Canadian Banking Industry &
Derivatives
Edwin Cheung
Isaac Schweigert
Sharan Brar
Tolek Strukoff
Agenda




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Economic & Market Analysis - Sharan
Risk Management Environment - Sharan
Royal Bank of Canada - Isaac
Bank of Montreal - Edwin
Canadian Imperial Bank of Commerce - Tolek
Economic & Market Analysis
Industry Structure
 Competition
 Market
Dynamics
Competition
The Canadian banking system is
mature, sophisticated and highly
competitive
 14 domestic banks; 33 foreign bank
subsidiaries; 20 foreign bank branches
 They collectively manage over $1.7
trillion in assets

Market Dynamics
The six large Canadian banks manage
over 90% of total bank assets
 Banks operate through an extensive
network of branches and automated
banking machines (ABM’s)
 Canada has the highest # of ABM’s per
capita
 Industry experiencing consolidation

Products Produced
 Products
 Technology
 Substitutes
Products
A bank performs the following activities:


accepts deposits
grants commercial loans
Bank Act 1954 & 1967 allowed:

granting of mortgages and consumer loans
Bank Act 1992 allowed:


operation of trust and securities subsidiaries
banks to be involved in wealth management
Technology
Technology is significantly altering the
structure of the Canadian bank industry
 Internet
 product innovation to improve services
 Canada is a leader in automated
banking
Substitutes
credit unions
 foreign banks
 small virtual competitors
 small region-specific/culturally specific
institutions

Cost and Revenue
Structure
 Revenue
Sources
 Cost Structure
Revenue Sources
Interest Income is a major source
 Importance of non-interest income is
increasing
 Fees for mutual fund management,
credit cards, derivatives trading, cheque
processing, foreign exchange

Cost Structure
Operations
 Human Resources

Firm Strategy & Future
Growth
Investment in technology and product
innovation
 Cost efficiency/alliances/consolidation
 Expansion of customer base
 Wealth management, corporate and
investment banking
 Expansion to select international
markets

Regulatory Environment
Bank Act
 Regulation modified every 5 years to
stay current and allow flexibility
 Office of the Superintendent of
Financial Institutions
 Restrictions in ownership

Regulatory Environment
International Monetary Fund
 Canada Deposit Insurance Corporation
 Canadian Securities Institute
(educational requirements)
 Provincial securities regulators
 IDA & MFDA

Risk Management
Environment
Risks
Major Risks:
 Market Risk
 Credit Risk
 Liquidity Risk
Measurement:
 Statistics
 Economic Capital
Techniques & Products
Techniques:
 Hedging
Products:
 Swaps
 Futures (Currency)
 Options
Prospects & Hazards
Prospects for Effective Risk Management:
 Banks in the business of RM
 Complicated
Hazards
 Large position sizes
 Complex
 Significant values at risk
 Operational risk
 Many external factors: interest rates,
exchange rates
RBC
Divisions of RBC

RBC Banking
– RBC Royal Bank
– RBC Centura (USA)

RBC Investments
– full service and self-directed brokerages
– private banking
– RBC Dain Rauscher (USA brokerage)

RBC Insurance
Divisions of RBC

RBC Capital Markets
– financial services to companies and
government
– hedge funds and private equity

RBC Global Services
– Transaction processing for mutual and
hedge funds
– Custodian for CI Mutual Funds, AIM and
Mackenzie
Net Income by Segment
6%
RBC Banking
7%
RBC Insurance
RBC Investments
15%
53%
12%
7%
RBC Capital
Markets
RBC Global
Services
Other
Factors Affecting Future Results
Credit, market, liquidity, insurance,
operational and other risks
 Health of economy, businesses and
capital markets
 Monetary policy in Canada and USA
 Competition
 Statute and regulatory changes

Risks to be Managed
Credit
 Market
 Liquidity
 Insurance
 Operational

Economic Capital

Calculation of equity needed to
underpin the risk
– based on solvency and debt ratings

Calculated for credit, goodwill &
intangibles, non-trading market risk,
insurance, fixed asset and trading
market risk
Economic Capital
9%
16%
34%
10%
31%
Credit
Goodwill
Operational
Other
Business Risk
Value at Risk (VaR)
Used to manage trading risks
 RBC uses a 99% confidence level and
back tests 500 previous days

Credit Risk
Includes off balance sheet
 Diversify loans by type and geography
 $1 billion in credit protection (2002)
 $300 million in derivatives (2002)

Credit Quality






Major area of risk
Moving to lower-risk mortgages and less business
loans
Purchased $1 billion in credit protection in 2002
Only deal with reinsurers with AAA rating
Largest domestic loan concentration is Ontario
Largest international loan concentration is USA
Worldwide Revenues
90
80
70
60
50
2000
2002
40
30
20
10
0
Canada
U.S.
Int'l
Market Risk
Interest rate
 Credit spread - from bonds and credit
derivatives
 FX - brokerage, investment, trading,
arbitrage and proprietary trading
 Trading activities - market making,
arbitrage in interest rate, FX and equity
markets

Liquidity Risk
Managed dynamically
 Overseen by the Liquidity Crisis Team
 Hedged with a pool of unencumbered,
high-quality assets
 Marketable or can be pledged as
collateral

Liquidity Management
$155 billion in liquid assets (41% of
total assets)
 RBC maintains a high credit rating to
have best possible access to capital
 Contingent liability plan
 Securitize assets to diversify funding
base

Securitization
$1.7 billion of government guaranteed
mortgages in 2002, $2.4 billion
outstanding
 $1.7 billion of credit card receivables
through an SPE

Insurance Risk
Product design and pricing risk
 Claims administration risk
 Underwriting risk
 Liability risk

Asset/Liability Management
Interest rate risk can be linear and nonlinear
 Linear risk is hedged with interest rate
swaps
 Non-linear risk comes from embedded
options in products offered

Off Balance Sheet
Guarantees and standby credit letters
 Leases on premises and equipment
 Derivatives which RBC is a counter
party with other institutions and in
trading

– $10.6 billion in credit risk

Special Purpose Entities
Special Purpose Entities
Used to securitize credit card
receivables
 Non-operating and have no employees
 Also provide SPE services to clients
 Issue paper to purchase the assets from
RBC

– Issued in SPE name, $20.6 billion o/s
Derivatives
Most are FX forwards, interest rate and
currency forwards, FX and interest rate
options and credit derivatives
 Margin requirements and premiums
recorded as assets
 Use hedge accounting for own
derivatives if applicable

Derivatives
Most relate to sales and trading
activities
 Market-making, positioning and
arbitrage
 No significant dealing in leveraged
derivatives
 Used for hedging and investing

Hedges
Fair Value Hedge-interest rate swaps
 Cash Flow Hedge-interest rate swaps
 Foreign exchange investments in
subsidiaries

– FX forwards
– US dollar denominated liabilities
Hedges

Hedge mortgages by securitization
– $3.7 billion in 2002, $1.7 billion sold to
investors

Redeemable deposits hedged with
interest rate options
BMO
Comprehensive risk governance
Enterprise-wide Risk Management
Effective process & models
Qualified risk professional
Integrated Risk Management

Management of risk is integrated with
the management of capital and strategy

Capital at Risk (CaR)
Total Capital Risk by Risk Type



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Strategic 11%
Operational 24%
Credit 38%
Market 27%
Total Capital RIsk by Risk Type
Strategic
Operational
Credit
Market
Direct Risk Management
Credit Risk
 Market risk
 Liquidity and Funding Risk
 Operational Risk

Credit Risk

Is the risk of loss due to the failure of a
borrower, endorser, guarantor or
counterparty to repay a loan of honor
another predetermined financial
obligation
Credit risk

Provision for credit losses was $820 M
(0.56% of average net loans and acceptance)

Gross impaired loans totaled $2,337M

Net loans exposure to cable and telecom
companies was approximately $2.0 billion
Credit risk

Risk measurement
– Gross impaired loans and acceptance

Measure the financial condition of the portfolio
– Provision for credit losses

A measure of credit quality experience
Provision for Credit Losses as a % of
Average Net Loans and Acceptance
0.70%
0.60%
0.50%
0.40%
0.30%
0.20%
0.10%
0.00%
From 1998 to 2002
Market Risk

Is the risk of a negative impact on the
balance sheet and income statement
resulting from adverse changes in the
value of financial instruments as a
result of changes in certain market
variables.
Market Risk

The market variables include:
Interest rates
Foreign exchange rates
Equity or commodity prices
Credit spreads
Credit migration and default
Market Risk

Risk measurement
– Market Value Exposure (MVE)
– 12-month Earnings Volatility
Value at Risk (VaR), an MVE measure,
calculate the magnitude of BMO’s market
risk.
Earnings Volatility (EV), a measure of the
adverse impact of potential changes in
market variables on 12-months after tax
income
Liquidity and Funding Risk

Is the risk of being unable to meet
financial commitments in a timely
manner at reasonable prices as the fall
due.
Financial commitments include liabilities
to depositors and suppliers, and lending
and investment commitments.
Liquidity and Funding Risk

Risk measurement
1) Cash and securities-to-total assets ratio
• Cash and securities totaled $63.0 billion
• Total assets $252.9 billion
2) Core deposits-to-total deposits ratio
• Core deposits totaled $96.5 billion
• Total deposits totaled $161.8 billion
Liquidity and Funding Risk
Cash and Securities as a % of Total Assets
Core Deposits as a % of Total deposits
35.0%
65.0%
30.0%
60.0%
25.0%
55.0%
20.0%
50.0%
15.0%
45.0%
40.0%
10.0%
35.0%
5.0%
30.0%
0.0%
From 1998 to 2002
From 1998 to 2002

Off-balance sheet special purpose entities
(SPEs)
– To securitize BMO assets in support of
capital or funding management

Customer credit commitments
– Integral part of BMO credit-granting
practices and create liquidity and funding
exposure.
Operational Risk

Is the risk of loss resulting form
inadequate or failed internal processes,
system or human error, or external
events
– Never be eliminated
Operational Risk

Composed of
– Operational risks, which include physical
and logical security, transaction processing,
operations control technology and
outsourcing risks
– Business and event risks, which include
strategic, image and reputation, taxation,
accounting and financial management,
legal, regulatory requirement and HR risks.
Operational Risk

Risk measurement:
– Combines the likelihood of an operational
risk event occurring with the probable loss
if it does occur
– Expected and unexpected loss can be
determined by the loss distribution
Operational Risk

BMO’s goal:
– To make this risk transparent throughout
the enterprise
Derivative portfolio

Interest rate contracts
– Swap, Futures, Option

Foreign Exchanges Contracts
– Cross-Currency swaps, Futures, Forward FX

Commodity Contracts
– Swap, Futures, Forward, Option
Equity Contracts
 Credit Contracts

CIBC
CIBC Business Lines

CIBC Retail: 49.4% of total assets
– Financial Services and lending, credit
cards, mortgages, deposits, insurance
and investment products to retail and
small business
– CIBC branches, ABM network, telephone
and internet banking
CIBC Business Lines

Wealth Management: 9.3%
– Relationship based advisory sales,
services and products through a sales
force of investment professionals.
– Full service brokerage in Canada and US,
discount brokerage, global private
banking and trust services, and asset
management
CIBC Business Lines

CIBC World Markets: 39.5%
– Provides integrated and corporate
banking solutions
– North America, UK, and Asia primarily
– Specializations: Mergers/Acquisitions,
research, sales/trading of
securities/derivatives, merchant banking
and commercial banking
CIBC Business Lines

Amicus: 1.8%
– Co-branded electronic retail banking
services.
– Operates through pavilions in retail
locations; offers variety of deposit and
credit products
Factors Affecting Future Results
Credit, market, liquidity, operational and
other risks
 Health of economy, businesses and
capital markets
 Monetary policy in Canada and USA
 Competition
 Statute and regulatory changes

Risks to be Managed
Credit
 Market
 Liquidity
 Operational

Risk Management Structure:

Manages risk within tolerance levels
established by is management
committees, BOD, and BOD committees
with the objective of optimizing
shareholder wealth
Credit Risk:

Essentially Default Risk
Credit Risk Management:
Reviewed by Capital & Risk Committee
(CRC)
 Reduce Concentrations
 Majority of risk from loan and
acceptance portfolio
 Credit risk also from off-balance sheet
activities
 Two key policies

Loans

Consumer Loans:
– 67% of CIBC portfolio: Inherently
diversified

Business and Government Loans:
– 33% of portfolio, 87% of which is in North
America (the rest in UK, Western Europe),
Asian exposure managed down
*Country Risk:
Risk that assets may become frozen in a
foreign country
 Manage risk through limits on exposure
 Argentina ordeal

Derivative Use:

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Active in credit derivative markets
CLO’s
Credit derivatives are used to mitigate sector
concentrations
Largest Sectors Hedged: telecom ($724
million), utilities ($354 million), and financial
institutions ($346 million)
Notional amount outstanding to credit
protection: $4 billion (Oct. 31, 2002)
Counterparty Credit Exposure:
Arises from its interest rate, foreign
exchange, equity, commodity and credit
derivatives market making and portfolio
management activities.
 Investment grade: 91% of CIBC’s
derivative credit exposure

Management of Market Risk:

The risk of financial loss arising from
changes in the values of financial
instruments and includes interest rate
credit spread, foreign exchange equity,
commodity and liquidity risks
Measures of Market Risk:
VaR: Values-at-Risk RMU
 Stress testing and scenario analysis,
 Backtesting,

VaR and RMU:
Statistically defined
 Market risk measure of the potential
loss from adverse movements that can
occur under normal market conditions
 An RMU is defined as the overnight loss
with less than a 1% probability of
occurring in normal markets.

Traded Activities:

Holds positions in both liquid and less
liquid trade’s financial instruments as a
fundamental component of providing
integrated financial solutions to meet
clients needs.

Foreign Exchange Risk
Non-trading Activities and Risks:
Interest Rate
 Non-Trading Equity Exposure
 FX-Risk
 Non-Exchange Traded Commodity
Derivatives

Management of Liquidity Risk:
Dynamic infrastructure, policies and
standards, measurement, monitoring
and control.
 Liquid assets
 $103.8 billion of wholesale term debt
 Moodys and S&P rating downgrades

SPE’s
Securitized various financial assets,
including credit card receivables,
residential and commercial mortgages,
and business loans through SPE’s
 *Securitization: entity transfers assets
to an SPE in exchange for cash

Management of Operational Risk:
Failures in internal controls, which
include people, processes and systems
 Insurance

Recommendation about Risk
Management:
Banks are in the business of risk
management
 Continual improvement methodology for
risk management

References
Canadian banks 2002: Perspectives on the Canadian banking
industry. Pricewaterhousecoopers Survey Report. Accessed
October 14, 2003 from <http://www.pwc.com>
Canadian securities course: Volume 1. (2001). Canadian Securities
Institute.
Canada’s Banks. 2002. Department of Finance. Accessed October
14 from <http://www.fin.gc.ca>