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Transcript
DVA, Own Credit and Funding cost:
The unresolved issues
Tanguy DEHAPIOT
MARCUS EVANS
Pricing Model Validation
10 Sep. 2013
Accounting and regulatory rules for Own Credit

Basel III paragraph 75 (following the 25th July 2012 amendment)
“Derecognise in the calculation of Common Equity Tier 1 all unrealised
gains and losses that have resulted from changes in the fair value of
liabilities that are due to changes in the bank’s own credit risk.
In addition, with regards to derivative liabilities, derecognise all
accounting valuation adjustments arising from the bank’s own credit
risk. The offsetting between valuation adjustments arising from the
bank’s own credit risk and those arising from its counterparties’ credit
risk is not allowed”



MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Derecognise variation for debts
Derecognise full stock for derivatives
Intensive debate between regulators and the financial industry
following Basel Committee consultative document “Application of
own credit risk adjustments to derivatives”, December 2011
2
Accounting and regulatory rules for Own Credit

CRR Article 30 – prudential filter for liabilities
Institutions shall not include the following items in any of own
funds:
(b) Gains or losses on liabilities of the institutions that are valued
at fair value that result from changes in the own credit standing of
the institution.
(c) All fair value gains or losses arising from the institution’s own
credit risks related to derivative liabilities. Institutions shall not
offset the fair value gains and losses arising from the institution’s
own credit risk (e.g. DVA) with those arising from its counterparty
credit risk (e.g. CVA)

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Modification compared to Basel III article 75 that required to
derecognise the full DVA amount (not the variation)
3
Accounting and regulatory rules for Own Credit

IFRS 9 paragraph 5.7.7 (a)
“The amount of change of fair value of the financial liability that is
attributable to the change of credit risk of that liability shall be
presented in other comprehensive income”



Realised gain on repurchases not recycled into P&L
Fair value option debts only  not applicable to derivatives
IFRS 9 paragraph B5.7.16
“The amount of change of fair value attributable to changes in credit
risk of a liability can be determined as the amount of change in its fair
value that is not attributable to changes in market condition that give
rise to market risk; or using an alternative method…”

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
IFRS 9 paragraph B5.7.17
“Changes in market conditions that give rise to market risk include
changes in a benchmark interest rate, the price of another entity’s
financial instrument, a commodity price, a foreign exchange rate”
4
Accounting literature on Own Credit

IASB Staff paper: “Credit Risk in Liability Measurement”, June
2009 + Discussion paper DP/2009/2

Questions from discussion paper:




Project Principal for staff paper: Wayne S. Upton Jr.
Arguments for incorporating credit risk:



Consistency at initial recognition, Wealth transfer, Account. mismatch
Arguments against incorporating credit risk:

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
When a liability is first recognised, should its measurement
incorporate the price of credit risk inherent in the liability?
Should current measurement following initial recognition incorporate
the price of credit risk inherent in the liability?
Counter-intuitive results, Accounting mismatch, Realisation
Alternatives to consider

1. Risk free debt + loss to income, 2.Risk free debt + charge to equity,
5
3. Freeze credit spread
The paradox: which company is stronger?

“Strong corporation” invests in low risk assets
Fair value
100

Fair value
90
Equity
Fair value
10
Leverage
9
“Weak corporation” invests in high risk assets
Fair value
100
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Low risk asset
111 proba 90%
0 proba 10%
Debt
100 proba 90%
0 proba 10%
High risk asset
125 proba 80%
0 proba 20%
Debt
100 proba 80%
0 proba 20%
Fair value
80
Equity
Fair value
20
Leverage
4
 “Strong corporation” seems to have more leverage, so more risky
6
 The higher the asset risk, the higher the equity, the stronger it appears
Realisability: Debt repurchase

Initial investment:
Fair value
Risky asset
100
125 proba 80%
0 proba 20%

Fair value
80
Equity
Fair value
20
Sell all assets then repurchase debt with cash raised:
Fair value
100
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Debt
100 proba 80%
0 proba 20%
Cash
100
Debt
100
Risk free
Fair value
100
Equity
Fair value
0
 We do not manage to realise the own credit gain
7
Counterintuitive effect of change of credit risk

Initial investment:
Fair value
100

Fair value
90
Equity
Fair value
10
Switch to new investment at no cost:
Fair value
100
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Low risk asset
111 proba 90%
0 proba 10%
Debt
100 proba 90%
0 proba 10%
High risk asset
125 proba 80%
0 proba 20%
Debt
100 proba 80%
0 proba 20%
Fair value
80
Equity
Fair value
20
 Did the COMPANY make a gain?
 Should it pay tax, dividends, bonus on this gain?
8
FASB Arguments for incorporating Credit risk

FASB paper: “Credit Standing in Liability Measurement” (G.
Michael Crooch, Wayne S. Upton), June 2001

Should credit standing affect the measurement on initial
recognition?



Should credit standing affect subsequent fresh start
measurement?

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
PRINCIPLE: “The simple act of borrowing money at prevailing
interest rates is not an event that gives rise to a gain or a loss”
CONCLUSION: “Any measurement that reports a loss from the
simple act of borrowing at the market rate must be rejected”

PRINCIPLE: “The fair value measurement system should not attach
different measurements to assets and liabilities that are economically
the same”
CONCLUSION: “Excluding changes in credit standing leads
inevitably to measuring two identical liabilities at different amounts.
9
That must surely provide an ‘inaccurate’ reading”
FASB Arguments for incorporating Credit risk

At inception, if the debt is valued as default free rather than with
its current credit risk, we would need to record a loss
Risky asset
Fair value
125 proba 80%
100
0 proba 20%

Debt
100 proba 80%
0 proba 20%
Fair value Cash received Bond value
80
80
80
Equity
Fair value Cash received Share value
20
20
80
If credit changes and we issue a new debt, the old debt must
have the same value as the new debt
Fair value
100 + 100 = 200
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
ASSETS
Old Debt
100 proba 80%
50 proba 20%
Fair value
90
New debt
100 proba 80%
Safe asset 2
100 proba 100% 50 proba 20%
Fair value
90
Risky asset 1
125 proba 80%
0 proba 20%
Equity
Fair value
20
10
Limited liability vs unlimited liability

Initial investment from limited liability company
Fair value
100

Fair value
80
Equity
Fair value
20
Conversion to an infinite liability company
Fair value
100
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Risky asset
125 proba 80%
0 proba 20%
Debt
100 proba 80%
0 proba 20%


Risky asset
125 proba 80%
0 proba 20%
Debt
100
Guaranteed by
shareholders
Equity
Fair value
100
Fair value
0
Creditors pay 20 to shareholders to make the change fair
The transformation is equivalent to bondholders buying a credit
protection from the shareholder  What is the P&L?
11
The shareholder insolvency put

Limited liability company
Fair value
100

Fair value
80
Creditors
Equity
Fair value
20
Shareholders
Infinite liability company + shareholder insolvency put
Fair value
100
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Risky asset
125 proba 80%
0 proba 20%
Debt
100 proba 80%
0 proba 20%

Risky asset
125 proba 80%
0 proba 20%
Debt
100
Guaranteed by
shareholders
Equity
Put option
Fair value
100
Creditors
Fair value
-20
Fair value
0
Shareholders
Fair value
+20
The two representation are economically equivalent for creditors and
shareholders  is the company’s equity the same?
12
The third party guarantee representation

IFRS 13 paragraph 44
“The issuer of a liability issued with an inseparable third party credit
enhancement that is accounted for separately from the liability shall
not include the effect of the credit enhancement (e.g. a third party
guarantee on debt) in the fair value measurement of the liability”



MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
i.e.: the third party guarantee is outside the balance sheet of the
issuer
Does it make a difference if we guarantee the assets rather than
the liabilities?
Does it make a difference if the guarantee is provided by the
parent company (i.e.: the shareholders)?
13
Merton & Perold analysis

Theory of Risk capital in financial firms, R. Merton & A. Perold, 1993

They compare 3 situations:




MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013

Guarantee on assets of the company by third party
Guarantee on liabilities of the company by the parent company
Defaultable liabilities with no guarantee
Conclusion: Risky debt = Default free debt – Debt insurance by creditors
Fair value
100
Risky asset
125 proba 80%
0 proba 20%
Default free debt
100
Fair value
20
Asset insurance
0 proba 80%
100 proba 20%
Equity
Fair value
100
Fair value
20
A limited liability company is equivalent to an asset insurance purchased
14
by the company from the creditors
Francis, Heckman, Mango analysis


Credit Standing and the Fair Value of Liabilities: A Critique, Philip E.
Heckman, 2003 (published 2004)
Insolvency Put: Whose Assets, Louise A. Francis, Philip E. Heckman,
Donald F. Mango, 2005 (FHM)
 They start with the analysis of the firm value: The Franchise value
needs to be added to the Tangible asset value
 They consider like Merton & Perold that the risky debt must be
decomposed as a default free debt plus an insolvency put
 The differ from Merton & Perold because they consider that the
insolvency put is not an asset of the company as it provides benefits
only to its owners

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013


The creditors have not sold the insurance to the company but to the
owners (limited liability shareholders)
The insolvency put is not an asset distributable to creditors
The difference between default free debt value and risk debt value
15 is
a borrowing penalty charged to earning
Different balance sheets
Accounting view
Tangible
assets
at market
Market view
Risky debt
including
own credit
Equity
Public balance sheet (FHM)
Tangible
assets
at market
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Tangible assets
at market
Risky debt
including
own credit
Bonds
FV
Franchise
value
Owner value
Shares
FV
Economic
value
- Insolvency put
Debt at default
free value
Tangible assets
at market
Debt at default
free value
Entreprise
net worth
Franchise
value
Entreprise
net value
+ Insolvency put
Bonds
FV
Shares
FV
16
Chasteen & Ransom analysis

Including Credit Standing in Measuring the Fair Value of
liabilities – Let’s pass This One To the Shareholders, Lanny G.
Chasteen & Charles R. Ransom, June 2007 (C&R)




MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013

The liability is measured as if it is default free: entities with identical
obligations should report liabilities of identical amounts
The difference between default free value and the risky value is
the put option, which is an asset of the shareholders
This difference is recorded as a distribution to shareholder
(decrease in equity)
Interest expenses in P&L are based on the current borrowing rate
(risky). The difference between interest rate expense and default
free value variation is accounted as an increase in shareholder’s
equity
Change of the entities credit risk has not direct P&L impact but
17
change in the default free rate has a P&L impact
The two views in debt measurement

FASB Approach: Asset and Liability symmetry
“For a liability, fair value should reflect the amount that would be paid
by the reporting entity to transfer the liability to a willing third party of
comparable credit standing (lay off amount)”
“When estimating fair value, we must be sure that the estimate is for
the liability that is recognised in the financial statement, and not some
other item”


MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Liability seen as an asset of a creditor
The alternative approach: Asset and liability differences
“The different entities with the same promised stream of cashflows
should report the same obligation regardless of the proceeds
received in exchange of the promise”
“A liability should be valued solely on the basis of the contractual
terms under the assumption that the contract will be performed”

Liability seen as the performance of an obligation from the debtor 18
Example
D (Assets – Debts) = D Equity = P&L + OCI + Var. Capital
Fair value
100
Risky asset
125 proba 80%
0 proba 20%
Debt
100 proba 80%
0 proba 20%
Equity
T0: Start of company (no asset, no debt, no equity)
T1: Raise 20 Capital from shareholders  Invest in risky assets
T2: Raise 80 Debt with redemption 100  Invest in risk assets
T3: Assets perform: sell assets for 125, pay back debt

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
We show the cash movements as well as P&L and capital
movements
19
Chasteem & Ransom analysis (1)

T1: Capital investment
Assets
20
20
I
Purchase assets
Capital increase
Shareholders
S
Value = 20
Net Worth =20
T0 T1: P&L = 0, Var. Capital = +20


T2: New Debt
Assets
80
Purchase assets
New debt
(Default free)
I
Entity
Net Worth = 0
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013

B
Sell Put
20
100
Value = 100-20 = 80
Buy Put
20
Capital
distribution
Bondholders
S
T1 T2: P&L = 0, Var. Capital = -20
Shareholders
Value = 20
Put = 20, Intrinsic Value = 0
20
Chasteem & Ransom analysis (2)

T3: Debt redemption (no default)
Redemption
Assets
125
Sell assets
I
Entity
Net Worth = 25



MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
100
B
S
Bondholders
Value = 100, P&L = +20
Shareholders
Value = 25, P&L = +5
T2 T3: P&L = +25 – 20 = +5, Var. Capital = +20
Recycle 20 from capital account into P&L
Differences FASB, Heckman, Chasteem & Ranson



FASB: T2 no impact on equity, P&L = 0, T3 P&L +5
Heckman: T2 borrowing penalty in P&L -20, T3 P&L +25
Chasteem & Ranson: T2 Capital decrease, T3 recycle to P&L
21
Does Funding spread exist without credit risk?

Example of investments with no credit risk




Investment 1: rolling overnight loan  pays EONIA
Investment 2: Fixed term loan  pays EONIA + spread
Why do investor require a strictly positive spread ?
Non arbitrage argument


Term loan + rolling overnight borrowing = profit with certainty
Strong assumptions:



Permanent borrowing at EONIA is not guaranteed

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
No bid-offer
We can always borrow overnight at EONIA


Bid-offer cost + capital charge
If we borrow continuously, we may be charged more than those
who alternate borrowing and lending, event with no default risk
22
EONIA is an average: some pay more than others
FVA: Separating Credit and Funding cost

A debt is issued at a spread over “Risk-free” rate. This is an “allin” financing cost that is observable. This spreads includes:




Ignoring the last component, there are two ways to split
between credit and funding



MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
The issuer credit risk
A “pure” cost of term funding (locking financing for a term)
A measure of the attractiveness of the paper (supply and demand)
Assume credit risk spread is measured by CDS and consider the
pure funding spread as the residue  The basis
Assume “pure” funding cost is measured with secured debt
(covered bonds) and consider the credit spread as the residue
The two methods lead to totally different splits

The first method lead to volatile credit spread and often negative
funding spread (if we borrow below CDS spread)
23
Discounting assets at cost of funding (incl. credit)
Risky asset
125 proba 80%
0 proba 20%
Safe asset
100 proba 100%

Debt
200 proba 80%
100 proba 20%
Expected value
180
Equity
25 proba 80%
0 proba 20%
Valuation of assets with Funding Cost Adjustments:
Debt discount rate = 11.1% = cost of funding
 Risky asset value: 100 x 0.9 = 90
 Safe asset value: 100 x 0.9 =90
 Net equity value: 180 – 180 = 0
 Same effect as removing Own credit effect from debt

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
24
Equity impact of new derivative

Initial situation
Debt
100 proba 80%
0 proba 20%
Fair value
80
Equity
25 proba 80%
0 proba 20%
Fair value
20
80%
+10
C does not default
20%
0
C defaults
80%
-10
I does not default
20%
0
I defaults
Fair value
Risky asset
100
125 proba 80%
0 proba 20%

Simple derivative
Pu = 50%
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Pd = 50%
Market
up
Market
down
25
Scenarios with debt and derivatives
Asset
Ctpy
Market Proba
Debt
Deriv.
Equity
Put S
OK
OK
OK
OK
Default
Default
Default
Default
OK
OK
Default
Default
OK
OK
Default
Default
Up
Down
Up
Down
Up
Down
Up
Down
100
100
100
100
10
0
0
0
80.8
+10
-10
0
-10
+10
0
0
0
0
35
15
25
15
0
0
0
0
19.2
0
0
0
0
90
110
100
110
20.2
A: Asset value
32%
32%
8%
8%
8%
8%
2%
2%
100%
L: Contractual debt
D: contractual derivative pay-off
Put S = Max(L-A-D,0) = (L-A-D). 1L-A-D>0 = 20.2
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
Put S = (L-A-Max(D,0)). 1L-A-D>0 + Max(-D,0). 1L-A-D>0
Put B = 19.2
Put C = DVA = 1
26
Initial payment flow

Before trading derivative
New debt
(Default free)
Entity
I
Net Worth = 0

Sell Put
20
100
Capital
distribution
S
C
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
I
Net Worth = -1
Shareholders
Put So = Put Bo = 20,
Derivative counterparty
Value = 100-20 = 80
1
1
Put C
1
Capital
distribution
Value = 100-20 = 80
Buy Put
20
After trading derivative
Entity
Bondholders
B
S
B
0.8?
Bondholders
Var Value = 80.8 – 80 = 0.8
Shareholders
Put S1 = Put C + Put B1 = 20.2
27
DVA analysis with external shareholder put
DFV: Default free value
CRV: Counterparty risk value
DVA(I) = Put(SI) = 1
SI
Buy Put
DFV(I) = - DFV(C) = 0
CRV = DFV –CVA
SC
Buy Put
1
1
Capital decrease
0
0
Default free derivative
CRV(I) = DFV(I) –CVA(I) = -1
Total Value I + SI = 0
Capital decrease
1
1
I
MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013
DVA(C) = Put(SC) = 1
C
CRV(C) = DFV(C) –CVA(C) = -1
Total Value C + SC = 0
28
Conclusion
We have detailed the alternative valuation of liabilities.
 DVA does not belong to the entity but is an asset of the
shareholders (the limited liability guarantee is a put option).
 The entity is compensated for the CVA cost at deal inception, so
initial P&L is zero and both counterparties agree the price.
 The entity has implicitly made a capital distribution (decrease) to
the shareholder and share intrinsic value decrease but time
value increases. DVA is like a dividend in kind.
 Basel III paragraph 75 seems correct: the new derivative
generates a decrease of CET1 capital. Stock vs. variation.
 The new derivative affects the value of other debts without
proper compensation between shareholders and creditors.
New subject: do we need a valuation adjustment for the cost of
29
capital that we can call KVA?

MARCUS EVANS
Pricing Model
Validation
10 Sep. 2013