X-Value Adjustments: accounting versus economic management perspectives

Alberto Elices, Head of XVA Model Validation, Banco Santander

Alberto Elices, Head of XVA Model Validation, Banco Santander

1. Introduction

Figure 1 shows a diagram with the relation among CVA, DVA and FVA. DVA generating positions provide collateral to the desk which gets consumed by CVA generating positions (if the collateral is re-hypothecable and can be reused). If the collateral consumed by CVA generating positions is higher than collateral provided by DVA generating positions, additional funding needs to be raised producing a funding cost to the bank. If the collateral provided by DVA generating positions exceeds the collateral consumed by CVA generating positions, the collateral surplus can be reused avoiding funding raise (e.g. using the collateral for repos, initial margin, avoiding some bond issuance of the bank, etc) producing a benefit. Most banks cannot extract this benefit because they don’t have a desk coordinating the reuse of collateral. The ideal situation would be to have a balance so that the amount of collateral provided by DVA compensates the collateral consumed by CVA and the FVA becomes as close to zero as possible.

3. Accounting versus management perspectives

Two major paradigms currently coexist in the market: the accounting and management perspectives (see [1] for more information). Financial institutions were initially sitting in the accounting perspective but they are progressively evolving into the management perspective.

The accounting perspective considers that the profit and loss includes unilateral CVA and DVA according to the accounting regulation (however the DVA cannot currently be recognized as Common Equity Tier 1 capital) and FVA is calculated with a market observable liquidity curve (e.g. built for instance with a basket of representative covered bonds or bond-CDS basis). This perspective has the advantage that fair valuation is comparable among institutions as adjustments are bilateral (include both CVA and DVA) and depend on market observable data. It also fosters a balance between CVA and DVA generating positions hedging one with the other. The main disadvantage of the accounting perspective is that hedging counterparty default is very difficult because hedging CVA unbalances the equilibrium between CVA and DVA and DVA cannot be hedged in practice (selling protection on oneself cannot be achieved as no counterparty would sensibly buy protection to an institution which should pay back when it defaults).

The management perspective considers that the bank cannot default (DVA disappears) and therefore the profit and loss only includes CVA and the FVA is calculated with the internal funding curve of the bank. The disadvantage of this perspective is that prices are no longer comparable among institutions (valuation is neither bilateral nor observable) but the advantage is that market and credit risk of CVA can be hedged as there is no DVA which compensates it and FVA could potentially be hedged through internal term operations between the desk and the financial area.

The new regulation and the market consensus are pointing to the management perspective although for now it would be necessary to comply with the accounting regulation too. The transition from the accounting to the management perspective implies a loss for institutions with an overall asset CVA generating position and a benefit, which may not always be realized, for institutions with an overall liability position.

4. Case study: corporates in Mexico

The situation in Mexico may produce a natural unbalance between CVA and DVA generating positions because the regulation does not allow banks to post collateral to corporates (see section 6 of [2]). Therefore, banks with high liabilities to corporates may accumulate big DVA positions compared with the CVA. This may happen for instance to banks closing cross currency swaps with corporates which receive USD and pay MXN to the bank where the USD appreciates with respect to the MXN. This may lead to a high DVA position not compensated by the CVA. Considering the accounting perspective where both CVA and DVA are included would produce an unmanageable high profit and loss volatility because DVA cannot be hedged and credit spreads in Mexico are both illiquid and volatile. A transition to the management perspective would allow reducing the profit and loss volatility because the DVA would not be included and the CVA can be hedged. The loss given by not including the DVA in the profit and loss could be recovered by monetizing the excess of collateral provided by the DVA position. Having into account that the DVA benefit can only be monetized when the bank defaults, this excess of collateral can always be monetized by reusing it (e.g. for repos, initial margin, reducing bond issuance, etc) to obtain a better return than just the overnight collateral remuneration.

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