Show me the money: banks explore DVA hedging

Show me the money


Show me the money: banks explore DVA hedging

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Show me the money: banks explore DVA hedging




Debit value adjustment (DVA) is controversial for obvious reasons – it allows an institution to report profits as its health deteriorates, reflecting the declining value of its liabilities. Banks downplay it in their earnings reports, while analysts and investors ignore it, but there is another way to reduce its impact – it can be hedged. This is already happening to some extent on the derivatives side, sources say, and Credit Suisse, UBS, UniCredit and one Canadian bank are all considering joining that growing group. But only one bank is thought to be hedging it across all its mark-to-market business: Goldman Sachs.

It is not an easy call. For one thing, any hedge would involve going long an institution’s own credit, or something closely correlated to it – a bank could buy back its own debt or sell credit default swap (CDS) protection on its peers, for example. However, the first of those options involves a cash outlay, while the second poses a basis risk. It may also be difficult to find a counterparty willing to take the other side of the trade. There is a more fundamental question, though: is it worth hedging a risk that investors already disregard?

For Goldman, it’s a matter of principle, according to one US bank risk manager. “Mark-to-market is like a religion at Goldman Sachs,” he says. “If something is accounted under fair value, then it is hedged – no exceptions.”

For other banks considering the issue, DVA is difficult to ignore because it is the flip-side of CVA. As the risk of counterparty default is priced upfront, hedged and attracts a capital charge, it would arguably be consistent to do the same with the risk of a bank’s own failure.

“It started with CVA. You can’t look at that and not think about DVA. But actively hedging your own credit is very difficult. We have been considering this over time, but haven’t made a decision yet,” says Rahul Dhumale, managing director overseeing the regulatory portfolio for the risk control function at UBS in London.

Jeremy Vice, head of CVA trading at UniCredit, is sceptical but open to the idea of setting CVA and DVA off against each other – what dealers call bilateral CVA – and then hedging the difference. “We are continually analysing how best to implement our counterparty risk management. Hedging bilateral CVA for derivatives is one of the strategies we are considering.” The head of credit portfolio management (CPM) at a Canadian bank says his firm is also considering implementing derivatives CVA hedging on a bilateral basis.

In the US, DVA is tackled by Financial Accounting Standard 157, which requires own-credit related effects to be included in profits or losses for all derivatives liabilities, and gives banks the option to extend that treatment to other liabilities. Canadian banks are subject to similar rules. For countries that use standards drawn up by the International Accounting Standards Board – which includes the European Union – the treatment is a little more ambiguous. But under the board’s new International Financial Reporting Standard 13, due to come into force in 2013, practice will be more aligned with the US (Risk February 2012, pages 35–37).

The concept is simple enough – when a bank’s credit spreads widen, DVA increases, reflecting a reduction in the value of its liabilities resulting from the increased probability of default. This means a paper profit is booked.

But DVA is also a sensitive topic – profiting from deteriorating credit does not make for positive headlines – and Bank of America Merrill Lynch (BAML), BNP Paribas, Citi, Goldman Sachs, JP Morgan, Morgan Stanley and Royal Bank of Scotland all declined to comment for this article. They also refused to say whether they currently hedge DVA.

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