Putting FVA in a cage

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.