DVA Own Credit and Funding cost The unresolved

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 th n Basel III paragraph 75 (following the 25 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” Derecognise variation for debts Ø Derecognise full stock for derivatives Ø MARCUS EVANS Pricing Model Validation 10 Sep. 2013 n Intensive debate between regulators and the financial 2 industry following Basel Committee consultative

Accounting and regulatory rules for Own Credit n 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) Ø 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 n 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 Ø Fair value option debts only not applicable to derivatives Ø n MARCUS EVANS Pricing Model Validation 10 Sep. 2013 IFRS 9 paragraph B 5. 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…” n IFRS 9 paragraph B 5. 7. 17 4

Accounting literature on Own Credit n IASB Staff paper: “Credit Risk in Liability Measurement”, June 2009 + Discussion paper DP/2009/2 l Questions from discussion paper: When a liability is first recognised, should its measurement incorporate the price of credit risk inherent in the liability? Ø Should current measurement following initial recognition incorporate the price of credit risk inherent in the liability? Ø l l Project Principal for staff paper: Wayne S. Upton Jr. Arguments for incorporating credit risk: Ø MARCUS EVANS Pricing Model Validation 10 Sep. 2013 l Consistency at initial recognition, Wealth transfer, Account. mismatch Arguments against incorporating credit risk: Ø Counter-intuitive results, Accounting mismatch, Realisation 5

The paradox: which company is stronger? n “Strong corporation” invests in low risk assets Fair value Low risk asset 100 111 proba 90% 0 proba 10% n Debt 100 proba 90% 0 proba Equity 10% Fair value 10 Leverage 9 “Weak corporation” invests in high risk assets Debt Fair value High risk asset 100 proba 80% 100 125 proba 80% 0 proba 20% Equity 20% MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Fair value 90 Fair value 80 Fair value 20 Leverage 4 “Strong corporation” seems to have more leverage, so 6 more risky

Realisability: Debt repurchase n Initial investment: Fair value Risky asset 100 125 proba 80% 0 proba 20% n Fair value 80 Fair value 20 Sell assets then repurchase debt with cash raised: Fair value 100 MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Debt 100 proba 80% 0 proba Equity 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 n Initial investment: Fair value Low risk asset 100 111 proba 90% 0 proba 10% n Fair value 90 Fair value 10 Switch to new investment at no cost: Fair value High risk asset 100 125 proba 80% 0 proba 20% MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Debt 100 proba 90% 0 proba Equity 10% Debt 100 proba 80% 0 proba Equity 20% Fair value 80 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 n FASB paper: “Credit Standing in Liability Measurement” (G. Michael Crooch, Wayne S. Upton), June 2001 l Should credit standing affect the measurement on initial recognition? PRINCIPLE: “The simple act of borrowing money at prevailing interest rates is not an event that gives rise to a gain or a loss” Ø CONCLUSION: “Any measurement that reports a loss from the simple act of borrowing at the market rate must be rejected” Ø l MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Should credit standing affect subsequent fresh start measurement? Ø PRINCIPLE: “The fair value measurement system should not attach different measurements to assets and 9 liabilities that are economically the same”

FASB Arguments for incorporating Credit risk n At inception, if the debt is valued as default free rather than with its current credit risk, we would need ASSETS to record a loss Debt Risky asset Fair value 125 proba 80% 100 0 proba 20% n 100 proba 80% 0 proba Equity 20% Fair value. Cash received Bond value 80 80 80 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 Old value Debt as the new debt Risky asset 1 Fair value 100 proba 125 proba 80% 90 80% Fair value 0 proba 20% 50 proba 100 + 100 = 200 New debt Fair value 20% Safe asset 2 100 proba 80% 90 MARCUS EVANS 100 proba 100% 50 proba 20% Pricing Model Fair value Validation Equity 10 Sep. 2013 20 10

Limited liability vs unlimited liability n Initial investment from limited liability company Fair value Risky asset 100 125 proba 80% 0 proba 20% n Debt 100 proba 80% 0 proba Equity 20% Fair value 20 Conversion to an infinite liability company Debt 100 Fair value Risky asset Guaranteed 100 125 proba 80% by 0 proba 20% shareholders Equity MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Fair value 80 l l Fair value 100 Fair value 0 Creditors pay 20 to shareholders to make the change fair 11 The transformation is equivalent to bondholders buying

The shareholder insolvency put n Limited liability company Fair value Risky asset 100 125 proba 80% 0 proba 20% n Debt 100 proba 80% 0 proba Equity 20% Fair value 80 Creditors Fair value Shareholders 20 Infinite liability company + shareholder insolvency. Put putoption Debt Fair value 100 Creditors Fair value Risky asset 100 -20 Guaranteed 100 125 proba 80% by 0 proba 20% Fair value Shareholders Fair value shareholders Equity +20 0 MARCUS EVANS Pricing Model Validation 10 Sep. 2013 l The two representation are economically equivalent for creditors and shareholders is the company’s equity the 12 same?

The third party guarantee representation n 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” n n n 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 n Theory of Risk capital in financial firms, R. Merton & A. Perold, 1993 l They compare 3 situations: Guarantee on assets of the company by third party Ø Guarantee on liabilities of the company by the parent company Ø Defaultable liabilities with no guarantee Ø l Conclusion: Riskyasset debt = Default free debt –value Debt Default free Fair value insurance 125 by creditors proba 80% debt 100 Fair value 20 MARCUS EVANS Pricing Model Validation 10 Sep. 2013 0 proba 20% Asset insurance 0 proba 80% 100 proba 20% 100 Equity Fair value 20 14

Francis, Heckman, Mango analysis n n MARCUS EVANS Pricing Model Validation 10 Sep. 2013 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) l They start with the analysis of the firm value: The Franchise value needs to be added to the Tangible asset value l They consider like Merton & Perold that the risky debt must be decomposed as a default free debt plus an insolvency put l 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 The creditors have not sold the insurance to the company but to the owners (limited liability shareholders) 15 Ø The insolvency put is not an asset distributable to creditors Ø

Different balance sheets Accounting view Tangible assets at market Risky debt including own credit Equity Market view Tangible assets at market Franchise value Risky debt including own credit Bonds FV Owner value Share s FV Economic Public balance sheet (FHM) value- Insolvency Tangible assets at market MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Debt at default free value Entreprise net worth Tangible assets at market Franchise value Bonds put FV Debt at default free value Entreprise net value + Insolvency put Share s FV 16

Chasteen & Ransom analysis n 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) l l l MARCUS EVANS Pricing Model Validation 10 Sep. 2013 l 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 17

The two views in debt measurement n 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” Ø n 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 18

Example D (Assets – Debts) = D Equity = P&L + OCI + Var. Capital Risky asset Fair value 125 proba 80% 100 0 proba 20% MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Debt 100 proba 80% 0 proba Equity 20% T 0: Start of company (no asset, no debt, no equity) T 1: Raise 20 Capital from shareholders Invest in risky assets T 2: Raise 80 Debt with redemption 100 Invest in risk assets T 3: Assets perform: sell assets for 125, pay back debt l We show the cash movements as well as P&L and capital movements 19

Chasteem & Ransom analysis (1) T 1: Capital investment 20 Assets n Purchase assets l n I Capital increase S Shareholders Value = 20 Net Worth =20 T 1: P&L = 0, Var. Capital = +20 T 2: New Debt Assets 80 Purchase assets MARCUS EVANS Pricing Model Validation 10 Sep. 2013 20 New debt (Default free) I Entity B 20 100 20 Bondholders Value = 100 -20 = 80 Sell Put Buy Put Net Worth = 0 Capital S distribution l T 1 T 2: P&L = 0, Var. Capital = -20 Shareholders Value = 20 Put = 20, Intrinsic 20 Value = 0

Chasteem & Ransom analysis (2) n T 3: Debt redemption (no default) Redemption Assets 125 Sell assets I Entity Net Worth = 25 l l n MARCUS EVANS Pricing Model Validation 10 Sep. 2013 100 B Bondholders S Shareholders Value = 100, P&L = +20 Value = 25, P&L = +5 T 2 T 3: P&L = +25 – 20 = +5, Var. Capital = +20 Recycle 20 from capital account into P&L Differences FASB, Heckman, Chasteem & Ranson l l FASB: T 2 no impact on equity, P&L = 0, T 3 P&L +5 Heckman: T 2 borrowing penalty in P&L -20, T 3 21

Does Funding spread exist without credit risk? n Example of investments with no credit risk l l l n 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 l l Term loan + rolling overnight borrowing = profit with certainty Strong assumptions: No bid-offer Ø We can always borrow overnight at EONIA Ø n MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Permanent borrowing at EONIA is not guaranteed l l Bid-offer cost + capital charge 22 If we borrow continuously, we may be charged more

FVA: Separating Credit and Funding cost n A debt is issued at a spread over “Risk-free” rate. This is an “all-in” financing cost that is observable. This spreads includes: l l l n Ignoring the last component, there are two ways to split between credit and funding l 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) l 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 23 debt (covered bonds) and consider the credit spread

Discounting assets at cost of funding (incl. credit) Debt 200 proba Expected value 180 80% 100 proba Equity 20% Safe asset 25 proba 80% 100 proba 100% 0 proba 20% Risky asset 125 proba 80% 0 proba 20% n Valuation of assets with Funding Cost Adjustments: Debt discount rate = 11. 1% = cost of funding l Risky asset value: 100 x 0. 9 = 90 l Safe asset value: 100 x 0. 9 =90 l Net equity value: 180 – 180 = 0 Same effect as removing Own credit effect from debt l MARCUS EVANS Pricing Model Validation 10 Sep. 2013 24

Equity impact of new derivative n Initial situation Debt Fair value 100 proba Fair value Risky asset 80 80% 100 125 proba 80% 0 proba 20% Equity Fair value 20% 25 proba 80% 20 0 proba 20% n Simple derivative Pu = 50% MARCUS EVANS Pricing Model Validation 10 Sep. 2013 Pd = 50% Market up Market down 80 % 20 % 80 % 20 +10 C does not default 0 C defaults -10 I does not default 0 I defaults 25

Scenarios with debt and derivatives Asset Ctpy Market Proba Debt Deriv. Equity Put S OK OK Default Up Down +10 -10 +10 0 0 OK OK Default A: Asset value off MARCUS EVANS Pricing Model Validation 10 Sep. 2013 32% 8% 8% 2% 2% 100 100 100 10 0 80. 8 L: Contractual debt 35 15 25 15 0 0 19. 2 0 0 90 110 100 110 20. 2 D: contractual derivative pay- Put S = Max(L-A-D, 0) = (L-A-D). 1 L-A-D>0 = 20. 2 Put S = (L-A-Max(D, 0)). 1 L-A-D>0 + Max(-D, 0). 1 L-A-D>0 26

Initial payment flow n Before trading derivative New debt (Default free) Entity I 100 B 20 MARCUS EVANS Pricing Model Validation 10 Sep. 2013 S After trading derivative Entity I Value = 100 -20 = 80 Sell Put Buy Put 20 Net Worth = 0 Capital distribution n Bondholders C Shareholders Put So = Put Bo = 20, Derivative counterparty Value = 100 -20 = 80 1 1 Net Worth = -1 Put C 1 Capital distribution S B Bondholders 0. 8? Var Value = 80. 8 – 80 = Shareholders 27 Put S 1 = Put C + Put B 1 = 20. 2

DVA analysis with external shareholder put DFV: Default free value CRV: Counterparty risk value DVA(I) = Put(SI) =1 SI Buy Put 1 Capital decrease MARCUS EVANS Pricing Model Validation 10 Sep. 2013 DFV(I) = - DFV(C) = 0 CRV = DFV –CVA SC Buy Put 1 1 1 0 I Default free derivative CRV(I) = DFV(I) –CVA(I) = -1 Total Value I + SI = 0 DVA(C) = Put(SC) =1 0 Capital decrease C CRV(C) = DFV(C) – CVA(C) = -1 Total Value C + SC = 0 28

Conclusion n n MARCUS EVANS Pricing Model Validation 10 Sep. 2013 n 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 CET 1 capital. 29