018 Other post-employment benefit plans 2018 22001199 CCoosstt ffoorr PPeennssiioonn PPllaannss aanndd OOtthheerr PPoosstt--EEmmppllooyymmeenntt BBeenneeffiittss Year ended October 31 Current service cost Interest expense (income), net Administration costs EExxppeennssee rreeccooggnniizzeedd iinn NNeett iinnccoommee RReemmeeaassuurreemmeennttss(1) Actuarial (gains) losses on defined benefit obligation Return on plan assets(2) RReemmeeaassuurreemmeennttss rreeccooggnniizzeedd iinn OOtthheerr ccoommpprreehheennssiivvee iinnccoommee 22001199 9933 11 44 9988 773322 ((557755)) 115577 225555 114 4 4 122 (239) 116 (123) (1) 33 66 99 2266 2266 3355 (1) (2) Changes related to the discount rate and to the return on plan assets are reviewed and updated on a quarterly basis. All other assumptions are updated annually. Excluding interest income. AAllllooccaattiioonn ooff tthhee FFaaiirr VVaalluuee ooff PPeennssiioonn PPllaann AAsssseettss As at October 31 Asset classes Cash and cash equivalents Equity securities Debt securities Canadian government Canadian provincial and municipal governments Other issuers Other QQuuootteedd iinn aann aaccttiivvee mmaarrkkeett(1) NNoott qquuootteedd iinn aann aaccttiivvee mmaarrkkeett −− 11,,445588 330066 −− −− −− 11,,776644 6633 447788 −− 11,,449911 557711 220022 22,,880055 22001199 TToottaall 6633 11,,993366 330066 11,,449911 557711 220022 44,,556699 Quoted in an active market(1) Not quoted in an active market − 1,482 223 − − − 1,705 91 482 − 1,115 383 142 2,213 5 7 12 (17) (17) (5) 2018 Total 91 1,964 223 1,115 383 142 3,918 (1) Unadjusted quoted prices in active markets for identical assets that the Bank can access at the measurement date. The Bank’s investment strategy for plan assets considers several factors, including the time horizon of pension plan obligations and investment risk. For each plan, an allocation range per asset class is defined using a mix of equity and debt securities to optimize the risk-return profile of plan assets and minimize asset/liability mismatching. The pension plan assets may include investment securities issued by the Bank. As at October 31, 2019 and 2018, the pension plan assets do not include any securities issued by the Bank. For fiscal 2019, the Bank and its related entities received $3 million ($5 million in fiscal 2018) in fees from the pension plans for related management, administration and custodial services. 190 190 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) AAllllooccaattiioonn ooff tthhee DDeeffiinneedd BBeenneeffiitt OObblliiggaattiioonn bbyy tthhee SSttaattuuss ooff DDeeffiinneedd BBeenneeffiitt PPllaann PPaarrttiicciippaannttss As at October 31 Active employees Retirees Participants with deferred vested benefits WWeeiigghhtteedd aavveerraaggee dduurraattiioonn ooff tthhee ddeeffiinneedd bbeenneeffiitt oobblliiggaattiioonn (in years) 22001199 4422 %% 5522 %% 66 %% 110000 %% 1177 Pension plans 2018 Other post-employment benefit plans 2018 22001199 45 % 51 % 4 % 100 % 16 2222 %% 7788 %% 31 % 69 % 110000 %% 100 % 1133 14 SSiiggnniiffiiccaanntt AAccttuuaarriiaall AAssssuummppttiioonnss ((WWeeiigghhtteedd AAvveerraaggee)) Discount Rate The discount rate assumption is based on an interest rate curve that represents the yields on corporate AA bonds. Short-term maturities are obtained using a curve based on observed data from corporate AA bonds. Long-term maturities are obtained using a curve based on observed data and extrapolated data. To measure the pension plan and other post-employment plan obligation, the vested benefits that the Bank expects to pay in each future period are discounted to the measurement date using the spot rate associated with each of the respective periods based on the yield curve derived using the above methodology. The sum of discounted benefit amounts represents the defined benefit obligation. An average discount rate that replicates this obligation is then computed. To better reflect current service cost, a separate discount rate was determined to account for the timing of future benefit payments associated with the additional year of service to be earned by the plan’s active participants. Since these benefits are, on average, being paid at a later date than the benefits already earned by participants as a whole (i.e., longer duration), this method results in the use of a generally higher discount rate for calculating current service cost than that used to measure obligations where the yield curve is positively sloped. The methodology used to determine this discount rate is the same as the one used to establish the discount rate for measuring the obligation. Other Assumptions For measurement purposes, the estimated annual growth rate for health care costs was 5.17% as at October 31, 2019 (5.23% as at October 31, 2018). Based on the assumption retained, this rate is expected to decrease gradually to 3.50% in 2038 and remain steady thereafter. Mortality assumptions are a determining factor when measuring the defined benefit obligation. Determining the expected benefit payout period is based on best estimate assumptions regarding mortality. Mortality tables are reviewed at least once a year, and the assumptions made are in accordance with accepted actuarial practice. New results regarding the plans are reviewed and used in calculating best estimates of future mortality. As at October 31 DDeeffiinneedd bbeenneeffiitt oobblliiggaattiioonn Discount rate Rate of compensation increase Health care cost trend rate Life expectancy (in years) at 65 for a participant currently at Age 65 Men Women Age 45 Men Women 22001199 33..1100 %% 33..0000 %% 2211..33 2233..66 2222..33 2244..66 Pension plans 2018 Other post-employment benefit plans 2018 22001199 4.05 % 3.00 % 21.2 23.6 22.3 24.5 33..1100 %% 33..0000 %% 55..1177 %% 2211..33 2233..66 2222..33 2244..66 4.05 % 3.00 % 5.23 % 21.2 23.6 22.3 24.5 National Bank of Canada 191 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 23 – Employee Benefits – Pension Plans and Other Post-Employment Benefits (cont.) Year ended October 31 PPeennssiioonn ppllaann eexxppeennssee Discount rate – Current service Discount rate – Interest expense (income), net Rate of compensation increase Health care cost trend rate Life expectancy (in years) at 65 for a participant currently at Age 65 Men Women Age 45 Men Women 22001199 Pension plans 2018 Other post-employment benefit plans 2018 22001199 44..1155 %% 44..0055 %% 33..0000 %% 3.75 % 3.65 % 3.00 % 2211..22 2233..66 2222..33 2244..55 21.2 23.5 22.2 24.5 44..1155 %% 44..0055 %% 33..0000 %% 55..2233 %% 2211..22 2233..66 2222..33 2244..55 3.75 % 3.65 % 3.00 % 5.28 % 21.2 23.5 22.2 24.5 SSeennssiittiivviittyy ooff SSiiggnniiffiiccaanntt AAssssuummppttiioonnss ffoorr 22001199 The following table shows the potential impacts of changes to key assumptions on the defined benefit obligation of the pension plans and other post-employment benefit plans as at October 31, 2019. These impacts are hypothetical and should be interpreted with caution as changes in each significant assumption may not be linear. Impact of a 0.25% increase in the discount rate Impact of a 0.25% decrease in the discount rate Impact of a 0.25% increase in the rate of compensation increase Impact of a 0.25% decrease in the rate of compensation increase Impact of a 1.00% increase in the health care cost trend rate Impact of a 1.00% decrease in the health care cost trend rate Impact of an increase in the age of participants by one year Impact of a decrease in the age of participants by one year PPrroojjeecctteedd BBeenneeffiitt PPaayymmeennttss Year ended October 31 2020 2021 2022 2023 2024 2025 to 2029 192 Pension plans Change in the obligation Other post-employment benefit plans Change in the obligation (191) 204 34 (35) (123) 119 (5) 5 − − 9 (7) (3) 3 Pension plans Other post-employment benefit plans 203 209 215 221 228 1,247 9 9 9 9 9 38 192 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 2244 –– IInnccoommee TTaaxxeess The Bank’s income tax expense reported in the consolidated financial statements is as follows. Year ended October 31 CCoonnssoolliiddaatteedd SSttaatteemmeenntt ooff IInnccoommee CCuurrrreenntt ttaaxxeess Current year Prior period adjustments DDeeffeerrrreedd ttaaxxeess Origination and reversal of temporary differences Prior period adjustments CCoonnssoolliiddaatteedd SSttaatteemmeenntt ooff CChhaannggeess iinn EEqquuiittyy Share issuance expense and other CCoonnssoolliiddaatteedd SSttaatteemmeenntt ooff CCoommpprreehheennssiivvee IInnccoommee Remeasurements of pension plans and other post-employment benefit plans Net change in cash flow hedges Other IInnccoommee ttaaxxeess The breakdown of the income tax expense is as follows. Year ended October 31 Current taxes Deferred taxes 22001199 2018 664477 2222 666699 ((118888)) ((1199)) ((220077)) 446622 −− ((4488)) ((5577)) 22 ((110033)) 335599 22001199 661177 ((225588)) 335599 504 16 520 15 9 24 544 (5) 37 2 2 41 580 2018 523 57 580 The temporary differences and tax loss carryforwards resulting in deferred tax assets and liabilities are as follows. DDeeffeerrrreedd ttaaxx aasssseettss Allowances for credit losses Deferred charges Defined benefit liability – Pension plans Defined benefit liability – Other post-employment benefit plans Investments in associates Deferred revenue Tax loss carryforwards Other items(2)(3) DDeeffeerrrreedd ttaaxx lliiaabbiilliittiieess Premises and equipment and intangible assets Defined benefit asset – Pension plans Investments in associates Other items NNeett ddeeffeerrrreedd ttaaxx aasssseettss ((lliiaabbiilliittiieess)) As at October 31 Consolidated Balance Sheet 2018(1) 22001199 Year ended October 31 Consolidated Statement of Income 2018(1) 22001199 Year ended October 31 Consolidated Statement of Comprehensive Income 2018 22001199 115500 226644 7788 5500 7755 4411 9955 4444 779977 ((114400)) ((3333)) ((1166)) ((5511)) ((224400)) 555577 143 233 36 54 54 38 26 26 610 (207) (41) (31) (32) (311) 299 77 3311 −− ((1100)) 2211 33 6699 1177 113388 6677 88 1155 ((2211)) 6699 220077 (16) (13) − − 14 − 2 (49) (62) (8) 16 (6) 36 38 (24) −− −− 4422 66 −− −− −− −− 4488 −− −− −− 22 22 5500 − − (33) (2) − − − − (35) − (2) − (1) (3) (38) (1) (2) (3) For the year ended October 31, 2018, certain amounts have been reclassified. As at October 31, 2019, the Consolidated Balance Sheet includes a negligible amount in deferred tax assets related to share issuance costs ($5 million as at October 31, 2018) reported in Retained earnings on the Consolidated Statement of Changes in Equity. As at November 1, 2018, as a result of adjustments upon IFRS 15 adoption, Deferred tax assets and Retained earnings increased by $1 million. National Bank of Canada 193 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 24 – Income Taxes (cont.) Net deferred tax assets are included in Other assets and net deferred tax liabilities are included in Other liabilities. As at October 31 Deferred tax assets Deferred tax liabilities 22001199 556622 ((55)) 555577 2018 324 (25) 299 According to forecasts, which are based on information available on October 31, 2019, the Bank believes that it is probable that the results of future operations will generate sufficient taxable income to utilize all the deferred tax assets before they expire. As at October 31, 2019, the total amount of temporary differences, unused tax loss carryforwards and unused tax credits for which no deferred tax asset has been recognized was $508 million ($369 million as at October 31, 2018). As at October 31, 2019, the total amount of temporary differences related to investments in subsidiaries, associates, and joint ventures for which no deferred tax liability has been recognized was $3,184 million ($1,972 million as at October 31, 2018). The following table provides a reconciliation of the Bank’s income tax rate. Year ended October 31 Income before income taxes Income taxes at Canadian statutory income tax rate Reduction in income tax rate due to Tax-exempt income from securities Non-taxable portion of capital gains Tax rates of subsidiaries, foreign entities and associates Other items Income taxes reported in the Consolidated Statement of Income and effective income tax rate NNoottiiccee ooff AAsssseessssmmeenntt $$ 22,,778844 774411 ((220088)) ((1177)) ((6677)) 1133 ((227799)) 446622 22001199 %% 110000..00 2266..66 ((77..55)) ((00..66)) ((22..44)) 00..55 ((1100..00)) 1166..66 $ 2,776 741 (161) (6) (36) 6 (197) 544 2018 % 100.0 26.7 (5.8) (0.2) (1.3) 0.2 (7.1) 19.6 In June 2019, the Bank was reassessed by the Canada Revenue Agency (CRA) for additional income tax and interest of approximately $150 million (including estimated provincial tax and interest) in respect of certain Canadian dividends received by the Bank during 2014. In prior fiscal years, the Bank was reassessed for additional income tax and interest of approximately $220 million (including provincial tax and interest) in respect of certain Canadian dividends received by the Bank during the 2013 and 2012 taxation years. The transactions to which the above-mentioned reassessments relate are similar to those prospectively addressed by income tax legislation enacted as a result of the 2015 Canadian federal budget. The CRA may issue reassessments to the Bank for taxation years subsequent to 2014 in regard to activities similar to those that were the subject of the above-mentioned reassessments. The Bank remains confident that its tax position was appropriate and intends to vigorously defend its position. As a result, no amount has been recognized in the consolidated financial statements as at October 31, 2019. 194 194 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 2255 –– EEaarrnniinnggss PPeerr SShhaarree Diluted earnings per share is calculated by dividing net income attributable to common shareholders by the weighted average number of common shares outstanding after taking into account the dilution effect of stock options using the treasury stock method and any gain (loss) on the redemption of preferred shares. Year ended October 31 22001199 2018 BBaassiicc eeaarrnniinnggss ppeerr sshhaarree Net income attributable to the Bank’s shareholders Dividends on preferred shares Net income attributable to common shareholders Weighted average basic number of common shares outstanding (thousands) BBaassiicc eeaarrnniinnggss ppeerr sshhaarree (dollars) DDiilluutteedd eeaarrnniinnggss ppeerr sshhaarree Net income attributable to common shareholders Weighted average basic number of common shares outstanding (thousands) Adjustment to average number of common shares (thousands) Stock options(1) Weighted average diluted number of common shares outstanding (thousands) DDiilluutteedd eeaarrnniinnggss ppeerr sshhaarree (dollars) 22,,225566 111166 22,,114400 333355,,110044 66..3399 22,,114400 333355,,110044 22,,552266 333377,,663300 66..3344 2,145 105 2,040 339,372 6.01 2,040 339,372 3,868 343,240 5.94 (1) For the year ended October 31, 2019, the calculation of the diluted earnings per share excluded an average number of 1,775,598 options outstanding with a weighted average exercise price of $64.14 (1,621,740 options outstanding with a weighted average exercise price of $64.14 for the year ended October 31, 2018), as the exercise price of these options was greater than the average price of the Bank’s common shares. NNoottee 2266 –– GGuuaarraanntteeeess,, CCoommmmiittmmeennttss aanndd CCoonnttiinnggeenntt LLiiaabbiilliittiieess GGuuaarraanntteeeess The maximum potential amount of future payments represents the maximum risk of loss if there were a total default by the guaranteed parties, without consideration of recoveries under recourse provisions, insurance policies or from collateral held or pledged. The maximum potential amount of future payments for significant guarantees issued by the Bank is presented in the following table. As at October 31 Letters of guarantee(1) Backstop liquidity, credit enhancement facilities and other(1) Securities lending 22001199 55,,223311 55,,665555 228800 2018 4,353 4,878 227 (1) For additional information on allowances for credit losses related to off-balance-sheet commitments, refer to Note 7 to these consolidated financial statements. LLeetttteerrss ooff GGuuaarraanntteeee In the normal course of business, the Bank issues letters of guarantee. These letters of guarantee represent irrevocable commitments that the Bank will make payments in the event that a client cannot meet its financial obligations to third parties. The Bank’s policy for requiring collateral security with respect to letters of guarantee is similar to that for loans. Generally, the term of these letters of guarantee is less than two years. BBaacckkssttoopp LLiiqquuiiddiittyy aanndd CCrreeddiitt EEnnhhaanncceemmeenntt FFaacciilliittiieess Facilities to Multi-Seller Conduits The Bank administers multi-seller conduits that purchase financial assets from clients and finance those purchases by issuing asset-backed commercial paper. The Bank provides backstop liquidity facilities to these multi-seller conduits. As at October 31, 2019, the notional amount of the global-style backstop liquidity facilities totalled $2.6 billion ($2.6 billion as at October 31, 2018), representing the total amount of the commercial paper outstanding. These backstop liquidity facilities can be drawn if the conduits are unable to access the commercial paper market, even if there is no general market disruption. These facilities have terms of less than one year and can be periodically renewed. The terms and conditions of these backstop liquidity facilities do not require the Bank to advance money to the conduits if the conduits are insolvent or involved in bankruptcy proceedings or to fund non-performing assets beyond the amount of the available credit enhancements. The backstop liquidity facilities provided by the Bank have not been drawn to date. National Bank of Canada 195 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 26 – Guarantees, Commitments and Contingent Liabilities (cont.) The Bank also provides credit enhancement facilities to these multi-seller conduits. These facilities have terms of less than one year and are automatically renewable unless the Bank sends a non-renewal notice. As at October 31, 2019 and 2018, the committed notional value for these facilities was $30 million. To date, the credit enhancement facilities provided by the Bank have not been drawn. The maximum risk of loss for the Bank cannot exceed the total amount of commercial paper outstanding, i.e., $2.6 billion as at October 31, 2019 ($2.6 billion as at October 31, 2018). As at October 31, 2019, the Bank held $13 million ($7 million as at October 31, 2018) of this commercial paper and, consequently, the maximum potential amount of future payments was $2.6 billion ($2.6 billion as at October 31, 2018). CDCC Overnight Liquidity Facility Canadian Derivatives Clearing Corporation (CDCC) acts as a central clearing counterparty for multiple financial instrument transactions in Canada. Certain fixed- income clearing members of CDCC have provided an equally shared committed and uncommitted global overnight liquidity facility for the purpose of supporting CDCC in its clearing activities of securities purchased under reverse repurchase agreements or sold under repurchase agreements. The objective of this facility is to maintain sufficient liquidity in the event of a clearing member’s default. As a fixed-income clearing member providing support to CDCC, the Bank provides a liquidity facility. As at October 31, 2019, the notional amount of the overnight uncommitted liquidity facility amounted to $3.0 billion ($2.3 billion as at October 31, 2018). As at October 31, 2019 and 2018, no amount had been drawn. SSeeccuurriittiieess LLeennddiinngg Under securities lending agreements the Bank has entered into with certain clients who have entrusted it with the safekeeping of their securities, the Bank lends the securities to third parties and indemnifies its clients in the event of loss. In order to protect itself against any contingent loss, the Bank obtains, as security from the borrower, a cash amount or extremely liquid marketable securities with a fair value greater than that of the securities loaned. No amount has been recognized on the Consolidated Balance Sheet with respect to potential indemnities resulting from securities lending agreements. OOtthheerr IInnddeemmnniiffiiccaattiioonn AAggrreeeemmeennttss In the normal course of business, including securitization transactions and discontinuances of businesses and operations, the Bank enters into numerous contractual agreements under which it undertakes to compensate the counterparty for costs incurred as a result of litigation, changes in laws and regulations (including tax legislation), claims with respect to past performance, incorrect representations or the non-performance of certain restrictive covenants. The Bank also undertakes to indemnify any person acting as a director or officer or performing a similar function within the Bank or one of its subsidiaries or another entity, at the request of the Bank, for all expenses incurred by that person in proceedings or investigations to which he or she is party in that capacity. Moreover, as a member of a securities transfer network and pursuant to the membership agreement and the regulations governing the operation of the network, the Bank granted collateral in favour of the Bank of Canada to guarantee any obligation of the Bank towards the Bank of Canada that could result from the Bank’s participation in the securities transfer network. The durations of the indemnification agreements vary according to circumstance; as at October 31, 2019 and 2018, given the nature of the agreements, the Bank is unable to make a reasonable estimate of the maximum potential liability it could be required to pay to counterparties. No amount has been recorded on the Consolidated Balance Sheet with respect to these agreements. CCoommmmiittmmeennttss CCrreeddiitt IInnssttrruummeennttss In the normal course of business, the Bank enters into various off-balance-sheet commitments. The credit instruments used to meet the financing needs of its clients represent the maximum amount of additional credit the Bank could be obligated to extend if the commitments were fully drawn. As at October 31 Letters of guarantee(1) Documentary letters of credit(2) Credit card receivables(3) Commitments to extend credit(3) 22001199 55,,223311 116633 77,,663300 6622,,112244 2018 4,353 142 7,874 57,794 (1) (2) (3) See the Letters of Guarantee heading on page 195. Documentary letters of credit are documents issued by the Bank and used in international trade to enable a third party to draw drafts on the Bank up to an amount established under specific terms and conditions; these instruments are collateralized by the delivery of the goods to which they are related. Credit card receivables and commitments to extend credit represent the undrawn portions of credit authorizations granted in the form of loans, acceptances, letters of guarantee and documentary letters of credit. The Bank is required at all times to make the undrawn portion of the credit authorization available, subject to certain conditions. FFiinnaanncciiaall AAsssseettss RReecceeiivveedd aass CCoollllaatteerraall As at October 31, 2019, the fair value of financial assets received as collateral that the Bank was authorized to sell or repledge was $55.3 billion ($57.5 billion as at October 31, 2018). These financial assets received as collateral consist of securities related to securities financing and derivative transactions as well as securities purchased under reverse repurchase agreements and securities borrowed. 196 6 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) OOtthheerr CCoommmmiittmmeennttss The Bank acts as an investor in investment banking activities where it enters into agreements to finance external private equity funds and investments in equity and debt securities at market value at the time the agreements are signed. In connection with these activities, the Bank has commitments to invest up to $92 million as at October 31, 2019 ($99 million as at October 31, 2018). In addition, through one of its subsidiaries, the Bank purchases retail loans originated by other financial institutions at market value at the time of purchase. As at October 31, 2019, the Bank had commitments to purchase loans of up to $1.6 billion. PPlleeddggeedd AAsssseettss In the normal course of business, the Bank pledges securities and other assets as collateral. A breakdown of encumbered assets pledged as collateral is provided in the following table. These transactions are concluded in accordance with standard terms and conditions for such transactions. As at October 31 22001199 2018 Assets pledged to Bank of Canada Direct clearing organizations(1) Assets pledged in relation to Derivative financial instrument transactions Borrowing, securities lending and securities sold under reverse repurchase agreements Securitization transactions Covered bonds(2) Other TToottaall 550022 11,,005522 22,,882222 4411,,994466 2233,,229999 1100,,330000 44 7799,,992255 502 1,130 1,652 41,378 22,083 8,995 125 75,865 (1) (2) Includes assets pledged as collateral for Large Value Transfer System (LVTS) activities. The Bank has a covered bond program. For additional information, see Notes 13 and 27 to these consolidated financial statements. CCoonnttiinnggeenntt LLiiaabbiilliittiieess MMaappllee FFiinnaanncciiaall GGrroouupp IInncc.. The Bank has a 24.9% equity interest in Maple Financial Group Inc. (Maple), a privately owned Canadian company that operated through direct and indirect wholly owned subsidiaries in Canada, Germany, the United Kingdom and the United States. Maple Bank GmbH (Maple GmbH), an indirect wholly owned subsidiary of Maple, has been the subject of an investigation into alleged tax irregularities by German prosecutors since September 2015 and, to the Bank’s knowledge, that investigation is ongoing. The Bank understands that the investigation is focusing on selected trading activities by Maple GmbH and some of its former employees, primarily during taxation years 2006 to 2010. The German authorities have alleged that these trading activities, often referred to as “cum/ex trading,” violated German tax laws. Neither the Bank nor its employees were involved in these trading activities and, to the Bank’s knowledge, are not the subject of this investigation. At that time, the Bank announced that if it were determined that portions of the dividends it received from Maple could be reasonably attributed to tax fraud by Maple GmbH, arrangements would be made to repay those amounts to the relevant authority. On February 6, 2016, the German Federal Financial Supervisory Authority, BaFin, placed a moratorium on the business activities of Maple GmbH preventing it from carrying out its normal business activities. In August 2016, Maple filed for bankruptcy under applicable Canadian laws, and a trustee was appointed to administer the company. Similar proceedings were initiated for each of Maple’s other material subsidiaries in their home jurisdictions. In light of the situation, the Bank wrote off the carrying value of its equity interest in Maple in an amount of $164 million ($145 million net of income taxes) during the first quarter of 2016. The $164 million write-off of the equity interest in this associate was recognized in the Non-interest income – Other item of the Consolidated Statement of Income for the year ended October 31, 2016 and was reported in the Financial Markets segment. While there has not yet been a determination of tax fraud on the part of Maple GmbH or its employees, in the insolvency proceedings of Maple GmbH the German finance office issued a declaration about the result of the tax audit at Maple GmbH and about the relevant tax consequences of the cum/ex trading and concluded a final tax claim of the tax authorities against the insolvency administrator. This claim was approved by the Maple GmbH creditor assembly. The Bank has been in contact with the German prosecutors, who have confirmed that, in their view based upon the evidence they have considered since the occurrence of the insolvency, the Bank was not involved in any respect with the alleged tax fraud undertaken by Maple GmbH nor was it negligent in failing to identify that alleged fraud. Further to discussions between the Bank and the German prosecutors concerning the amounts deemed attributable to the alleged tax fraud, the Bank paid 7.7 million euros to the German tax authorities on November 19, 2019. The Bank has been engaging in discussions with the bankruptcy and insolvency administrators of relevant Maple entities regarding potential claims they may assert against Maple’s former shareholders in relation to the insolvency of Maple and its subsidiaries. The Bank does not see a legal basis for any such liability but is nevertheless continuing discussions at this time. If any payments are required, they are not expected to be material to the Bank’s financial position. National Bank of Canada 197 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 26 – Guarantees, Commitments and Contingent Liabilities (cont.) LLiittiiggaattiioonn In the normal course of business, the Bank and its subsidiaries are involved in various claims relating, among other matters, to loan portfolios, investment portfolios and supplier agreements, including court proceedings, investigations or claims of a regulatory nature, class actions or other legal remedies of varied natures. More specifically, the Bank is involved as a defendant in class actions instituted by consumers contesting, inter alia, certain transaction fees or who wish to avail themselves of certain legislative provisions relating to consumer protection. The recent developments in the main legal proceedings involving the Bank are as follows: Watson In 2011, a class action was filed in the Supreme Court of British Columbia against Visa Corporation Canada (Visa) and MasterCard International Incorporated (MasterCard) (the Networks) as well as National Bank and a number of other Canadian financial institutions. A similar action was also initiated in Quebec, Ontario, Alberta and Saskatchewan. In each of the actions, the Networks and financial institutions are alleged to have been involved in a price-fixing system to maintain and increase the fees paid by merchants on transactions executed using the credit cards of the Networks. In so doing, they would notably be in breach of the Competition Act. An unspecified amount of compensatory and punitive damages is being claimed. In 2017, a settlement was reached with the plaintiffs; in 2018 it was approved by the trial courts in each of the five jurisdictions where the action was initiated. The rulings approving the settlement are now the subject of appeal proceedings in multiple jurisdictions. Defrance On January 21, 2019, the Quebec Superior Court authorized a class action against the Bank and several other Canadian financial institutions. The originating application was served to the Bank on April 23, 2019. The class action was initiated on behalf of consumers residing in Quebec. The plaintiffs allege that non- sufficient funds charges, billed by all of the defendants when a payment order is refused due to non-sufficient funds, are illegal and prohibited by the Consumer Protection Act. The plaintiffs are claiming, in the form of damages, the repayment of these charges as well as punitive damages. It is impossible to determine the outcome of the claims instituted or which may be instituted against the Bank and its subsidiaries. The Bank estimates, based on the information at its disposal, that while the amount of contingent liabilities pertaining to these claims, taken individually or in the aggregate, could have a material impact on the Bank’s consolidated results of operation for a particular period, it would not have a material adverse impact on the Bank’s consolidated financial position. 198 198 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 2277 –– SSttrruuccttuurreedd EEnnttiittiieess A structured entity is an entity created to accomplish a narrow and well-defined objective and is designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate solely to administrative tasks and the relevant activities are directed by means of contractual arrangements. Structured entities are assessed for consolidation in accordance with the accounting treatment described in Note 1. The Bank’s maximum exposure to loss resulting from its interests in these structured entities consists primarily of the investments in these entities, the fair value of derivative financial instrument contracts entered into with them, and the backstop liquidity and credit enhancement facilities granted to certain structured entities. In the normal course of business, the Bank may enter into financing transactions with third-party structured entities, including commercial loans, reverse repurchase agreements, prime brokerage margin lending, and similar collateralized lending transactions. While such transactions expose the Bank to the counterparty credit risk of the structured entities, this exposure is mitigated by the collateral related to these transactions. The Bank typically has neither power nor significant variable returns resulting from financing transactions with structured entities and does not consolidate such entities. Financing transactions with third-party-sponsored structured entities are included in the Bank's consolidated financial statements and are not included in the table accompanying this note. NNoonn--CCoonnssoolliiddaatteedd SSttrruuccttuurreedd EEnnttiittiieess Multi-Seller Conduits The Bank administers multi-seller conduits that purchase financial assets from clients and finance those purchases by issuing commercial paper backed by the assets acquired. Clients use these multi-seller conduits to diversify their funding sources and reduce borrowing costs, while continuing to manage the financial assets and providing some amount of first-loss protection. Notes issued by the conduits and held by third parties provide additional credit loss protection. The Bank acts as a financial agent and provides these conduits with administrative and transaction structuring services as well as backstop liquidity and credit enhancement facilities under the commercial paper program. These facilities are presented and described in Note 26. The Bank has concluded derivative financial instrument contracts with these conduits, the fair value of which is presented on the Bank’s Consolidated Balance Sheet. Although the Bank has the ability to direct the relevant activities of these conduits, it cannot use its power to affect the amount of the returns it obtains, as it acts as an agent. Consequently, the Bank does not control these conduits and does not consolidate them. Investment Funds The Bank enters into derivative or other financial instrument contracts with third parties to provide them with the desired exposure to certain investment funds. The Bank economically hedges the risks related to these derivatives by investing in those investment funds. The Bank can also hold economic interests in certain investment funds as part of its investing activities. In addition, the Bank is sponsor and investment manager of mutual funds in which it has insignificant or no interest. The Bank does not control the funds where its holdings are not significant as in these circumstances, the Bank either acts only as an agent or does not have any power over the relevant activities. In both cases, it does not have significant exposure to the variable returns of the funds. Therefore, the Bank does not consolidate these funds. Private Investments As part of its investment banking operations, the Bank invests in several limited liability partnerships and other incorporated entities. These investment companies in turn invest in operating companies with a view to reselling these investments at a profit over the medium or long term. The Bank does not intervene in the operations of these entities; its only role is that of an investor. Consequently, it does not control these companies and does not consolidate them. Asset-Backed Structured Entities The Bank invested in certain asset-backed structured entities. The underlying assets consist of residential mortgages, consumer loans, equipment loans and leases. The Bank does not have the ability to direct the relevant activities of these structured entities and has no exposure to their variable returns, other than the right to receive interest income and dividend income from its investments. Consequently, the Bank does not control these structured entities and does not consolidate them. National Bank of Canada 199 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 27 – Structured Entities (cont.) The following table presents the carrying amounts of the assets and liabilities relating to the Bank’s interests in non-consolidated structured entities, the Bank’s maximum exposure to loss from these interests, as well as the total assets of these structured entities. The structured entity Canada Housing Trust is not presented. For additional information, see Note 8 to these consolidated financial statements. AAsssseettss oonn tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett Securities at fair value through profit or loss Securities at amortized cost Derivative financial instruments As at October 31, 2018 LLiiaabbiilliittiieess oonn tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett Derivative financial instruments As at October 31, 2018 MMaaxxiimmuumm eexxppoossuurree ttoo lloossss Securities Liquidity, credit enhancement facilities and commitments As at October 31, 2018 TToottaall aasssseettss ooff tthhee ssttrruuccttuurreedd eennttiittiieess As at October 31, 2018 MMuullttii--sseelllleerr ccoonndduuiittss(1) IInnvveessttmmeenntt ffuunnddss(2) PPrriivvaattee iinnvveessttmmeennttss(3) AAss aatt OOccttoobbeerr 3311,, 22001199 AAsssseett--bbaacckkeedd ssttrruuccttuurreedd eennttiittiieess(4) 1133 −− 22 1155 7 −− 26 1155 22,,660088 22,,662233 2,557 22,,664477 2,589 554400 −− −− 554400 139 −− − 554400 −− 554400 139 11,,997700 1,054 8811 −− −− 8811 86 −− − 8811 −− 8811 86 448822 492 −− 22,,446622 33 22,,446655 1,450 −− − 22,,446655 224422 22,,770077 1,552 66,,550066 3,612 (1) (2) (3) (4) The main underlying assets, located in Canada, are residential mortgages, automobile loans, automobile inventory financings, and other receivables. As at October 31, 2019, the notional committed amount of the global-style liquidity facilities totalled $2.6 billion ($2.6 billion as at October 31, 2018), representing the total amount of commercial paper outstanding. The Bank also provides series-wide credit enhancement facilities for a notional committed amount of $30 million ($30 million as at October 31, 2018). The maximum exposure to loss cannot exceed the amount of commercial paper outstanding. As at October 31, 2019, the Bank held $13 million in commercial paper ($7 million as at October 31, 2018) and, consequently, the maximum potential amount of future payments as at October 31, 2019 is limited to $2.6 billion ($2.6 billion as at October 31, 2018), which represents the undrawn liquidity and credit enhancement facilities. The underlying assets are various financial instruments and are presented on a net asset basis. Certain investment funds are in a trading portfolio. The underlying assets are private investments. The amount of total assets of the structured entities corresponds to the amount for the most recent available period. The underlying assets are residential mortgages, consumer loans, equipment loans and leases. CCoonnssoolliiddaatteedd SSttrruuccttuurreedd EEnnttiittiieess Securitization Entity for the Bank’s Credit Card Receivables In April 2015, the Bank set up Canadian Credit Card Trust II (CCCT II) to continue its credit card securitization program on a revolving basis and to use the entity for capital management and funding purposes. The Bank provides first-loss protection against the losses since it retains the excess spread from the portfolio of sold receivables. The excess spread represents the residual net interest income after all the expenses related to this structure have been paid. The Bank also provides second-loss protection as it holds subordinated notes issued by CCCT II. In addition, the Bank acts as an administrative agent and servicer and as such is responsible for the daily administration and management of CCCT II’s credit card receivables. The Bank therefore has the ability to direct the relevant activities of CCCT II and can exercise its power to affect the amount of returns it obtains. Consequently, the Bank controls CCCT II and consolidates it. Investment Funds The Bank enters into derivative or other financial instrument contracts with third parties to provide them with the desired exposure to certain investment funds. The Bank economically hedges the risks related to these derivatives by investing in those investment funds. The Bank can also hold economic interests in certain investment funds as part of its investing activities. The Bank controls the relevant activities of these funds through its involvement as an investor and its significant exposure to their variable returns. Therefore, the Bank consolidates these funds. 200 0 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Covered Bonds NBC Covered Bond Guarantor (Legislative) Limited Partnership In December 2013, the Bank established the covered bond legislative program under which covered bonds are issued. It therefore created NBC Covered Bond Guarantor (Legislative) Limited Partnership (the Guarantor) to guarantee payment of the principal and interest owed to the bondholders. The Bank sold uninsured residential mortgages to the Guarantor and granted it loans to facilitate the acquisition of these assets. The Bank acts as manager of the partnership and has decision-making authority over its relevant activities in accordance with the contractual terms governing the covered bond legislative program. In addition, the Bank is able, in accordance with the contractual terms governing the covered bond legislative program, to affect the variable returns of the partnership, which are directly related to the return on the mortgage loan portfolio and the interest on the loans from the Bank. Consequently, the Bank controls the partnership and consolidates it. NBC Asset Trust The Bank created NBC Asset Trust for its funding and capital management needs. The securities issued by this trust constitute innovative capital instruments and are eligible as additional Tier 1 capital, but because these instruments do not satisfy the non-viability contingent capital requirements, they are to be phased out at a rate of 10% per year between 2013 and 2022. For additional information, see Note 19 to these consolidated financial statements. The issuance proceeds were used to acquire, from the Bank, residential mortgage loans. The Bank continues to administer these loans and is committed to repurchase from NBC Asset Trust the capital balance and unpaid accrued interest on any loan that is more than 90 days past due. The Bank also manages day-to-day operations and holds the special voting securities of the trust. After the distribution has been paid to the holders of the trust capital securities, the Bank, as the sole holder of the special trust securities, is entitled to receive the balance of net residual funds. Therefore, the Bank has the ability to direct the relevant activities of NBC Asset Trust and can use its power to affect the amount of returns it obtains. Consequently, the Bank controls this trust and consolidates it. Third-Party Structured Entities In 2018, the Bank, through one of its subsidiaries, provided financing to a third-party structured entity in exchange for a 100% interest in a loan portfolio, the sole asset held by that entity. The Bank controls and therefore consolidates the structured entity, as it has the ability to direct the entity’s relevant activities through its involvement in the decision-making process. The Bank is also exposed to the entity’s variable returns. The following table presents the Bank’s investments and other assets in the consolidated structured entities as well as the total assets of these entities. As at October 31 CCoonnssoolliiddaatteedd ssttrruuccttuurreedd eennttiittiieess Securitization entity for the Bank’s credit card receivables(2)(3) Investment funds(4) Covered bonds(5) Building(6) NBC Asset Trust(7) Third-party structured entities(8) IInnvveessttmmeennttss aanndd ootthheerr aasssseettss 884499 228866 1166,,116677 −− 770000 223322 1188,,223344 22001199 TToottaall aasssseettss(1) 11,,776655 331111 1166,,551155 −− 11,,006633 223322 1199,,888866 Investments and other assets 898 289 12,886 61 700 305 15,139 2018 Total assets(1) 2,053 310 13,153 54 1,060 305 16,935 (1) (2) (3) (4) (5) (6) (7) (8) There are restrictions that stem mainly from regulatory requirements, corporate or securities laws and contractual arrangements that limit the ability of certain consolidated structured entities to transfer funds to the Bank. The underlying assets are credit card receivables. The Bank’s investment is presented net of third-party holdings. The underlying assets are various financial instruments and are presented on a net asset basis. Certain investment funds are in a trading portfolio. The underlying assets are uninsured residential mortgage loans of the Bank. The average maturity of these underlying assets is two years. As at October 31, 2019, the total amount of transferred mortgage loans was $16.2 billion ($12.9 billion as at October 31, 2018), and the total amount of covered bonds of $9.5 billion was recognized in Deposits on the Consolidated Balance Sheet ($8.3 billion as at October 31, 2018). For additional information, see Note 13 to these consolidated financial statements. As at October 31, 2018, the underlying asset was the Bank’s head office building, which was sold on July 30, 2019. For additional information, see Note 10 to these consolidated financial statements. The underlying assets are insured and uninsured residential mortgage loans of the Bank. As at October 31, 2019, insured loans amounted to $12 million ($18 million as at October 31, 2018). The average maturity of the underlying assets is one year. For additional information, see Note 19 to these consolidated financial statements. The underlying assets consist of a loan portfolio. National Bank of Canada 1 201 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 2288 –– RReellaatteedd PPaarrttyy DDiisscclloossuurreess In the normal course of business, the Bank provides various banking services to related parties and enters into contractual agreements and other operations with related parties. The Bank considers the following to be related parties:     its key officers and directors and members of their immediate family, i.e., spouses and children under 18 living in the same household; entities over which its key officers and directors and their immediate family have control or significant influence through their significant voting power; the Bank’s associates and joint ventures; the Bank’s pension plans (for additional information, see Note 23 to these consolidated financial statements). According to the established definition, the Bank’s key officers are those persons having authority and responsibility for planning, directing and controlling the Bank’s activities, directly or indirectly. RReellaatteedd PPaarrttyy TTrraannssaaccttiioonnss As at October 31 AAsssseettss Mortgage loans and other loans Other LLiiaabbiilliittiieess Deposits Other Key officers and directors(1) 2018 36 − 59 − 22001199 33 −− 3399 −− 22001199 333399 (2) −− 663322 (3) 33 Related entities 2018 (2) 298 8 (3) 511 16 (1) (2) (3) As at October 31, 2019, key officers, directors and their immediate family members were holding $69 million of the Bank’s common and preferred shares ($67 million as at October 31, 2018). As at October 31, 2019, mortgage loans and other loans consisted of: (i) no loans to the Bank’s associates and joint ventures (no loans as at October 31, 2018) and (ii) $339 million in loans to entities over which the Bank’s key officers, directors or their immediate family members exercise control or significant influence through significant voting power ($298 million as at October 31, 2018). As at October 31, 2019, deposits consisted of: (i) $395 million in deposits from the Bank’s associates and joint ventures ($306 million as at October 31, 2018) and (ii) $237 million in deposits from entities over which the Bank’s key officers, directors or their immediate family members exercise control or significant influence through significant voting power ($205 million as at October 31, 2018). The contractual agreements and other transactions with related entities as well as with directors and key officers are entered into under conditions similar to those offered to non-related third parties. These agreements did not have a significant impact on the Bank’s results. The Bank also offers a deferred stock unit plan to directors who are not Bank employees. For additional information, see Notes 9, 22 and 27 to these consolidated financial statements. CCoommppeennssaattiioonn ooff KKeeyy OOffffiicceerrss aanndd DDiirreeccttoorrss Year ended October 31 Compensation and other short-term and long-term benefits Share-based payments 22001199 2233 2255 2018 22 25 202 2 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) PPrriinncciippaall SSuubbssiiddiiaarriieess ooff tthhee BBaannkk(1) Name Business activity Principal office address CCaannaaddaa aanndd UUnniitteedd SSttaatteess National Bank Acquisition Holding Inc. National Bank Financial Inc. NBF International Holdings Inc. National Bank of Canada Financial Group Inc. Credigy Ltd. National Bank of Canada Financial Inc. National Bank Life Insurance Company Natcan Trust Company National Bank Trust Inc. National Bank Realty Inc. National Bank Investments Inc. NatBC Holding Corporation Natbank, National Association OOtthheerr ccoouunnttrriieess Natcan Global Holdings Ltd. NBC Global Finance Limited NBC Financial Markets Asia Limited Advanced Bank of Asia Limited ATA IT Ltd. Holding company Investment dealer Holding company Holding company Holding company Investment dealer Insurance Trustee Trustee Real estate Mutual funds dealer Holding company Commercial bank Montreal, Canada Montreal, Canada Montreal, Canada New York, NY, United States Atlanta, GA, United States New York, NY, United States Montreal, Canada Montreal, Canada Montreal, Canada Montreal, Canada Montreal, Canada Hollywood, FL, United States Hollywood, FL, United States Holding company Investment services Investment dealer Commercial bank Information technology Sliema, Malta Dublin, Ireland Hong Kong, China Phnom Penh, Cambodia Bangkok, Thailand AAss aatt OOccttoobbeerr 3311,, 22001199 Investment at cost Voting shares(2) 100% 100% 100% 100% 80% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 1,464 238 195 80 585 31 22 5 377 3 (1) (2) Excluding consolidated structured entities. For additional information, see Note 27 to these consolidated financial statements. The Bank’s percentage of voting rights in these subsidiaries. NNoottee 2299 –– MMaannaaggeemmeenntt ooff tthhee RRiisskkss AAssssoocciiaatteedd WWiitthh FFiinnaanncciiaall IInnssttrruummeennttss The Bank is exposed to credit risk, market risk, liquidity risk and financing risk. The Bank’s objectives, policies and procedures for managing risk and the risk measurement methods are presented in the Risk Management section of the MD&A for the year ended October 31, 2019. Text in grey shading and tables identified with an asterisk (*) in the Risk Management section of the MD&A for the year ended October 31, 2019 are an integral part of these consolidated financial statements. RReessiidduuaall CCoonnttrraaccttuuaall MMaattuurriittiieess ooff BBaallaannccee SShheeeett IItteemmss aanndd OOffff--BBaallaannccee--SShheeeett CCoommmmiittmmeennttss The following tables present balance sheet items and off-balance-sheet commitments by residual contractual maturity as at October 31, 2019 and 2018. The information gathered from this maturity analysis is a component of liquidity and funding management. However, this maturity profile does not represent how the Bank manages its interest rate risk nor its liquidity risk and funding needs. The Bank considers factors other than contractual maturity in the assessment of liquid assets or in determining expected future cash flows. In the normal course of business, the Bank enters into various off-balance-sheet commitments. The credit instruments used to meet the funding needs of its clients represent the maximum amount of additional credit the Bank could be obligated to extend if the commitments were fully drawn. The Bank also has future minimum commitments under leases for premises as well for other contracts, mainly commitments to purchase loans and contracts for outsourced information technology services. Most of the lease commitments are related to operating leases. National Bank of Canada 3 203 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 29 –– Management of the Risks Associated With Financial Instruments (cont.) AAsssseettss CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss SSeeccuurriittiieess At fair value through profit or loss At fair value through other comprehensive income At amortized cost SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd LLooaannss(1) Residential mortgage Personal Credit card Business and government Customers’ liability under acceptances Allowances for credit losses OOtthheerr Derivative financial instruments Investments in associates and joint ventures Premises and equipment Goodwill Intangible assets Other assets(1) 11 mmoonntthh oorr lleessss OOvveerr 11 mmoonntthh ttoo 33 mmoonntthhss OOvveerr 33 mmoonntthhss ttoo 66 mmoonntthhss OOvveerr 66 mmoonntthhss ttoo 99 mmoonntthhss OOvveerr 99 mmoonntthhss ttoo 1122 mmoonntthhss OOvveerr 11 yyeeaarr ttoo 22 yyeeaarrss OOvveerr 22 yyeeaarrss ttoo 55 yyeeaarrss OOvveerr 55 yyeeaarrss NNoo ssppeecciiffiieedd mmaattuurriittyy TToottaall AAss aatt OOccttoobbeerr 3311,, 22001199 77,,330011 11,,663388 112211 111111 3333 −− −− −− 44,,449944 1133,,669988 11,,222288 3366 3333 11,,229977 664477 1144 8844 774455 665588 2266 226622 994466 225566 55 333311 559922 441111 11 110055 551177 44,,221155 77,,445511 66,,887722 4400,,008855 6611,,882233 33,,221133 11,,770044 99,,113322 44,,774499 55,,885533 1188,,005533 11,,998822 11,,338833 1100,,223377 662222 −− 4400,,770077 1100,,664488 99,,775555 8822,,222266 77,,224477 11,,336655 992222 449955 −− 11,,331177 −− −− 66,,337777 1177,,772233 773344 225533 11,,116611 443300 11,,995599 880033 33,,009933 997722 22,,889933 884433 1100,,667744 33,,336677 3322,,660011 1111,,557766 33,,337755 33,,440077 88,,446699 22,,777711 22,,999955 33,,220033 22,,222222 66,,001166 1133,,444455 22,,777711 66,,113388 771100 4455 −− −− −− −− −− 1155,,559944 55,,007722 55,,880022 77,,226688 55,,995588 2200,,005577 5577,,662222 99,,555533 668811 1155,,229933 22,,332222 88,,770077 5577,,117711 3366,,994444 22,,332222 5500,,559999 −− ((667788)) 2266,,332255 66,,889933 ((667788)) 115533,,225511 556644 661144 448833 226622 119944 884477 22,,003399 33,,112266 −− 88,,112299 11,,442255 11,,998899 3333,,442288 114422 775566 99,,557766 8877 557700 88,,336611 8888 335500 88,,881166 8888 228822 66,,779900 226666 11,,111133 3311,,661199 110077 22,,114466 7777,,882211 3388 33,,116644 2222,,995544 338855 449900 11,,441122 11,,440066 449977 44,,119900 8822,,009933 338855 449900 11,,441122 11,,440066 22,,773388 1144,,556600 228811,,445588 (1) Amounts collectible on demand are considered to have no specified maturity. 204 4 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) 11 mmoonntthh oorr lleessss OOvveerr 11 mmoonntthh ttoo 33 mmoonntthhss OOvveerr 33 mmoonntthhss ttoo 66 mmoonntthhss OOvveerr 66 mmoonntthhss ttoo 99 mmoonntthhss OOvveerr 99 mmoonntthhss ttoo 1122 mmoonntthhss OOvveerr 11 yyeeaarr ttoo 22 yyeeaarrss OOvveerr 22 yyeeaarrss ttoo 55 yyeeaarrss OOvveerr 55 yyeeaarrss NNoo ssppeecciiffiieedd mmaattuurriittyy TToottaall AAss aatt OOccttoobbeerr 3311,, 22001199 LLiiaabbiilliittiieess aanndd eeqquuiittyy DDeeppoossiittss(1)(2) Personal Business and government Deposit-taking institutions OOtthheerr Acceptances Obligations related to securities sold short(3) Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments Liabilities related to transferred receivables(4) Securitization – Credit card(5) Other liabilities – Other items(1)(5) SSuubboorrddiinnaatteedd ddeebbtt EEqquuiittyy OOffff--bbaallaannccee--sshheeeett ccoommmmiittmmeennttss Letters of guarantee and documentary letters of credit Credit card receivables(6) Backstop liquidity and credit enhancement facilities(7) Commitments to extend credit(8) Obligations related to: Lease commitments Other contracts(9) 11,,771166 2200,,225522 771111 2222,,667799 66,,113388 550044 77,,449933 779933 −− −− 11,,229988 1166,,222266 −− 11,,998833 66,,005500 6699 88,,110022 771100 117766 11,,228811 776633 11,,449911 −− 333300 44,,775511 −− 33,,004455 66,,663300 7799 99,,775544 4455 119955 22,,888811 555566 999955 887744 114411 55,,668877 −− 22,,669966 44,,777788 2299 77,,550033 −− 3344 22,,774433 229922 888811 −− 6633 44,,001133 −− 33,,004422 22,,772233 227755 66,,004400 −− 449955 −− 221144 337755 −− 3366 11,,112200 −− 66,,110055 66,,441111 −− 1122,,551166 77,,227766 1111,,770066 55 1188,,998877 22,,660066 66,,221133 4466 88,,886655 3311,,559966 6600,,550033 33,,002211 9955,,112200 6600,,006655 112255,,226666 44,,223355 118899,,556666 −− −− −− −− 66,,889933 331155 22,,773388 55,,114477 33,,224455 1122,,884499 −− 771122 33,,664400 −− 5588 44,,772255 −− −− 11,,995599 1100,,662233 3377 8844 1155,,444411 −− −− 11,,556633 33,,330077 −− 229922 1100,,330099 777733 3388,,990055 1122,,885533 1155,,444411 1111,,551166 77,,116600 1177,,224411 3344,,442288 1199,,994477 333355 11,,443300 441111 11,,001199 888888 11,,225588 5533 −− −− 11,,991166 1155 44,,555522 88 115588 1177 228899 33,,001177 44,,110033 2266 552233 1155 55,,006644 2277 442233 −− 44,,001199 2266 338800 −− 44,,225588 −− 1100,,332266 9999 119988 224499 225577 −− 778844 223399 −− 77,,550022 −− 2211,,990000 66,,885522 −− −− 22,,996644 1133,,771111 2211,,331122 991111 55,,226666 7755,,998833 −− 777733 1155,,113366 112233,,996677 1155,,113366 228811,,445588 −− 77,,663300 55,,339944 77,,663300 22,,660088 2277,,110022 55,,665555 6622,,112244 −− −− 669911 22,,222288 (1) (2) (3) (4) (5) (6) (7) (8) (9) Amounts payable upon demand or notice are considered to have no specified maturity. The Deposits item is presented in greater detail than it is on the Consolidated Balance Sheet. Amounts are disclosed according to the remaining contractual maturity of the underlying security. These amounts mainly include liabilities related to the securitization of mortgage loans. The Other liabilities item is presented in greater detail than it is on the Consolidated Balance Sheet. These amounts are unconditionally revocable at the Bank’s discretion at any time. In the event of payment on one of the backstop liquidity facilities, the Bank will receive as collateral government bonds in an amount up to $3.0 billion. These amounts include $45.2 billion that is unconditionally revocable at the Bank’s discretion at any time. These amounts include $0.3 billion in contractual commitments related to the head office building under construction. National Bank of Canada 5 205 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) Note 29 –– Management of the Risks Associated With Financial Instruments (cont.) AAsssseettss CCaasshh aanndd ddeeppoossiittss wwiitthh ffiinnaanncciiaall iinnssttiittuuttiioonnss SSeeccuurriittiieess At fair value through profit or loss At fair value through other comprehensive income At amortized cost SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss aanndd sseeccuurriittiieess bboorrrroowweedd LLooaannss(1) Residential mortgage Personal Credit card Business and government Customers’ liability under acceptances Allowances for credit losses OOtthheerr Derivative financial instruments Investments in associates and joint ventures Premises and equipment Goodwill Intangible assets Other assets(1) 1 month or less Over 1 month to 3 months Over 3 months to 6 months Over 6 months to 9 months Over 9 months to 12 months Over 1 year to 2 years Over 2 years to 5 years Over 5 years No specified maturity Total As at October 31, 2018 9,544 790 41 1 19 10 − − 2,351 12,756 1,972 1,706 1,039 1,429 1,457 5,634 10,501 5,443 26,636 55,817 3 − 1,975 183 10 1,899 7 9 1,055 66 − 1,495 68 730 2,255 714 814 7,162 1,892 6,162 18,555 2,502 573 8,518 233 − 26,869 5,668 8,298 69,783 7,759 1,242 2,154 271 790 2,151 − − 3,792 18,159 724 365 950 395 1,583 622 2,653 1,070 2,105 762 10,124 3,914 32,675 10,509 2,085 3,116 7,557 2,454 2,246 3,672 2,206 4,244 12,838 2,402 6,019 670 112 − − − − − 14,665 4,469 4,563 7,395 5,073 18,282 56,022 7,603 752 16,604 2,325 8,987 53,651 37,357 2,325 46,606 − (658) 28,010 6,801 (658) 146,082 642 884 718 375 287 951 2,005 2,746 − 8,608 574 1,216 35,159 108 992 9,392 66 784 8,597 61 436 9,598 131 418 8,555 119 1,070 28,675 31 2,036 76,613 54 2,800 18,921 645 601 1,412 1,314 1,967 5,939 66,961 645 601 1,412 1,314 3,111 15,691 262,471 (1) Amounts collectible on demand are considered to have no specified maturity. 206 6 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) LLiiaabbiilliittiieess aanndd eeqquuiittyy DDeeppoossiittss(1)(2) Personal Business and government Deposit-taking institutions OOtthheerr Acceptances Obligations related to securities sold short(3) Obligations related to securities sold under repurchase agreements and securities loaned Derivative financial instruments Liabilities related to transferred receivables(4) Securitization – Credit card(5) Other liabilities – Other items(1)(5) SSuubboorrddiinnaatteedd ddeebbtt EEqquuiittyy OOffff--bbaallaannccee--sshheeeett ccoommmmiittmmeennttss Letters of guarantee and documentary letters of credit Credit card receivables(6) Backstop liquidity and credit enhancement facilities(7) Commitments to extend credit(8) Obligations related to(9): Lease commitments Other contracts 1 month or less Over 1 month to 3 months Over 3 months to 6 months Over 6 months to 9 months Over 9 months to 12 months Over 1 year to 2 years Over 2 years to 5 years Over 5 years No specified maturity Total As at October 31, 2018 1,630 12,082 949 14,661 6,019 1,061 6,912 427 − 36 548 15,003 − 2,324 9,725 541 12,590 670 362 1,981 668 2,244 − 241 6,166 − 2,631 5,587 200 8,418 112 201 3,826 288 226 − 56 4,709 − 2,033 2,953 15 5,001 − 33 1,607 245 867 − 20 2,772 − 2,785 1,988 263 5,036 5,156 7,017 − 12,173 8,994 11,050 − 20,044 2,327 5,025 50 7,402 27,808 54,894 2,803 85,505 55,688 110,321 4,821 170,830 − − − − − 6,801 311 1,753 3,729 5,946 4,384 17,780 − 181 537 − 59 1,088 − − 856 3,088 874 66 6,637 − − 1,485 10,072 − 63 15,349 − 1,886 3,066 − 207 11,105 5,672 − 19,998 6,036 − − 3,654 13,710 20,100 910 4,914 76,539 − 747 − 747 29,664 18,756 13,127 7,773 6,124 18,810 35,393 19,254 78 1,269 540 1,296 688 566 58 − − 2,394 15 4,161 2,298 3,886 15 4,988 − 4,737 7 18 16 12 23 18 22 17 22 32 − 3,839 86 102 − 6,777 218 101 − 304 254 − 14,355 113,570 14,355 262,471 − 7,874 4,495 7,874 2,550 26,708 4,878 57,794 − − 648 300 (1) (2) (3) (4) (5) (6) (7) (8) (9) Amounts payable upon demand or notice are considered to have no specified maturity. The Deposits item is presented in greater detail than it is on the Consolidated Balance Sheet. Amounts have been disclosed according to the remaining contractual maturity of the underlying security. These amounts mainly include liabilities related to the securitization of mortgage loans. The Other liabilities item is presented in greater detail than it is on the Consolidated Balance Sheet. These amounts are unconditionally revocable at the Bank’s discretion at any time. In the event of payment on one of the backstop liquidity facilities, the Bank will receive as collateral government bonds in an amount up to $2.3 billion. These amounts include $42.9 billion that is unconditionally revocable at the Bank’s discretion at any time. After refining the process used to identify lease commitments and other contracts, certain amounts have been modified from those previously reported as at October 31, 2018. National Bank of Canada 7 207 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) NNoottee 3300 –– SSeeggmmeenntt DDiisscclloossuurreess The Bank carries out its activities in four business segments, which are defined below. For presentation purposes, other activities are grouped in the Other heading. Each reportable segment is distinguished by services offered, type of clientele and marketing strategy. The presentation of segment disclosures is consistent with the presentation adopted by the Bank for the year beginning November 1, 2018. This presentation reflects the fact that advisor banking service activities, which had previously been presented in the Wealth Management segment, are now presented in the Personal and Commercial segment. The Bank made this change to better align the monitoring of its activities with its management structure. PPeerrssoonnaall aanndd CCoommmmeerrcciiaall The Personal and Commercial segment encompasses the banking, financing, and investing services offered to individuals, advisors and businesses as well as insurance operations. WWeeaalltthh MMaannaaggeemmeenntt The Wealth Management segment comprises investment solutions, trust services, banking services, lending services and other wealth management solutions offered through internal and third-party distribution networks. FFiinnaanncciiaall MMaarrkkeettss The Financial Markets segment encompasses corporate banking and investment banking and financial solutions for large and mid-size corporations, public sector organizations, and institutional investors. The segment is also active in proprietary trading and investment activities for the Bank. UU..SS.. SSppeecciiaallttyy FFiinnaannccee aanndd IInntteerrnnaattiioonnaall ((UUSSSSFF&&II)) The USSF&I segment encompasses the specialty finance expertise provided by subsidiary Credigy; the activities of subsidiary ABA Bank, which offers financial products and services to individuals and businesses in Cambodia; and the activities of targeted investments in certain emerging markets. OOtthheerr This heading encompasses treasury activities, liquidity management, Bank funding, asset/liability management activities, certain non-recurring items and the unallocated portion of corporate units. The segment disclosures have been prepared in accordance with the accounting policies described in Note 1 to these consolidated financial statements, except for the net interest income, non-interest income and income taxes (recovery) of the operating segments, which are presented on a taxable equivalent basis. Taxable equivalent basis is a calculation method that consists in grossing up certain tax-exempt income by the amount of income tax that would have otherwise been payable. The effect of these adjustments is reversed under the Other heading. Operations support charges are allocated to each operating segment presented in the business segment results. The Bank assesses performance based on the net income attributable to the Bank’s shareholders. Intersegment revenues are recognized at the exchange amount. Segment assets correspond to average assets used in segment operations. RReessuullttss bbyy BBuussiinneessss SSeeggmmeenntt Year ended October 31(1) Net interest income(2) Non-interest income(2)(3) Total revenues Non-interest expenses(4) Contribution Provisions for credit losses Income before income taxes (recovery) Income taxes (recovery)(2) Net income Non-controlling interests Net income attributable to the Bank’s shareholders Average assets Personal and Commercial 2018 22001199 Wealth Management 2018 22001199 22,,338833 11,,006699 33,,445522 11,,881166 11,,663366 223377 2,276 1,033 3,309 1,782 1,527 228 11,,339999 337722 11,,002277 −− 1,299 347 952 − 447700 11,,227733 11,,774433 11,,006677 667766 −− 667766 117777 449999 −− 446 1,243 1,689 1,058 631 1 630 166 464 − 22001199 447744 11,,227766 11,,775500 774433 11,,000077 3300 997777 226600 771177 −− Financial Markets 2018 22001199 USSF&I 2018 409 1,334 1,743 697 1,046 4 1,042 278 764 − 665566 5599 771155 228855 443300 8800 335500 7711 227799 4400 584 55 639 251 388 94 294 72 222 38 22001199 ((338877)) 115599 ((222288)) 339900 ((661188)) −− ((661188)) ((441188)) ((220000)) 2266 Other 2018 (333) 119 (214) 275 (489) − (489) (319) (170) 49 22001199 33,,559966 33,,883366 77,,443322 44,,330011 33,,113311 334477 22,,778844 446622 22,,332222 6666 Total 2018 3,382 3,784 7,166 4,063 3,103 327 2,776 544 2,232 87 11,,002277 952 111122,,779988 106,857 449999 66,,221199 464 6,167 771177 111122,,449933 764 100,721 223399 1100,,998855 184 9,270 ((222266)) 4433,,666677 (219) 42,925 22,,225566 228866,,116622 2,145 265,940 (1) (2) (3) (4) For the year ended October 31, 2018, certain amounts have been reclassified, mainly amounts related to advisor banking service activities, which have been transferred from the Wealth Management segment to the Personal and Commercial segment. For the year ended October 31, 2019, Net interest income was grossed up by $195 million ($144 million in 2018), Non-interest income was grossed up by $135 million ($101 million in 2018), and an equivalent amount was recognized in Income taxes (recovery). The effect of these adjustments is reversed under the Other heading. For the Other heading of segment results, the Non-interest income item includes a $79 million gain on disposal of Fiera Capital Corporation shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss resulting from the fair value measurement of an investment. For the Other heading of segment results, the Non-interest expenses item includes $57 million in impairment losses on premises and equipment and on intangible assets, $45 million in provisions for onerous contracts, an $11 million charge related to Maple, and $10 million in severance pay. 208 8 National Bank of Canada2019 Annual Report Audited Consolidated Financial Statements Notes to the Audited Consolidated Financial Statements (millions of Canadian dollars) RReessuullttss bbyy GGeeooggrraapphhiicc SSeeggmmeenntt Year ended October 31 Net interest income Non-interest income(1) Total revenues Non-interest expenses(2) Contribution Provisions for credit losses Income before income taxes Income taxes Net income Non-controlling interests Net income attributable to the Bank’s shareholders Average assets 22001199 22,,446666 33,,550022 55,,996688 33,,993311 22,,003377 226677 11,,777700 330033 11,,446677 3366 11,,443311 223311,,666677 Canada 2018 United States 2018 22001199 2,531 3,488 6,019 3,750 2,269 233 2,036 412 1,624 54 1,570 218,647 555511 8844 663355 221100 442255 6688 335577 5588 229999 3300 226699 2200,,441111 469 108 577 205 372 81 291 85 206 33 173 20,503 22001199 557799 225500 882299 116600 666699 1122 665577 110011 555566 −− 555566 3344,,008844 Other 2018 382 188 570 108 462 13 449 47 402 − 402 26,790 22001199 33,,559966 33,,883366 77,,443322 44,,330011 33,,113311 334477 22,,778844 446622 22,,332222 6666 22,,225566 228866,,116622 Total 2018 3,382 3,784 7,166 4,063 3,103 327 2,776 544 2,232 87 2,145 265,940 (1) (2) For Canada, the Non-interest income item includes a $79 million gain on disposal of Fiera Capital Corporation shares, a $50 million gain on disposal of premises and equipment, and a $33 million loss resulting from the fair value measurement of an investment. For Canada, the Non-interest expenses item includes $57 million in impairment losses on premises and equipment and on intangible assets, $45 million in provisions for onerous contracts, an $11 million charge related to Maple and $10 million in severance pay. NNoottee 3311 –– AAccqquuiissiittiioonn On September 27, 2019, the Bank acquired the entire remaining non-controlling interest in the Cambodian subsidiary Advanced Bank of Asia Limited (ABA Bank) for $84 million. Following this transaction, ABA Bank became a wholly owned subsidiary of the Bank. NNoottee 3322 –– EEvveenntt AAfftteerr tthhee CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett DDaattee On November 19, 2019, the Bank paid 7.7 million euros to the German tax authorities in relation to the Maple case. This payment was made upon a final tax claim of the tax authorities against the insolvency administrator that was approved by the Maple GmbH creditor assembly. As at October 31, 2019, a provision of $11 million was recorded to reflect this adjusting event after the Consolidated Balance Sheet date. For additional information, see Note 26 to these consolidated financial statements. National Bank of Canada 9 209 National Bank of Canada2019 Annual Report Supplementary Information Statistical Review Glossary of Financial Terms Information for Shareholders 221122 221144 221166 Supplementary Information Statistical Review As at October 31(1) (millions of Canadian dollars) CCoonnssoolliiddaatteedd BBaallaannccee SShheeeett ddaattaa Cash and deposits with financial institutions Securities Securities purchased under reverse repurchase agreements and securities borrowed Loans Other assets TToottaall aasssseettss Deposits Other liabilities Non-controlling interests Subordinated debt Share capital Preferred Common Contributed surplus Retained earnings Accumulated other comprehensive income Non-controlling interests TToottaall lliiaabbiilliittiieess aanndd eeqquuiittyy 22001199 2018 2017 2016 2015 2014 2013 2012 2011 2010 1133,,669988 8822,,222266 12,756 69,783 8,802 65,343 8,183 64,541 7,567 56,040 8,086 52,953 3,596 53,744 3,249 54,898 2,851 56,592 2,274 54,268 1177,,772233 115533,,225511 1144,,556600 228811,,445588 118899,,556666 7755,,998833 18,159 146,082 15,691 262,471 170,830 76,539 20,789 136,457 14,436 245,827 156,671 75,589 13,948 128,036 17,498 232,206 142,066 77,026 17,702 116,676 18,105 216,090 130,458 72,755 24,525 106,959 12,906 205,429 119,883 73,163 21,449 97,338 12,092 188,219 102,111 74,729 15,529 90,922 13,305 177,903 93,474 73,948 12,507 80,758 14,146 166,854 85,787 71,791 777733 747 9 1,012 1,522 1,881 2,426 2,470 2,000 22,,445500 22,,994499 5511 99,,331122 1166 335588 228811,,445588 2,450 2,822 57 8,472 175 379 262,471 2,050 2,768 58 7,706 168 808 245,827 1,650 2,645 73 6,706 218 810 232,206 1,023 2,614 67 6,705 145 801 216,090 1,223 2,293 52 5,850 289 795 205,429 677 2,160 58 5,055 214 789 188,219 762 2,054 58 4,091 255 791 177,903 762 1,970 46 3,366 337 795 166,854 10,878 63,134 14,748 145,302 81,785 53,059 1,217 2,033 1,089 1,804 66 4,081 168 145,302 Average assets 228866,,116622 265,940 248,351 235,913 222,929 206,680 193,509 181,344 165,942 140,360 Net impaired loans(2)(3) under IFRS 9 Net impaired loans(3) under IAS 39 CCoonnssoolliiddaatteedd SSttaatteemmeenntt ooff IInnccoommee ddaattaa Net interest income Non-interest income TToottaall rreevveennuueess Provisions for credit losses Non-interest expenses Income taxes Non-controlling interests NNeett iinnccoommee Non-controlling interests NNeett iinnccoommee aattttrriibbuuttaabbllee ttoo tthhee BBaannkk’ss sshhaarreehhoollddeerrss 445500 404 206 281 254 248 183 179 175 162 33,,559966 33,,883366 77,,443322 334477 44,,330011 446622 22,,332222 6666 22,,225566 3,382 3,784 7,166 327 4,063 544 2,232 87 3,436 3,173 6,609 244 3,857 484 2,024 84 3,205 2,635 5,840 484 3,875 225 1,256 75 2,929 2,817 5,746 228 3,665 234 1,619 70 2,761 2,703 5,464 208 3,423 295 1,538 69 2,478 2,673 5,151 181 3,206 252 1,512 63 2,365 2,936 5,301 180 3,207 317 1,597 61 2,318 2,336 4,654 184 2,952 264 1,254 60 1,933 2,351 4,284 144 2,822 221 63 1,034 2,145 1,940 1,181 1,549 1,469 1,449 1,536 1,194 (1) (2) (3) The figures for 2010 are presented in accordance with previous Canadian GAAP, and certain amounts from fiscal years 2013, 2012 and 2011 have been adjusted to reflect changes to the accounting standards in 2014. Given the adoption of IFRS 9, all loans classified in Stage 3 of the expected credit loss model are impaired loans. Under IAS 39, loans were considered impaired according to different criteria. Net impaired loans are presented net of allowances for credit losses on Stage 3 loan amounts drawn and, in this table, the net impaired loans presented exclude POCI loans. Includes customers’ liability under acceptances. 212 212 National Bank of Canada2019 Annual Report Supplementary Information Statistical Review As at October 31(1) 22001199 2018 2017 2016 2015 2014 2013 2012 2011 2010 Number of common shares(2) (thousands) Number of common shareholders on record Basic earnings per share(2) Diluted earnings per share(2) Dividend per share(2) Share price(2) High Low Close Book value(2) Dividends on preferred shares Series 15 Series 16 Series 20 Series 21 Series 24 Series 26 Series 28 Series 30 Series 32 Series 34 Series 36 Series 38 Series 40 Series 42 FFiinnaanncciiaall rraattiiooss Return on common shareholders’ equity Return on average assets RReegguullaattoorryy rraattiiooss uunnddeerr BBaasseell IIIIII Capital ratios(3) CET1(4) Tier 1(4) Total(4) Leverage ratio(4) OOtthheerr iinnffoorrmmaattiioonn Number of employees(9)(10) Branches in Canada Banking machines in Canada 333344,,117722 335,071 339,592 338,053 337,236 329,297 325,983 322,617 320,948 325,544 2200,,889944 21,325 21,542 21,966 22,152 22,394 22,737 23,180 23,588 23,598 $$ $$ $$ $$ $$ $$ $$ $$ $$ $$ $$ $$ $$ $$ 66..3399 66..3344 22..6666 6688..0022 5544..9977 6688..0022 3366..8899 –– –– –– –– –– –– –– 11..00115566 00..99775500 11..44000000 11..33550000 11..11112255 11..11550000 11..22337755 $ $ $ $ $ $ $ $ $ $ $ $ $ $ 6.01 $ 5.44 5.94 $ 2.44 $ 5.38 2.28 65.63 $ 58.69 $ 59.76 $ 34.40 $ 62.74 46.83 62.61 31.51 – – – – – – – $ 1.0250 $ 0.9750 $ 1.4000 $ 1.3500 $ 1.1125 $ 0.9310 0.5323 – – – – – – 0.9500 1.0250 0.9750 1.4000 1.3500 0.4724 – – $ $ $ $ $ $ $ $ $ $ $ $ 3.31 $ 4.56 3.29 $ 2.18 $ 4.51 2.04 47.88 $ 35.83 $ 47.88 $ 28.52 $ 55.06 40.75 43.31 28.26 – – – $ – – – 0.9500 $ 1.0250 $ 0.9750 $ 1.1373 0.5733 – – – – – 1.5000 – – – 0.9500 1.0250 1.0760 – – – – – $ $ $ $ $ $ $ $ $ $ $ $ $ 4.36 4.32 1.88 53.88 41.60 52.68 25.76 – 1.2125 1.5000 – 0.4125 0.4125 0.9500 0.7849 – – – – – – $ $ $ $ $ $ $ $ $ $ $ $ $ $ 4.34 $ 4.63 $ 3.41 $ 3.00 4.31 $ 1.70 $ 4.58 $ 1.54 $ 3.37 $ 1.37 $ 2.97 1.24 45.24 $ 36.18 $ 45.24 $ 22.97 $ 40.64 $ 31.64 $ 38.59 $ 20.02 $ 40.72 $ 32.43 $ 35.57 $ 17.82 $ 33.94 27.23 33.57 18.80 0.2444 $ 1.2125 $ 1.5000 $ 1.0078 $ 1.6500 $ 1.6500 $ 0.9728 – – – – – – – 1.4625 $ 1.2125 $ 1.5000 $ 1.3438 $ 1.6500 $ 1.6500 $ – – – – – – – – 1.4625 $ 1.2125 $ 1.5000 $ 1.3438 $ 1.6500 $ 1.6500 $ 1.4625 1.2125 1.5000 1.3438 1.6500 1.6500 – – – – – – – – – – – – – – – – 1188..00 %% 00..8811 %% 18.4 % 0.84 % 18.1 % 0.81 % 11.7 % 0.53 % 16.9 % 0.73 % 17.9 % 0.74 % 20.1 % 0.78 % 24.1 % 0.88 % 19.8 % 0.76 % 17.0 % 0.74 % 1111..77 %% 1155..00 %% 1166..11 %% 44..00 %% 11.7 % 15.5 % 16.8 % 4.0 % 11.2 % 14.9 %(5) 15.1 %(5) 4.0 % 10.1 % 13.5 % 15.3 % 3.7 % 9.9 % 12.5 %(6) 14.0 %(8) 3.7 % 9.2 % 12.3 %(7) 15.1 %(7) 8.7 % 11.4 % 15.0 % 7.3 % 10.1 % 14.1 % 7.6 % 10.8 % 14.3 % 14.0 % 17.5 % 2244,,555577 442222 993399 22,426 428 937 20,584 429 931 20,600 450 938 19,026 452 930 18,725 452 935 16,675 453 937 16,636 451 923 16,217 448 893 15,298 442 869 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) The figures for 2010 are presented in accordance with previous Canadian GAAP, and certain amounts from fiscal years 2013, 2012 and 2011 have been adjusted to reflect changes to the accounting standards in 2014. The figures for 2014 and prior years have been adjusted to reflect the stock dividend paid in 2014. The October 31, 2013, 2012 and 2011 ratios have not been adjusted to reflect changes in accounting standards. Since October 31, 2013, the capital ratios were calculated using the “all-in” methodology and the October 31, 2012 and 2011 ratios are presented on a pro forma basis. Taking into account the redemption of the Series 28 preferred shares on November 15, 2017. Taking into account the redemption of the Series 20 preferred shares on November 15, 2015. Taking into account the redemption of the Series 16 preferred shares on November 15, 2014. Taking into account the redemption of the Series 20 preferred shares on November 15, 2015 and the $500 million redemption of notes on November 2, 2015. Full-time equivalent. Includes employees from Credigy Ltd. and Advanced Bank of Asia Limited for fiscal years 2014 to 2019. National Bank of Canada 213 National Bank of Canada2019 Annual Report Supplementary Information GGlloossssaarryy ooff FFiinnaanncciiaall TTeerrmmss AAcccceeppttaanncceess Acceptances constitute a guarantee of payment by a bank and can be traded in the money market. The Bank earns a “stamping fee” for providing this guarantee. AAlllloowwaanncceess ffoorr ccrreeddiitt lloosssseess Allowances for credit losses represent management’s unbiased estimate of expected credit losses as at the balance sheet date. These allowances are primarily related to loans and off-balance-sheet items such as loan commitments and financial guarantees. AAsssseettss uunnddeerr aaddmmiinniissttrraattiioonn Assets in respect of which a financial institution provides administrative services such as custodial services, collection of investment income, settlement of purchase and sale transactions and record-keeping. Assets under administration, which are beneficially owned by clients, are not reported on the balance sheet of the institution offering such services. AAsssseettss uunnddeerr mmaannaaggeemmeenntt Assets managed by a financial institution that are beneficially owned by clients. Management services are more comprehensive than administrative services, and include selecting investments or offering investment advice. Assets under management, which may also be administered by the financial institution, are not reported on the financial institution’s balance sheet. AAvveerraaggee iinntteerreesstt--bbeeaarriinngg aasssseettss Average interest-bearing assets include deposits with financial institutions, certain interest-bearing cash items, securities, securities purchased under reverse repurchase agreements and securities borrowed, and loans but excludes other assets. The average is calculated based on the daily averages for the year. BBaassiiss ppooiinntt Unit of measure equal to one one-hundredth of a percentage point (0.01%). CCoommmmoonn EEqquuiittyy TTiieerr 11 ((CCEETT11)) ccaappiittaall rraattiioo Common Equity Tier 1 capital consists of common shareholders’ equity less goodwill, intangible assets and other capital deductions. Common Equity Tier 1 capital ratio is calculated by dividing Common Equity Tier 1 capital by the corresponding risk-weighted assets. DDeerriivvaattiivvee ffiinnaanncciiaall iinnssttrruummeennttss Derivative financial instruments are financial contracts whose value is derived from an underlying interest rate, exchange rate or equity, commodity or credit instrument or index. Examples of derivatives include swaps, options, forward rate agreements and futures. The notional amount of the derivative is the contract amount used as a reference point to calculate the payments to be exchanged between the two parties, and the notional amount itself is generally not exchanged by the parties. DDiivviiddeenndd ppaayyoouutt rraattiioo Common dividends as a percentage of net income after preferred share dividends. EEccoonnoommiicc ccaappiittaall Economic capital is the internal measure used by the Bank to determine the capital required for its solvency and to pursue its business operations. Economic capital takes into consideration the credit, market, operational, business and other risks to which the Bank is exposed, as well as the risk diversification effect among them and among the business segments. Economic capital thus helps the Bank to determine the capital required to protect itself against such risks and ensure its long-term viability. EEffffiicciieennccyy rraattiioo Non-interest expenses as a percentage of total revenue, the efficiency ratio measures the efficiency of the Bank’s operations. FFaaiirr vvaalluuee The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal market at the measurement date under current market conditions (i.e., an exit price). HHeeddggiinngg The purpose of a hedging transaction is to modify the Bank’s exposure to one or more risks by creating an offset between changes in the fair value of, or the cash flows attributable to, the hedged item and the hedging instrument. IImmppaaiirreedd llooaannss The Bank considers a financial asset, other than a credit card receivable, to be credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of the financial asset have occurred or when contractual payments are 90 days past due. Credit card receivables are considered credit-impaired and are fully written off at the earlier of the following: when a notice of bankruptcy is received, a settlement proposal is made, or contractual payments are 180 days past due. LLeevveerraaggee rraattiioo The leverage ratio is calculated by dividing Tier 1 capital by total exposure. Total exposure is defined as the sum of on-balance-sheet assets (including derivative exposures and securities financing transaction exposures) and off- balance-sheet items. LLiiqquuiiddiittyy ccoovveerraaggee rraattiioo The liquidity coverage ratio is a measure designed to ensure that the Bank has sufficient high-quality liquid assets to cover net cash outflows given a severe, 30-day liquidity crisis. MMaasstteerr nneettttiinngg aaggrreeeemmeenntt Legal agreement between two parties that have multiple derivative contracts with each other that provides for the net settlement of all contracts through a single payment, in the event of default, insolvency or bankruptcy. NNeett iinntteerreesstt mmaarrggiinn Net interest income as a percentage of average interest-bearing assets. 214 214 National Bank of Canada2019 Annual Report Supplementary Information Glossary of Financial Terms OOffffiiccee ooff tthhee SSuuppeerriinntteennddeenntt ooff FFiinnaanncciiaall IInnssttiittuuttiioonnss ((CCaannaaddaa)) ((OOSSFFII)) The mandate of the Office of the Superintendent of Financial Institutions (OSFI) is to regulate and supervise financial institutions and private pension plans subject to federal oversight, to help minimize undue losses to depositors and policyholders and, thereby, to contribute to public confidence in the Canadian financial system. SSttrruuccttuurreedd eennttiittyy A structured entity is an entity created to accomplish a narrow and well- defined objective and is designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when voting rights relate solely to administrative tasks and the relevant activities are directed by means of contractual arrangements. OOppeerraattiinngg lleevveerraaggee Operating leverage is the difference between the growth rate for total revenues and the growth rate for non-interest expenses. TTaaxxaabbllee eeqquuiivvaalleenntt bbaassiiss Taxable equivalent basis is a calculation method that consists in grossing up certain tax-exempt income by the amount of income tax that would have otherwise been payable. PPrroovviissiioonnss ffoorr ccrreeddiitt lloosssseess The amount charged to income necessary to bring the allowances for credit losses to a level determined appropriate by management. RReettuurrnn oonn ccoommmmoonn sshhaarreehhoollddeerrss’’ eeqquuiittyy ((RROOEE)) Net income, less dividends on preferred shares, expressed as a percentage of the average value of common shareholders’ equity. RRiisskk--wweeiigghhtteedd aasssseettss Assets are risk weighted according to the guidelines established by OSFI. In the Standardized calculation approach, factors are applied to the face value of certain assets in order to reflect comparable risk levels. In the Advanced Internal Rating-Based (AIRB) approach, risk-weighted assets are derived from the Bank's internal models, which represent the Bank's own assessment of the risks it incurs. Off-balance-sheet instruments are converted to balance sheet (or credit) equivalents by adjusting the notional values before applying the appropriate risk-weighting factors. SSeeccuurriittiieess ppuurrcchhaasseedd uunnddeerr rreevveerrssee rreeppuurrcchhaassee aaggrreeeemmeennttss Securities purchased by the Bank from a client pursuant to an agreement under which the securities will be resold to the same client on a specified date and at a specified price. Such an agreement is a form of short-term collateralized lending. SSeeccuurriittiieess ssoolldd uunnddeerr rreeppuurrcchhaassee aaggrreeeemmeennttss Financial obligations related to securities sold pursuant to an agreement under which the securities will be repurchased on a specified date and at a specified price. Such an agreement is a form of short-term funding. TTiieerr 11 ccaappiittaall rraattiioo Tier 1 capital ratio consists of Common Equity Tier 1 capital and Additional Tier 1 instruments, namely, eligible non-cumulative preferred shares and the eligible amount of innovative instruments. Tier 1 capital ratio is calculated by dividing Tier 1 capital, less regulatory adjustments, by the corresponding risk- weighted assets. TToottaall ccaappiittaall rraattiioo Total capital is the sum of Tier 1 and Tier 2 capital. Tier 2 capital consists of the eligible portion of subordinated debt and certain credit loss allowances. Total capital ratio less regulatory adjustments, by the corresponding risk-weighted assets. is calculated by dividing total capital, TToottaall sshhaarreehhoollddeerr rreettuurrnn The total shareholder return (TSR) represents the average total return on an investment in the Bank’s common shares. The return includes changes in share price and assumes that the dividends received were reinvested in additional common shares of the Bank. VVaalluuee--aatt--RRiisskk ((VVaaRR)) VaR is a statistical measure of risk that is used to quantify market risks across products, per types of risks and aggregate risk on a portfolio basis. VaR is defined as the maximum loss at a specific confidence level over a certain horizon under normal market conditions. The VaR method has the advantage of providing a uniform measurement of financial instrument-related market risks based on a single statistical confidence level and time horizon. National Bank of Canada 215 National Bank of Canada2019 Annual Report Supplementary Information IInnffoorrmmaattiioonn ffoorr SShhaarreehhoollddeerrss DDeessccrriippttiioonn ooff SShhaarree CCaappiittaall DDiivviiddeennddss DDeeccllaarreedd oonn CCoommmmoonn SShhaarreess DDuurriinngg FFiissccaall 22001199 The authorized share capital of the Bank consists of an unlimited number of common shares, without par value, an unlimited number of first preferred shares, without par value, issuable for a maximum aggregate consideration of $5 billion, and 15 million second preferred shares, without par value, issuable for a maximum aggregate consideration of $300 million. As at October 31, 2019, the Bank had a total of 334,172,411 common shares and 98,000,000 first preferred shares issued and outstanding. Record date Payment date Dividend per share ($) December 31, 2018 March 25, 2019 June 25, 2019 September 30, 2019 February 1, 2019 May 1, 2019 August 1, 2019 November 1, 2019 0.65 0.65 0.68 0.68 SSttoocckk EExxcchhaannggee LLiissttiinnggss DDiivviiddeennddss DDeeccllaarreedd oonn PPrreeffeerrrreedd SShhaarreess DDuurriinngg FFiissccaall 22001199 The Bank’s common shares and Series 30, 32, 34, 36, 38, 40 and 42 First Preferred Shares are listed on the Toronto Stock Exchange in Canada. Record date Payment date Series 30 Series 32 Series 34 Series 36 Dividend per share ($) Series 42 Series 40 Series 38 Issue or class Common shares First Preferred Shares Series 30 Series 32 Series 34 Series 36 Series 38 Series 40 Series 42 Ticker symbol NA NA.PR.S NA.PR.W NA.PR.X NA.PR.A NA.PR.C NA.PR.E NA.PR.G NNuummbbeerr ooff RReeggiisstteerreedd SShhaarreehhoollddeerrss As at October 31, 2019, there were 20,894 common shareholders recorded in the Bank’s common share register. DDiivviiddeennddss DDiivviiddeenndd DDaatteess iinn FFiissccaall 22002200 (subject to approval by the Board of Directors of the Bank) Record date Common shares December 30, 2019 March 30, 2020 June 29, 2020 September 28, 2020 Preferred shares, Series 30, 32, 34, 36, 38, 40 and 42 January 6, 2020 April 6, 2020 July 6, 2020 October 6, 2020 Payment date February 1, 2020 May 1, 2020 August 1, 2020 November 1, 2020 February 15, 2020 May 15, 2020 August 15, 2020 November 15, 2020 Jan. 7, 19 Apr. 5, 19 Jul. 8, 19 Oct. 7, 19 Feb. 15, 19 May 15, 19 Aug. 15, 19 Nov. 15, 19 0.2563 0.2438 0.3500 0.3375 0.2781 0.2875 0.3094 0.2562 0.2437 0.3500 0.3375 0.2782 0.2875 0.3094 0.2516 0.2438 0.3500 0.3375 0.2781 0.2875 0.3093 0.2515 0.2437 0.3500 0.3375 0.2781 0.2875 0.3094 Dividends paid are “eligible dividends” in accordance with the Income Tax Act (Canada). DDiivviiddeenndd RReeiinnvveessttmmeenntt aanndd SShhaarree PPuurrcchhaassee PPllaann National Bank has a Dividend Reinvestment and Share Purchase Plan for Canadian holders of its common and preferred shares under which they can acquire common shares of the Bank without paying commissions or administration fees. Canadian participants acquire common shares through the reinvestment of cash dividends paid on the shares they hold or through optional cash payments of at least $1 per payment, up to a maximum of $5,000 per quarter. For additional information, shareholders may contact National Bank’s registrar and transfer agent, Computershare Trust Company of Canada, at 1-888-838-1407. To participate in the plan, National Bank’s beneficial or non- registered common shareholders must contact their financial institution or broker. DDiirreecctt DDeeppoossiitt Shareholders may elect to have their dividend payments deposited directly via electronic funds transfer to their bank account at any financial institution that is a member of the Canadian Payments Association. To do so, they must send a written request to the Transfer Agent, Computershare Trust Company of Canada. 216 216 National Bank of Canada2019 Annual Report HHeeaadd OOffffiiccee National Bank of Canada 600 De La Gauchetière Street West, 4th Floor Montreal, Quebec H3B 4L2 Canada Telephone: 514-394-5000 Website: nbc.ca AAnnnnuuaall MMeeeettiinngg The Annual Meeting of Holders of Common Shares of the Bank will be held on April 24, 2020, at National Bank of Canada’s head Office in Montreal, Quebec, Canada. PPuubblliicc AAccccoouunnttaabbiilliittyy SSttaatteemmeenntt The 2019 Social Responsibility Report will be available in March 2020 on the Bank’s website at nbc.ca. CCoommmmuunniiccaattiioonn wwiitthh SShhaarreehhoollddeerrss For information about stock transfers, address changes, dividends, lost certificates, tax forms and estate transfers, shareholders of record may contact the Transfer Agent at the following address: CCoommppuutteerrsshhaarree TTrruusstt CCoommppaannyy ooff CCaannaaddaa Share Ownership Management 100 University Avenue, 8th Floor Toronto, Ontario M5J 2Y1 Canada Telephone: 1-888-838-1407 1-888-453-0330 Fax: service@computershare.com E-mail: computershare.com Website: CCaauuttiioonn RReeggaarrddiinngg FFoorrwwaarrdd--LLooookkiinngg SSttaatteemmeennttss From time to time, National Bank of Canada makes written and oral forward-looking statements, including in this Annual Report, in other filings with Canadian regulators, in reports to shareholders, in press releases and in other communications. All such statements are made pursuant to the Canadian and American securities legislation and the provisions of the United States Private Securities Litigation Reform Act of 1995. Additional information about these statements can be found on page 13 of this Annual Report. TTrraaddeemmaarrkkss The trademarks belonging to National Bank of Canada and used in this report include National Bank of Canada, Private Wealth 1859, CashPerformer, NBC CapS II, NBC Asset Trust, NBC Capital Trust, and National Bank All-in-One and their respective logos. Certain trademarks owned by third parties are also mentioned in this report. PPoouurr oobbtteenniirr uunnee vveerrssiioonn ffrraannççaaiissee dduu RRaappppoorrtt aannnnuueell,, vveeuuiilllleezz vvoouuss aaddrreesssseerr àà :: Relations avec les investisseurs Banque Nationale du Canada 600, rue De La Gauchetière Ouest, 7e étage Montréal (Québec) H3B 4L2 Canada Téléphone : Adresse électronique : relationsinvestisseurs@bnc.ca 1 866 517-5455 LLeeggaall DDeeppoossiitt ISBN 978-2-921835-63-3 Legal deposit – Bibliothèque et Archives nationales du Québec, 2019 Legal deposit – Library and Archives Canada, 2019 Shareholders whose shares are held by a market intermediary are asked to contact the market intermediary concerned. PPrriinnttiinngg L’Empreinte Other shareholder inquiries can be addressed to: Investor Relations National Bank of Canada National Bank Tower 600 De La Gauchetière Street West, 7th Floor Montreal, Quebec H3B 4L2 Canada Telephone: 1-866-517-5455 E-mail: Website: investorrelations@nbc.ca nbc.ca/investorrelations NNoorrmmaall CCoouurrssee IIssssuueerr BBiidd The Bank began a normal course issuer bid (NCIB) to repurchase for cancellation up to 6,000,000 common shares for the period starting June 10, 2019 and ending June 9, 2020. Shareholders may obtain, free of charge, a copy of the notice of intent regarding this NCIB, which was approved by the Toronto Stock Exchange, by writing to the Corporate Secretary, National Bank of Canada, 600 De La Gauchetière Street West, 4th floor, Montreal, Quebec, Canada H3B 4L2. National Bank of Canada is proud to help save the environment by using EcoLogo and Forest Stewardship Council® (FSC®) certified paper. At a Glance Founded in 1859, National Bank of Canada offers financial services to individuals, businesses, institutional clients and governments across Canada. We are one of Canada’s six systemically important banks and among the most profitable banks on a global basis by return on equity. We operate through three business segments in Canada—Personal and Commercial Banking, Wealth Management and Financial Markets—which represent our main sources of revenue. A fourth segment—U.S. Specialty Finance and International—complements the growth of our domestic operations. We are a leading bank in our core Quebec market and also hold leadership positions across the country in selected activities. We strive to meet the highest standards of social responsibility while creating value for our shareholders. We are proud to be recognized as an employer of choice and for promoting diversity and inclusion. We are headquartered in Montreal, and our securities are listed on the Toronto Stock Exchange (TSX: NA). Table of Contents 3 Message From the President and Chief Executive Officer 5 Members of the Office of the President 6 Message From the Chairman of the Board 7 Members of the Board of Directors 8 Our One Mission 9 Environmental, Social and Governance (ESG) 12 Risk Disclosures 13 Management’s Discussion and Analysis 111 Audited Consolidated Financial Statements 212 Statistical Review 214 Glossary of Financial Terms 216 Information for Shareholders 2.7 million Clients(1) 25,487 Employees(2) 495 Branches(3) 1,480 Banking Machines(4) $565 B Assets Under Administration $281 B Total Assets $7,432 M Total Revenues $2,322 M Net Income $22.7 B Market Capitalization and Under Management 9% 23% 45% 23% 19% 26% 55% 2019 Total Revenues by Business Segment(5) 2019 Total Revenues by Geographic Distribution(5) Personal and Commercial Province of Quebec Wealth Management Financial Markets Other Canadian provinces Outside of Canada U.S. Specialty Finance and International (1 ) Clients of the Personal and Commercial segment (2) Worldwide (3) 422 in Canada, 70 in Cambodia and 3 in the United States (Florida) (4) 939 in Canada and 541 in Cambodia (5) Excluding the Other heading ANNUAL REPORT 1920 t r o p e R l a u n n A 9 1 0 2 ® The NATIONAL BANK logo is a registered trademark of National Bank of Canada.

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