
Putting FVA in a cage
If banks can't standardise funding charges, accountants or regulators should step in

We didn't set out to write yearly updates on the evolution of funding valuation adjustment (FVA). It just worked out that way. We also had no idea that the original analogy used for the first of these articles – Mary Shelley's Frankenstein – would lend itself so well to the later instalments.
In the first chapter, written two years ago, banks were in agreement FVA should exist, but were struggling to make sense of the accounting dictum that the fair value of a trade should represent its exit price – what another market participant would pay to step into the bank's shoes. Without any guidance on the matter from accounting standard-setters or regulators, banks were left to create their own FVA frameworks, using a variety of more or less savoury materials.
The monster was on the loose in the second chapter: JP Morgan had announced its $1.5 billion loss a few months earlier. Banks were trying to impose some kind of order on their creation but were only uncovering extra layers of complexity – one of the new debates focused on whether FVA should be tied to the life expectancy of the counterparties to a trade.
Today, some quants and banks argue the monster should be destroyed. The $6.1 billion aggregate loss suffered by 20 banks is too big, they claim – its design is a deformation of reality. Banks that have tested an alternative approach say it is far less damaging.
Admittedly, at this point, the analogy might have been stretched a little too far. The good news is that we're now at the end of Shelley's book – convinced he has to put an end to the horror, Dr Frankenstein pursues his creation to the Arctic. He fails, and dies.
It will be interesting to see whether the market has any more luck. A plausible outcome of the rival framework's emergence is that bank FVA frameworks become even more diverse, that their accounts and derivatives prices become less comparable, that banks end up being pulled in one direction or another by competitive pressures, rather than a conviction that they are accurately reporting a genuine cost.
A plausible outcome of the rival framework’s emergence is that bank FVA frameworks become even more diverse
That's why it's a positive thing regulators and accounting standard-setters are finally taking an interest in the topic. The Basel Committee on Banking Supervision has launched an FVA project; US prudential regulators are nosing around; the US Financial Accounting Standards Board is also considering whether some kind of action is needed; and the Bank of England wants seven UK banks to include FVA in this year's round of stress tests.
If Frankenstein fails to kill the monster, someone may have to put it in a cage.
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Printing this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Copying this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@risk.net
More on Derivatives
US life insurer index options market hits $1trn mark
Counterparty Radar: Lincoln Financial emerges as top player in Q4 with $43 billion portfolio increase
Long-end euro swap pricing anomaly remains largely untapped
Deviation in swap curve attracts limited interest because of regulatory and pension reform barriers
SG1 growth slower than expected, say LPs
Despite sluggish take-up of Singapore FX matching engines, some hope a new NDF venue will offer a boost
Eurex scrambles to avert Treasury collateral ban on US default
Current policy prevents CCP from selectively excluding eligible collateral
Information geometry of risks and returns
An innovative product design framework and its geometric interpretation is introduced
Regional banks face soaring term SOFR spreads
Bid/offers hit 10bp as dealers price counterparty risk into non-cleared Libor transition trades
US court greenlights most claims in Currenex class action
Civil lawsuit brought by XTX and two other financial firms advances to next stage before trial
Allianz Life halves index CDS book in Q4
Counterparty Radar: Move by US market behemoth pushes life insurers’ notional down by almost 40%