Reflecting credit risk in fair value of derivatives

By Francisco Roque A. Lumbres and Viktor Xenon O. Lequin

(First of two parts)

First Published in Business World (8/12/2013)

The 2008 financial crisis has led to some significant changes in the areas of fair value and risk management, including an increased emphasis on counterparty credit risk in derivatives. These changes are starting to take root in the Philippines through the implementation of Philippine Financial Reporting Standard (PFRS) 13, Fair Value Measurement, and the adoption of the Basel III capital reforms on counterparty credit risk. PFRS 13, which took effect on Jan. 1, 2013, requires all entities to consider credit risk in determining the fair value of derivatives. The BangkoSentralngPilipinas (BSP) plans to adopt the Basel III capital rules on counterparty credit risk, currently contained in an exposure draft that is expected to take effect starting Jan. 1, 2014 when finalized.

With these developments, entities face a challenge to adopt the expanded requirements and fundamentally rethink their approach to managing and reporting counterparty credit risk.
Even prior to the financial crisis, many parties have long recognized the need for credit risk adjustments to derivatives. In practice, however, most entities continued to value derivatives without considering these credit adjustments. Before the crisis, entities generally valued derivatives using a model with an implicit no-default assumption. This assumption is apparent in the use of risk-free rates in present value calculations, in valuation techniques such as the Black-Scholes model.

The apparent disregard for credit risk in derivatives is thought to be attributable to at least two factors. First is that the most active derivatives traders are the largest global banks that, as a group, constitute entities with the highest credit ratings. Therefore, the market perceived the credit risk in transactions with this group as negligible. Second is that market participants recognize the practical difficulty of implementing counterparty credit risk calculations.

But, the global financial crisis in 2008 destroyed all notions that market participants had about the apparent immunity of global banks to credit risk, and it removed misconceptions about the significance of derivatives credit risk to the financial markets. Failure of institutions such as Lehman Brothers, and the near collapse of other institutions in the wake of the credit crunch, had abolished ideas about the invulnerability of too-big-to-fail banks. Market participants could no longer take the credit risk of the largest banks for granted. Moreover, the crisis highlighted a peculiarly dangerous characteristic of counterparty credit risk, which is its capability to produce a systemic shock that can shake the global financial markets and spill over to the real economy. A default by a single “big marquee name” counterparty bank can swiftly erode market participants’ confidence in the financial system, which is then crippled.

Counterparty credit risk can also exacerbate weaknesses in the financial system in periods of great stress. The increased participation of non-financial entities in derivatives for the purpose of hedging has also substantially contributed to credit risk in the derivatives market.

Accounting standard-setting bodies [such as the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB)] and central banks were quick to learn from the crisis and have issued requirements to address the heightened concerns about counterparty credit risk, such as credit valuation adjustment (CVA) and debit valuation adjustment (DVA) for financial reporting and expanded counterparty risk capital requirements for banks.

CVA is an adjustment to the measurement of derivative assets to reflect the default risk of the counterparty. In other words, the intention when making an adjustment for CVA is to reflect the correct value of an entity’s derivative positions taking into account the risk of non-performance by the derivative counterparty.

PFRS 13 justifies making a credit adjustment when there is market evidence that entities make such adjustments in pricing their derivatives. It is seen that foreign counterparties include credit adjustments in their derivatives transactions with Philippine entities (bank or non-bank), although it seems unclear whether Philippine entities do the same. However, with the proposed BSP counterparty credit risk guidelines to be implemented beginning Jan. 1, 2014, it is expected that Philippine banks will now be required to make credit adjustments on their derivatives transactions, not only for regulatory capital requirements but also for meeting financial reporting requirements.

DVA, on the other hand, is an adjustment to the measurement of derivative liabilities to reflect the own default risk of the entity. An entity, therefore, incorporates into its valuation the potential for its own non-performance, on the basis that it would expect any well-informed counterparty to consider this credit risk in valuing a derivative deal. Also, PFRS 13 is explicit that own credit risk must be incorporated in determining fair value of a liability.

The basic conceptual model for calculating CVA draws on the expected credit loss formula:

CVA = Expected Credit Loss
    = PD * LGD * EPE

PD = probability of default of a counterparty on its obligation

LGD = loss given default, or amount per dollar of exposure not expected to be recoverable in the event of default

EPE = expected positive exposure or estimate of the positive exposure at the time of default

CVA is the expected loss (PD * LGD) on an expected positive exposure. In calculating CVA, the current exposure (or current fair value) is not the appropriate measure of EPE, since it does not take into account how the value of the derivative may change over the future as a result of changes in underlying market factors. For the purpose of CVA, entities should consider the potential future exposure in EPE in addition to current exposure.

PFRS 13 does not prescribe any particular methodology for calculating CVA, given that there are a number of different methodologies in the market. Most advanced banks in the US and Europe (often the derivatives counterparties of Philippine entities) would use complex simulation techniques to determine derivatives fair value and CVA. Less sophisticated entities use less complex and less precise techniques, such as single or multiple credit spread approaches and constant or variable exposure approaches.

Entities should exercise judgment in selecting the approach to measure CVA and DVA, provided that they consider:

the materiality of the derivatives to the financial statements;

the number and type of derivatives in the portfolio; and

other circumstances surrounding the derivatives activities such as collateral arrangements, etc.

PFRS 13 requires the maximum use of market observable inputs as opposed to unobservable inputs in determining fair value, regardless of approach selected.

In the second part of this article, the regulatory capital requirements for banks pertaining to counterparty credit risk and an overview of the business impact and implementation issues will be discussed.

Francisco Roque A. Lumbres, CFA, PRM is a partner of SGV & Co.
Viktor Xenon O. Lequin is a senior associate of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.