Understanding Own Credit and Funding Costs: Addressing the Unresolved Challenges

DVA, Own Credit and Funding cost: The unresolved issuesTanguy DEHAPIOT

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” • 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

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) • Modification compared to Basel III article 75 that required to derecognise the full DVA amount (not the variation)

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…” • 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”

Accounting literature on Own Credit • IASB Staff paper: “Credit Risk in Liability Measurement”, June 2009 + Discussion paper DP/2009/2 • Questions from discussion paper: • 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? • 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: • Counter-intuitive results, Accounting mismatch, Realisation • Alternatives to consider • 1. Risk free debt + loss to income, 2.Risk free debt + charge to equity, 3. Freeze credit spread

The paradox: which company is stronger? • “Strong corporation” invests in low risk assets • “Weak corporation” invests in high risk assets  “Strong corporation” seems to have more leverage, so more risky  The higher the asset risk, the higher the equity, the stronger it appears Debt 100 proba 90% 0 proba 10% Fair value 90 Fair value 100 Low risk asset 111 proba 90% 0 proba 10% Leverage 9 Fair value 10 Equity Debt 100 proba 80% 0 proba 20% Fair value 80 Fair value 100 High risk asset 125 proba 80% 0 proba 20% Leverage 4 Fair value 20 Equity

Realisability: Debt repurchase • Initial investment: • Sell all assets then repurchase debt with cash raised:  We do not manage to realise the own credit gain Debt 100 proba 80% 0 proba 20% Fair value 80 Fair value 100 Risky asset 125 proba 80% 0 proba 20% Fair value 20 Equity Debt 100 Risk free Fair value 100 Cash 100 Fair value 100 Fair value 0 Equity

Counterintuitive effect of change of credit risk • Initial investment: • Switch to new investment at no cost:  Did the COMPANY make a gain?  Should it pay tax, dividends, bonus on this gain? Debt 100 proba 90% 0 proba 10% Fair value 90 Fair value 100 Low risk asset 111 proba 90% 0 proba 10% Fair value 10 Equity Debt 100 proba 80% 0 proba 20% Fair value 80 Fair value 100 High risk asset 125 proba 80% 0 proba 20% Fair value 20 Equity

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? • 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” • Should credit standing affect subsequent fresh start measurement? • 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. 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 • If credit changes and we issue a new debt, the old debt must have the same value as the new debt ASSETS Debt 100 proba 80% 0 proba 20% Fair value 80 Cash received 80 Bond value 80 Risky asset 125 proba 80% 0 proba 20% Fair value 100 Fair value 20 Cash received 20 Share value 80 Equity Old Debt 100 proba 80% 50 proba 20% Risky asset 1 125 proba 80% 0 proba 20% Fair value 90 Fair value 100 + 100 = 200 New debt 100 proba 80% 50 proba 20% Fair value 90 Safe asset 2 100 proba 100% Fair value 20 Equity

Limited liability vs unlimited liability Debt 100 proba 80% 0 proba 20% • Initial investment from limited liability company • Conversion to an infinite liability company • 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? Fair value 80 Fair value 100 Risky asset 125 proba 80% 0 proba 20% Fair value 20 Equity Debt 100 Guaranteed by shareholders Fair value 100 Fair value 100 Risky asset 125 proba 80% 0 proba 20% Fair value 0 Equity

The shareholder insolvency put • Limited liability company • Infinite liability company + shareholder insolvency put • The two representation are economically equivalent for creditors and shareholders  is the company’s equity the same? Debt 100 proba 80% 0 proba 20% Fair value 80 Creditors Fair value 100 Risky asset 125 proba 80% 0 proba 20% Fair value 20 Equity Shareholders Put option Debt 100 Guaranteed by shareholders Fair value 100 Fair value -20 Creditors Fair value 100 Risky asset 125 proba 80% 0 proba 20% Fair value +20 Fair value 0 Shareholders Equity

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” • 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)?

Merton & Perold analysis • Theory of Risk capital in financial firms, R. Merton & A. Perold, 1993 • They compare 3 situations: • 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 • A limited liability company is equivalent to an asset insurance purchased by the company from the creditors Risky asset 125 proba 80% 0 proba 20% Default free debt 100 Fair value 100 Fair value 100 Asset insurance 0 proba 80% 100 proba 20% Fair value 20 Fair value 20 Equity

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 • 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 is a borrowing penalty charged to earning

Different balance sheets Risky debt including own credit Accounting view Market view Economic Public balance sheet (FHM) value Risky debt including own credit Bonds FV Tangible assets at market Tangible assets at market Franchise value Shares FV Equity Owner value - Insolvency put Bonds FV Debt at default free value Tangible assets at market Debt at default free value Tangible assets at market Entreprise net value Franchise value Entreprise net worth Shares FV + Insolvency put

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) • 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 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” • 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

Example D (Assets – Debts) = D Equity = P&L + OCI + Var. Capital Debt 100 proba 80% 0 proba 20% Risky asset 125 proba 80% 0 proba 20% Fair value 100 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 • We show the cash movements as well as P&L and capital movements

Chasteem & Ransom analysis (1) • T1: Capital investment • T1 T2: P&L = 0, Var. Capital = -20 20 20 Shareholders Assets S I Purchase assets Capital increase Value = 20 Net Worth =20 • T0 T1: P&L = 0, Var. Capital = +20 • T2: New Debt New debt (Default free) Bondholders B Value = 100-20 = 80 80 I Sell Put 20 Assets 100 Purchase assets Buy Put Entity 20 Shareholders S Net Worth = 0 Capital distribution Value = 20 Put = 20, Intrinsic Value = 0

Chasteem & Ransom analysis (2) • T3: Debt redemption (no default) Redemption Bondholders B Value = 100, P&L = +20 100 125 I Assets Sell assets Entity Shareholders S Net Worth = 25 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

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: • No bid-offer • We can always borrow overnight at EONIA • Permanent borrowing at EONIA is not guaranteed • 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 • 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 “all-in” financing cost that is observable. This spreads includes: • 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) • Ignoring the last component, there are two ways to split between credit and funding • 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)

Discounting assets at cost of funding (incl. credit) Debt 200 proba 80% 100 proba 20% Risky asset 125 proba 80% 0 proba 20% Expected value 180 • 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 Equity 25 proba 80% 0 proba 20% Safe asset 100 proba 100%

Equity impact of new derivative • Initial situation Debt 100 proba 80% 0 proba 20% Fair value 80 Fair value 100 Risky asset 125 proba 80% 0 proba 20% Equity 25 proba 80% 0 proba 20% Fair value 20 • Simple derivative +10 C does not default 80% Market up 0 C defaults Pu = 50% 20% 80% -10 I does not default Market down Pd = 50% 0 I defaults 20%

Scenarios with debt and derivatives Asset Ctpy Market Proba Debt Deriv. Equity Put S OK OK Up 32% 100 +10 35 0 OK OK Down 32% 100 -10 15 0 OK Default Up 8% 100 0 25 0 OK Default Down 8% 100 -10 15 0 Default OK Up 8% 10 +10 0 90 Default OK Down 8% 0 0 0 110 Default Default Up 2% 0 0 0 100 Default Default Down 2% 0 0 0110 100% 80.8 0 19.2 20.2 A: Asset value L: Contractual debt D: contractual derivative pay-off Put S = Max(L-A-D,0) = (L-A-D). 1L-A-D>0 = 20.2 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

Initial payment flow • Before trading derivative New debt (Default free) Bondholders B Value = 100-20 = 80 I Sell Put Entity 20 100 Buy Put 20 Net Worth = 0 Shareholders Capital distribution S Put So = Put Bo = 20, • After trading derivative Derivative counterparty C Value = 100-20 = 80 I Entity 1 1 Bondholders B Put C Var Value = 80.8 – 80 = 0.8 0.8? Net Worth = -1 1 Shareholders S Capital distribution Put S1 = Put C + Put B1 = 20.2

DVA analysis with external shareholder put DFV: Default free value DFV(I) = - DFV(C) = 0 CRV: Counterparty risk value CRV = DFV –CVA DVA(I) = Put(SI) = 1 SI SC DVA(C) = Put(SC) = 1 Buy Put Buy Put 1 1 Capital decrease Capital decrease 1 1 0 0 I C Default free derivative CRV(I) = DFV(I) –CVA(I) = -1 CRV(C) = DFV(C) –CVA(C) = -1 Total Value I + SI = 0 Total Value C + SC = 0

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 capital that we can call KVA?

Understanding Own Credit and Funding Costs: Addressing the Unresolved Challenges