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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