Credit risk relates to the risk that a counterparty will default before the maturity/expiration of a transaction and will consequently be unable to meet all contractual payments, thereby resulting in a loss for the other party to the transaction. A valuation adjustment for credit reflects the amount at which such risk is measured by a market participant.
The valuation adjustments that have become prevalent across global markets are those that reflect the two-way risk of loss for the reporting entity (the corporate in this case) and the counterparty. These are commonly referred to as a credit valuation adjustment (CVA) – i.e. an adjustment reflecting the credit risk exposure to the counterparty – and a debt valuation adjustment (DVA) – i.e. an adjustment reflecting the corporate’s own credit risk to which the counterparty is exposed.
Although each may be relevant for both derivative assets and liabilities, CVA tends to be most significant for derivative assets and DVA for derivative liabilities.
The progression of IFRS requirements and changing regulations for banks are encouraging corporates and banks, respectively, to apply CVA/DVA as best practice.
The implementation of CVA by a corporate increases the transparency to be able to attribute the risk components of the financial instrument’s pricing, by allowing the credit risk component to be separated out from the pricing relating to other market risks. This in turn allows the corporate to better interrogate the pricing offered by their bankers, in particular relating to the premium charged for counterparty credit risk (CVA at inception).
The calculation of CVA from the corporate’s perspective (i.e. representing the bank’s own credit risk – DVA) allows the corporate to quantify the potential credit risk exposure that it has to the bank over the life of the instrument. This enables the corporate to negotiate the incorporation of the bank’s DVA (corporate’s CVA) in the inception pricing, reducing the overall cost to the corporate. Banks have historically been considered to be risk-free and therefore have not been required to pass on any pricing benefit associated with its own credit risk to corporates. With the introduction of CVA/DVA concepts, this opinion is being challenged across the local and global financial markets.
The requirements of IFRS 13: Fair Value Measurement, effective for periods beginning on or after 1 January 2013, have amplified the focus on incorporating credit/non-performance risk in asset and liability fair valuations. Even though IFRS 13 and IAS 39 don’t provide specific guidance on how this can be achieved or calculated, CVA and DVA have become the generally accepted methods for estimating the valuation adjustment to financial asset and liability prices for credit risk.
With the introduction of Basel III CVA calculation and capital requirements, banks are required to hold capital against CVA volatility. This capital charge is in addition to the existing counterparty credit risk capital charges and represents a further cost to banks for taking on client credit exposures. As with other capital charges, a portion of the cost is likely to be passed onto the corporate customer through the pricing, increasing the cost to the corporate for entering into financial instrument trades with a bank.
The impact of the these capital requirements is lower in South Africa as a result of a directive issued by the South African Reserve Bank, which permits banks to hold zero percent capital for CVA risk for over-the-counter (OTC) derivatives that are denominated and transacted solely in Rand or entered into bilaterally between local counterparties. However this directive is only applicable from 1 January 2014 to 31 December 2014, where after the full Basel III requirements are expected to be adopted.
The adoption of CVA shouldn’t automatically translate into additional costs or escalated pricing for corporates entering into financial instrument transactions. CVA has resulted in more accurate estimation of the potential counterparty credit risk that a bank is exposed to from a corporate over the life of an instrument.
The methods used to quantify the credit risk exposures pre-CVA were less technical and often relied on arbitrary assumptions or static data. As a result, CVA calculations may in fact identify scenarios where corporates are being charged a higher credit premium than warranted and could allow for reduced pricing for the corporate going forward.
The implementation of CVA across the banking industry and in a corporate’s own operations is likely to impact on the following areas:
- the cost of entering into new financial instrument transactions, as a result of the incorporation of more accurate estimations of counterparty credit risk into the initial pricing
- volatility in the financial instrument fair values reported for accounting purposes, as a result of changes in the underlying credit risk assumptions impacting fair value
- accounting, presentation and disclosure of financial instruments based on the requirements of IFRS 13 to separately consider and incorporate credit risk in fair valuations
- funding and opportunity costs for corporates as a result of a move by the banking industry to collateralise OTC financial instrument transactions, in order to mitigate their credit risk exposure and CVA recognised
In our experience, the local market remains divided on the inclusion of DVA into financial reporting results. This is consistent with ongoing debates being held in Europe and the US in this regard.
The argument for recognising DVA is centered on the adjustment being in compliance with the IFRS 13 accounting requirements, to include an assessment of an entity’s own credit risk in the fair valuation of its financial liabilities. The DVA calculation represents one of the potential methods available to a corporate to include credit risk into the fair value calculation. It also ensures congruency between the financial liability presented by the issuer (net of DVA) and the financial asset presented by the holder (net of CVA).
Arguments used to rationalize not recognising DVA relate to counter-intuitive accounting results when a gain is recognised in the Statement of Comprehensive Income in the event of a deterioration in the credit profile of an entity. In addition, an entity’s own credit risk (introduced through the recognition of DVA) can be challenging to hedge and the use of credit derivatives to mitigate the risk are often restricted by the industry regulators.
Some relief to the potential volatility in earnings, arising from the recognition of DVA, is offered by an accounting policy election option set out in IFRS 9. The accounting policy is available for financial liabilities that have been designated at fair value, and allows fair value changes arising from changes in an entity’s own credit risk only to be deferred to Other Comprehensive Income. This allowance in IFRS 9 can be early adopted without having to adopt the rest of the standard.
The calculation and implementation of CVA/DVA into the financial reporting, risk management and trading processes of an organisation, hold many advantages for South African corporates. Amongst these are:
- an ability to accurately quantify, monitor and manage credit risk within the organisation
- compliance with the measurement and disclosure requirements of IFRS 13
- a capability to independently verify financial instrument pricing at inception and on settlement and attribute the key risk components of these valuations
As with any new process or methodology implemented within an organisation, CVA/DVA poses certain challenges to corporates, some unique to the South African credit markets.
- Observability of credit inputs – The corporate credit market in South Africa remains thinly traded and concentrated to only a few traded names. The lack of liquidity makes it challenging to source observable credit spreads (or probability of defaults) for input into the CVA calculation models. This opens the CVA calculation to independent scrutiny and judgment.
- Resources and skills – CVA methodologies can be highly technical and involve complex mathematical calculations and Monte Carlo simulations. Resources with quantitative, valuation and financial risk management experience are required to oversee CVA calculations, price verification and risk management processes.
- Governance and operational processes – Governance frameworks, risk management policies and associated operational processes may need to be reviewed as a result of the introduction of fair value volatility relating to counterparty and an entity’s own credit risk into financial reporting.
- Systems – There are limited treasury management systems that currently offer fully automated solutions to calculate CVA/DVA. With the challenge of South African credit inputs not being readily available on financial data platforms such as Bloomberg and Reuters, customised automated solutions or manual spreadsheet calculations are often the practical alternatives.
KPMG offers an extensive range of financial engineering and risk consulting services applicable to CVA/DVA training, implementation and assessment. We are able to provide an “end-to-end” approach: governance and strategy, valuation models and methodologies, independent price verification, operating models and processes, software/automation solutions and structuring solutions for risk management and hedging.