Cutting edge introduction: FVA out of balance

In recent years, quants and practitioners have spent a lot of time and energy explaining why funding valuation adjustment (FVA) – the costs that arise when an uncollateralised trade is hedged with a collateralised one – should be part of derivatives pricing. They were so persuasive that at least 14 major banks now include it in their public accounts, but while there is consensus at a high level, valuation and reporting practices remain a bit of a mess (Risk April 2013 and Risk April 2014).

In this month's first technical, FVA accounting, risk management and collateral trading, Claudio Albanese, chief executive of Global Valuation, Leif Andersen, global co-head of the quantitative strategies group at Bank of America Merrill Lynch (BAML) and Stefano Iabichino, a PhD student and analyst at Global Valuation, set up a rigorous accounting framework for FVA, tidying up what they consider to be incorrect practices within the industry, which includes reporting FVA in earnings.

Many banks currently split FVA into a funding benefit adjustment (FBA) – which arises when a bank is receiving collateral from its hedge counterparty and does not have to on-post it to the client – and a funding cost adjustment (FCA), which reflects the costs that arise when the value of the trades flips round. But this accounting method has its blind spots. It can overlook the default risk of the bank or its counterparties, for example, and there is an awkward overlap between FBA and debit valuation adjustment (DVA) – both FBA and DVA see a bank booking profits when its creditworthiness deteriorates.

In practice, banks also have the option of rehypothecating variation margin across trades and counterparties, meaning benefits can be used to mitigate costs directly – a practice that is thought to be ignored in current FVA accounting policies. Existing practice is to calculate FVA at the level of netting sets and then to aggregate it across them. Banks end up with a restatement of their earnings to reflect the adjustment.

The authors introduce a framework called FVA/FDA – with the new acronym standing for funding debt adjustment. It expands the calculation of FVA from netting sets to a larger collection of unsecured trades, where cash received from funding can be rehypothecated – what the authors call a ‘funding set'. They also show FVA losses should not affect earnings and should instead be reflected in common equity Tier I capital.

If you have to fund derivatives by borrowing unsecured, you are hurting shareholders

The FDA term in this approach arises from the assumption that when a bank faces a funding cost, someone else receives an equal benefit – specifically, in the case of uncollateralised derivatives, it is an internal wealth transfer from shareholders to bondholders. So essentially, FVA and FDA cancel each other out on the balance sheet, but the fact remains that shareholders, and traders for that matter, take a hit due to funding costs.

"If you have to fund derivatives by borrowing unsecured capital, you are hurting shareholders because you are giving away pieces of the firm to bondholders who can recover from a pool of unsecured derivatives on a bank's default. It will not change the value of the derivative to the firm as a whole, but it will to shareholders. From an accounting perspective, this can be reflected in equity capital rather than by changing the overall market value of the derivative," says BAML's Andersen.

This year's Risk quants of the year, Christoph Burgard of Barclays and Mats Kjaer of Bloomberg were among the first to interpret FVA as a result of a wealth transfer in their 2013 paper, Funding strategies, funding costs (Risk January 2015, and Risk December 2013).

"In accounting, fair value is a rather vague and subjective concept. The authors decided to take the bold step to interpret fair value as the combined value to the shareholders and senior creditors of the firm. As the payment of the funding spreads is an internal transfer from shareholders to the senior creditors, the fair value is not affected. This is consistent with the Modigliani-Miller theory and the conclusions reached in our paper," says Bloomberg's Kjaer, referring to the theory that a firm's value should not depend on how it is financed.

The rehypothecation-based method produces lower FVA deductions from equity than those based on current frameworks. In funds transfer pricing charge computations, the method also manages to eliminate DVA owing to the fact that it cannot be monetised by the trader – anything without value to shareholders disappears. "It involves a lot of rethinking, as you have two notions of values for a derivative – how much firms benefit and how much shareholders benefit. This can be a hard nut to crack, and is awkward in incentive management, but I think it reflects reality," says BAML's Andersen.

In our second technical, Warehousing credit risk: pricing, capital and tax, Chris Kenyon, a director in the CVA/FVA quantitative research team at Lloyds Banking Group in London, and Andrew Green, the head of the team, extend Burgard and Kjaer's semi-replication method to model the effects of credit risk warehousing in pricing, also incorporating capital and tax effects.