Accounting for MVA under IFRS 13 & 9

1. Accounting for MVAunder IFRS 13 & 9 Richard Kenyon, BSc Hons (Dunelm), PGCertTLHE, PGDipExpM, ACIL, ACA, FHEA Senior Lecturer, Accounting & Finance Dept, Birmingham City Business School

2. Acknowledgements and Disclaimers Joint work with Chris Kenyon acting as Independent Researcher The views expressed in here are the personal views of the authors and do not necessarily reflect the views or policies of current or previous employers. Not guaranteed fit for any purpose. Use at your own risk.

3. Objectives • Assess whether MVA is an acceptable component of fair value for accounting purposes • Identify how to account for MVA in compliance with IFRS • Consider implications Based on “Accounting for Derivatives with Initial Margin Under IFRS 13” https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2874703

4. What is MVA? • Here: the lifetime cost of (dynamic) Initial Margin • As defined in (Green & Kenyon 2015, Kenyon & Green 2015) • What margin? The dynamic initial margin required under Basel regulations BCBS-261, BCBS-317 starting 1st September 2016, and the dynamic initial margin required by Central Counterparties (CCPs). • Contractually defined in CSD (Collateral Support Deed) • Dynamic initial margin complements the variation margin contractually defined in CSA (Collateral Support Annex)

5. Accounting Background Accounting Equation: Equity = Reserves + Share Capital Equity = Net Assets Debit side: Net Assets – assets in business Credit side: Equity – capital investment Should match under double entry rules 5

6. Why is MVA relevant to accounting? • Accounting Standards require ‘Fair Value’: • IFRS 9 (Financial Instruments) requires valuation at fair value • IFRS 13 (Fair Value) gives a choice of methods, ideally ‘the price that would be received … or paid … in and orderly transaction between market participants ie an exit price • Derivatives are unlikely to be able to be measured on pure market valuation

7. Accounting models for FV Aim to maximise (external) observable inputs but IFRS 13 (Fair Value Measurement) allows financial management models, i.e.‘mark to model’ as opposed to ‘mark to market’ IFRS 13 describes present value (management accounting) techniques as part of the standard (para. B12) MVA could be another cost to include in a PV model

8. Should MVA be in Fair Value? • Management accounting states that all relevant costs (i.e. incremental costs) should be included (Drury 2015; p199). • Initial Margin generally required for most derivatives under Basel as regulations BCBS-261,-317 phase in, or from Clearing Arrangements (CA’s) with CCPs.

9. Reasons for MVA in FV Connected intimately with Derivative. Overarching ISDA defines the netting set and there is an additional CSDcontract for Initial Margin (as well as CSA for Variation Margin). The accounting concept of substance over form means MVA should be accounted for as part of the related derivative transaction (IFRS, 2010 Section 4.6, IFRS, 2015 Section 2.14)). Substance over form is derived from ‘true and fair’ requirement in s393 Companies Act 2006.

10. Accounting Value • The accounting value of a derivative is not simply the price of the derivative transaction. • Instead, under IFRS 13 the fair value can be assessed as the PV of the costs and revenues associated with the derivative. • To exit a trade the incoming institution must take on same obligation as original institution. • So the value imitates the accounting ‘exit’ price. • Thus the collaterals specifically & contractually linked to the derivative (via BCBS-261,-317 or CCP practices) should be valued with them.

11. How to Account for MVA • Value derivative with MVA included using Fair Value principles & techniques as permitted by IFRS 13, i.e. • Value the termsheet of the derivative • Value the CSA contractually linked to the derivative • May be combined with the termsheet valuation via CSA-discounting, or separate • CSA collateral is known as Variation Margin • Value the CSD/CA contractually linked to the derivative • Difficult to combine directly into the termsheet valuation, usually separate • CSD collateral is known as Initial Margin If the termsheet has been adjusted to take into account collateral posting costs then initially value will be £0 to leave it flat in the case of an interest rate swap.

12. Ongoing accounting for MVA Changes in derivative value mirrored by changes in PnL – using IFRS 13 & 9 – ‘at fair value through profit or loss’ If the derivative asset increases, matching increase in profit If the derivative asset falls, matching fall in profit

13. Accounting for Collateral Costs MVA is a symptom of the collateral costs – not the accounting for them. Collateral costs will still be accounted for along with any cost and/or income from the derivative. Costs and income should be recognised using the matching (accruals) concept (Accounting Framework, 2010).

14. Unit of Account IFRS 13 refers to ‘Unit of Account’ (to be defined in the standard on the relevant type of transaction) when describing what group of assets/liabilities should be included in a valuation at Fair Value. IFRS 9 does not refer to a Unit of Account but in classifying the financial instrument it refers to the entity’s business model for managing the financial assets and the contractual cash flow characteristics of the financial asset.

15. Business Model, Classification The entity’s approach to managing the derivative is at least as important as the actual cash flows involved. Several business models may coexist depending upon particular business objectives. Business model assessment is facts based, not a matter of intention. Portfolio may be separated into sub-portfolios in order to reflect the management of those assets. Evidence on what the ‘facts’ are includes performance of the model, how risks are managed and the compensation of managers. Thus the accounting takes it lead from how the bank is undertaking its management of derivatives.

16. From PnL to Reserves • IFRS 9 states that movements on financial instruments (assets or liabilities) that meet the characteristics of financial instruments such as swaps should be treated through the PnL • Reserves are the accumulation of items that have gone through the Other Comprehensive Income (OCI) and PnL (plus other items such as Share Premium Account)

17. Dividends • Reserves include realised and unrealised profits and losses. • Companies Act (s830, 2006) only permits payment of dividends out of net realised profits less losses. • May be legal question as to what realised profit is attributable to any single particular derivative, especially as the collateral and derivative are tightly linked.

18. Provisions & Reserves? • Financial Instruments (FI) cannot have provisions against them according to IAS 37 (2016) Provisions – should build in +ve/-ve cash flows to reflect all FI components in valuation model (IAS 37). • Derivatives are Financial Instruments • Accounting Reserves are the accumulation of profits to reflect the accumulation of net assets. Changes in FI value are reflected in reserves (IFRS 9).

19. MVA related Accounting Disclosures • Disclose how Fair Value (FV) is arrived at in accounts. • FV to include MVA along with other ‘A’s • Changes in FV of FI are reflected in PnL account, disclosed if material & components disclosed (depending on their materiality too)

20. Regulatory Implications Accounting for MVA (lifetime cost of IM Collateral) means that spurious profits do not appear and increase available capital.

21. Conclusions • Is MVA an acceptable component of Fair Value? Yes under IFRS 9 (Financial instruments) and IFRS 13 (Fair Value Measurement). • Accounting unit for MVA and for derivatives should reflect trading model of the bank. • Accounting for MVA (lifetime cost of IM Collateral) means that spurious profits do not appear and increase available capital.

22. References/Bibliography Albanese, Caenazzo, and Crépey (2016). Capital and Funding, Risk 29(4) BCBS-317 (2015). Margin requirements for non-centrally cleared derivatives. BCBS/IOSCO. Companies Act (2006). Section 393. Retrieved from http://www.legislation.gov.uk/ukpga/2006/46/section/393 Drury (2015). Management and Cost Accounting (9th ed.). Andover: Cengage Learning EMEA. Financial Reporting Council (2010). The Conceptual Framework for Financial Reporting. FRC: London. Green, A. and C. Kenyon (2015). MVA by Replication and Regression. Risk 27, 82–87. Green, A., 2015. XVA: Credit, Funding and Capital Valuation Adjustments. John Wiley & Sons. Green, A., C. Kenyon, and C. Dennis (2014). KVA: Capital Valuation Adjustment by Replication. Risk 27(12), 82–87. Green, A., and C. Kenyon (2017). XVA at the exercise boundary, Risk (to appear) , available at SSRN:papers.ssrn.com/abstract=2814619 IAS 37 (2016 version). Provisions, Contingent Liabilities and Contingent Assets. IASB: London. IFRS 9 (2016 version). Financial Instruments. IASB: London. IFRS 13 (2016 version). Fair Value Measurement. IASB: London. Hull, J., and White, A. (2012). Is FVA a cost for derivatives desks? Risk,(July), 83-85 Kenyon, C. and A. Green (2015). Efficient XVA management: pricing, hedging and allocation. Risk 28(7), 80-84 Kenyon, C. and A. Green (Eds.) (2016). Landmarks in XVA, Risk Books Kenyon, C., and Green, A. (2014). Regulatory costs break risk neutrality. Risk, 76. Kenyon, R. and C. Kenyon (2016). Accounting for KVA under IFRS 13. Risk 29(3), 82–87. Koehler, E. and A. Simanenka (2015). Collateral risk for fair valuation and ccr capital. Available at SSRN 2694112. Lichters, R., Stamm, R., & Gallagher, D. (2015). Modern Derivatives Pricing and Credit Exposure Analysis: Theory and Practice of CSA and XVA Pricing, Exposure Simulation and Backtesting. Springer.Morini, M, (2016) The FVA Debate – Reloaded. In Landmarks in XVA, Chapter 6, Risk Books (Eds Kenyon and Green) Piterbarg, V. (2010). Funding beyond discounting. Risk 23(6), 46. Piterbarg, V. (2012). Cooking with collateral. Risk 25(8), 46. Ramirez, J. (2015). Accounting for Derivatives: Advanced Hedging Under IFRS 9. John Wiley & Sons. Schubert, D. (2013). Multi-curve hedge accounting models. Risk 26(1), 89. Sherif, N. (2016a). KVA pushes accounting standards to the limit. Risk 29(3). Sherif, N. (2016b). MVA: swaps scale new heights in complexity. Risk 29(7). Sherif, N. (2016c). Dealers wake up to MVA impact of new funding rules. Risk 29(7).

23. Companies Act 2006, s830 830 Distributions to be made only out of profits available for the purpose (1) A company may only make a distribution out of profits available for the purpose. (2) A company's profits available for distribution are its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made. (3) Subsection (2) has effect subject to sections 832 and 835 (investment companies etc: distributions out of accumulated revenue profits).