Impact of regulatory and accounting changes critical to viability of bank’s OTC derivatives business

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  • Banks divided on how to tackle impacts of Basel III and IFRS 13 on fair value of derivatives
  • Basel III could triple the existing counterparty credit risk charge for dealing houses
  • Industry split on using a debit valuation adjustment

Singapore, 22 October 2012 – EY’s survey, Reflecting credit and funding adjustments in the fair value of derivatives and issued debt, captures the progress of 19 of the largest, most sophisticated dealing houses and benchmarks current practice in calculating credit and funding adjustments to fair value, as well as the impact of Basel III on this process.

“Determining the fair value of derivatives contracts continues to be one of the key issues for the banking sector in 2012,” says Frank De Jonghe, Europe, Middle East, India and Africa (EMEIA) Capital Requirements Leader at EY. “If not managed carefully, the cross over between the more volatile accounting measurement introduced by IFRS 13 and Basel III will significantly hike up dealing houses’ capital requirements and also introduce significant volatility in results.”

Tara Kengla, EY’s EMEIA Financial Accounting Advisory Services Leader, adds: “While firms tackle the implementation and ongoing management of the two regimes they will be questioning the viability of their OTC derivatives businesses in their current format.”

On the impact for Asean-based banks, Lim Eng Hong, Asean Financial Services Risk Management and Compliance Leader at EY says: "Due to the overall increase in capital requirements for the trading book under the Basel III rules, derivative business activities may become less profitable or attractive to the market participants. This in turn forces a rethink of banks' strategies in terms of the suitable products and markets mixed that produces an appropriate balance of capital usage against the desired levels of returns. The result of which may be reduction in the market size of OTC derivatives transactions."


CVA VaR hike up capital charges under Basel III
Basel III introduces a Credit Valuation Adjustment (CVA) volatility charge, which is designed to cover potential changes in the value of the firm’s CVA. This CVA VaR (Value at Risk) charge in Basel III could have a significant impact on the regulatory capital required to support the retained credit risk from bank’s derivatives businesses.

"For most players in the derivatives markets the CVA volatility charge is a very material additional capital charge. For some dealing houses it could even treble the current counterparty credit risk charge,” says Frank.

"While banks would like to hedge economic risk and reduce income statement volatility, it is expected that the impact of the CVA VaR charge is significant enough to impact the hedging practices of banks — particularly those that are active in the capital markets business — and therefore can demonstrate that their credit hedges should be recognized as credit risk mitigants for the purposes of calculating the CVA VaR charge."


DVA contentious but unavoidable
All survey respondents record both a CVA on derivative assets and Own Credit Adjustment (OCA) on liabilities accounted for under the fair value option. Just 13 record a Debit Valuation Adjustment (DVA) on derivative liabilities which factors the credit risk of the bank into the valuations.

The six respondents who do not record a DVA cite a number of reasons for not doing so: the counterintuitive impact of recording a gain in profit or loss as their own credit-worthiness deteriorates; the fact that they would likely not be able to ‘monetize’ or obtain an economic benefit from the own credit gain upon transfer or close out of a derivative liability; the increase in systemic risk that can arise from hedging DVA; and finally, that accounting standards have not historically been explicit in requiring such an adjustment.

"The new accounting standard means that banks cannot avoid reflecting the bank’s credit risk in derivative liabilities,” says Tara. “This will exacerbate the age-old debate around banks recording profits on derivatives as their credit-worthiness deteriorates but the regulatory lines are clear and the market now needs to work out the best way to implement the use of DVA.”


The issue of incorporating funding costs remains largely unresolved
The majority of dealing houses have moved to OIS (Overnight Index Swap) for the valuation of collateralized derivatives, however no such consensus exists for the valuation of uncollateralized derivatives. The recent Libor scandal has put the spotlight on the debate around how banks measure their cost of funding and highlighted the possibility of banks introducing a funding valuation adjustment (FVA) to more accurately reflect the cost of funding in their valuations.

Just three respondents in the survey currently record a funding valuation adjustment on uncollateralized derivatives, with a further three respondents commenting that they plan to introduce such an adjustment during 2012. Of the respondents who intend to introduce a funding valuation adjustment (FVA) for this year end, there was no clear consensus on exactly how the adjustment would be calculated.

“There remains a significant amount of industry discussion around incorporating an entity’s cost of funding into the fair value of uncollateralized derivatives. Many respondents are still having internal discussions to conclude on whether an FVA is justifiable from a theoretical perspective. However the survey shows that the market is beginning to move in favor of the FVA,” says Tara.
 

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