XVA: an accounting challenge?

XVA: an accounting challenge?

by Famien Konan

XVA in a nutshell

The Global Financial Crisis of 2008-2009 has instituted financial institutions to reflect the market price of counterparty risk (CVA), own-default risk (DVA), funding costs and benefits (FVA), collateral (ColVA), capital (KVA) and initial margin (MVA) on the fair valuations of derivatives for pricing and accounting purposes.

These valuation adjustments, collectively defined as XVAs, are the consequences of Basel III regulatory requirements, but also market practices of banks to factor in the price of the deals the risks and costs of trading derivatives. Thus, the price of derivatives has become the sum of the “risk-free price” and the XVAs: risky price = risk-free price + XVA.

Figure 1: An overview of XVAs

Source: XvA goes mainstream, Solum Financial and McKinsey & Company, Inc. (June 2017)

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The theoretical foundations and practical implementation of XVAs have been a matter of debate and controversy over the past years, due to misalignment between market, accounting, and regulatory practices. Banks have been accused of boosting their profits by recording gains on the fall in value of their debt through DVA, while hedging of DVA is problematic and monetization of own default is almost impossible. Similarly, inclusion of FVA in derivatives pricing has raised concerns between market participants about the potential for double counting with DVA, or the violation of the law of one price.

approaches for XVA accounting

Accounting standards such as FAS 157 (US GAAP) and IFRS13 ‘Fair value measurement’ require firms to account for their derivatives exposures using both CVA and DVA figures priced at fair value. These accounting standards assume implicitly that the reporting entity is able to perfectly hedge its own default, and market funding costs/benefits should be ignored. It creates a symmetric world where counterparties can readily trade with one another at the same price.

This is opposed to the quantitative finance point of view, which considers that the adjustments to the economic value of a derivative asset/liability should reflect its replication strategy, by means of a selffinancing portfolio hedging out credit risk, collateral, and funding costs. This approach, which has its origin in the Black-Scholes risk-neutral pricing framework, has yielded two different ways of accounting the XVAs: a “CVA + symmetric funding approach” which considers a funding benefit (FBA) and a funding cost (FCA) term, and a “Bilateral CVA + asymmetric funding“ which has a DVA and a FCA term.

As hedging of own default is problematic, the CVA + symmetric funding approach is the most appropriateto report XVAs on the balance sheet. Banks have favored this approach, in which the funding benefit (FBA)is referred to as DVA to remain consistent with accounting requirements.

Other XVAs such as KVA, MVA and ColVA are rarely viewed as fair value adjustments for accountingpurposes. Banks rather apply them either for P&L transfer or pricing.

Figure 2: Approaches for XVA Accounting

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impact of covid-19 and bank capital rules on XVA accounting

While it has certainly become the norm to recognize CVA, DVA and FVA in the accounts for large financial institutions, COVID-19 and the new bank capital rules put a spotlight on XVA accounting. XVAs have been some of the biggest losses disclosed by banks at the peak of the pandemic. For example, Bank of America, Goldman Sachs and JP Morgan reported combined FVA losses of almost $2 billion in the first quarter of 2020. Many banks have faced high CVA and FVA volatility due to uncollateralized exposures, driven by the widening of the LIBOR-OIS spread, clients’ credit spreads and decrease in interest rates following cut of central banks’ policy rates. However, it was very difficult for banks to hedge the counterparty credit risk due to low liquidity in single-names CDS during the pandemic, while the credit spread component of FVA is simply not hedgeable as it is a risk premium embedded in the funding costs.

A standard risk management strategy of XVA is to hedge the variability of the counterparty credit spread through Single-Same CDS, Single-Name Contingent CDS and Index CDS, and the exposure component of the XVA with FX and interest rate hedges. Even when hedging transactions were executed, they resulted in an increase of market risk charges. Indeed, CVA became a significant proportion of market risk RWA as banks must add a capital requirement to cover the risk of losses arising from CVA volatility, in response to changes in counterparty credit spreads and market risk factors that drive valuations of derivative transactions.

The current BCBS capital rules for CVA risk covers only the credit risk component of CVA. Until the revised standard which considers the exposure component of CVA risk, along with its associated CVA hedges is effective in 2023, some jurisdictions have exempted dealers from this capital charge. This is not the case for European banks, for which hedges linked to CVA count towards market RWAs. Market participants do recognize that bank capital rules have a significant impact on XVA figures, as the hedge instruments reducing the CVA risk may cause additional P&L volatility.

further accounting considerations

To reduce earnings volatility and reflect the economics of XVA on the balance sheet, there have been calls from dealers and academics for a review of the accounting of XVA in two respects.

The first proposal is to move the FVA from P&L into another comprehensive income (OCI) section, as this item is almost impossible to hedge and could cause additional P&L volatility, especially during a stress period. The move of DVA in 2016 as an accounting item under OCI has set a precedent for this.

The second aspect is related to the KVA. A bank’s hurdle rate of return on capital should be introduced into the fair value of a derivative to reflect the capital requirements under Basel III, but also to align the valuation with the exit price. This approach is consistent with widely adopted accounting principles and according to IFRS 13. The change in KVA will be recognized in fair value in P&L or in OCI statements and added into Reserves.

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Although these new accounting treatments would fix some of the issues faced by market participants when reporting XVA figures, it could take years for regulators to decide on their validity in the light of existing regulations and allow their practical implementation. In the meantime, accounting for XVA will remain a challenge.

references

1. BCBS-d507. (2020). Targeted revisions to the credit valuation adjustment risk framework.2. BCBS-d424. (2017). Basel III: Finalizing post-crisis reforms.3. Becker, L. (2020). FVA losses back in spotlight after coronavirus stress. Risk, April 16

4. Burgard, C. and Kjaer, M. (2011) Partial differential equation representations of derivatives with bilateral counterparty risk and funding costs, Journal of Credit Risk, vol. 7, no. 3, pp. 75–93.

5. Burgard, C. and Kjaer, M. (2013). Funding strategies, funding costs. Risk, December, 82-87.6. Kenyon, R. and Kenyon, C. (2016). Accounting for KVA under IFRS 13. Risk, March,82-877. Rega-Jones, N. (2020). Funding pain prompts calls to rehome FVA. Risk, November 05.8. Solum Financial and McKinsey & Company, Inc. (2017). XvA goes mainstream.

author Famien Konan

Famien Konan is a Principal Syndication Officer at the African Development Bank with over fourteen years of experience in the financial services sector. He also specializes in treasury risk management, and the implementation of quantitative analysis tools and methods for investment management. Mr. Konan began his career as a financial software consultant in the credit derivatives markets. He holds a master’s degree in telecommunications engineering from IMT Atlantique (Telecom Bretagne), as well as a mathematical degree from Université de Bretagne-Occidentale. He is a PRM holder since 2010.

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