Corporate treasurers have faced many a regulatory challenge before, and IFRS 13 is no exception. Deploying a compliant fair value methodology under this new standard has been causing many treasurers significant angst over the last few months. They are not helped by the plethora of mixed messages, confusing guidance and inconsistent treatment from various experts in the market. Reval, which already has been working under the US equivalent standard ASC 820 (FAS 157), is able to provide some practical insights gained through our experience in the US.
The calculation of fair value defined under IFRS 13 typically results in organisations needing to implement new fair value methodologies. The guidance itself is reasonably straight forward, as IFRS 13.9 defines fair value as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
So, fair value must be calculated at an exit price, and the standard later confirms that that price must include the non-performance (credit) risk. As most ‘market participants’ in the derivatives space are banks, the initial interpretation of this requirement was that corporations should fair value their portfolio the same way banks price their trades. However, there are a number of issues with trying to mirror how banks price transactions, particularly in respect to the pricing of non-performance risk:
- While banks adequately incorporate their client´s credit risk, using Credit Value Adjustments (CVA), they don’t usually adjust for their own credit risk, using Debit Value Adjustments (DVA),
- Banks tend to use very sophisticated Potential Exposure models based on Monte Carlo simulation techniques.
- Banks also use Funding Value Adjustments to incorporate their internal costs of funding a corporate OTC position.
- Finally, banks charge a margin for the business over and above all other pricing.
In general, corporations have very little visibility into their banks’ internal processes and margin levels. The Potential Exposure models tend to be proprietary and not replicable outside of the bank. It is also safe to assume that no two banks price the same transaction identically, given all of the variables in play. To this end, it would not be practicable for corporates to replicate each bank’s pricing methodology.
So on to Plan B: Although not replicating the bank’s pricing, corporates could adopt the same Potential Exposure methodology to recreate the general credit pricing approach in the market. The big challenge here is complexity. These models tend to be built and maintained by the bank’s team of quantitative experts who analyse the CVA outcomes, tinkering with credit inputs and market rate volatilities to approximate the most accurate assessment of credit risk.
The typical corporate finance or treasury function doesn’t have the internal expertise or technology to build such a model. Even if they were to purchase a vendor solution, many organisations would struggle to interpret the results and manage the ongoing assumptions required to make these models work. Auditors themselves have begun to recognise the increased operational risk such a complex model would bring in the hands of smaller treasury teams.
Furthermore, the majority of corporations need CVA and DVA adjustments per transaction, as hedge accounting is a per-deal–mechanism. Typically, Potential Exposure methods are portfolio-based measures that don’t translate well in transaction-level breakdowns.
That leaves us with Plan C: Corporates could move to a selection of simpler, easier-to-manage CVA and DVA calculation methodologies such as simplified duration and discount spread approaches. While these methods are not as sophisticated as the bank methodologies, they make up for that in being transparent, easier to understand and applicable to individual deals as well as portfolios. Reval’s discount spread approach has been tested across hundreds of clients for the last six years and will deliver robust credit adjustments for organisations seeking compliance with IFRS 13.
Caught between a bank and a hard place? Getting close enough to the bank, while maintaining a method that is easy to understand and deploy seems to be the best way out of this latest regulatory squeeze for corporate treasurers.