Modern Modelling: How Advances in FVA Are Boosting Capital Management Efficiency
Since the last financial crisis, banks have been struggling in reaching their return on capital targets. Continuous change in the business landscape, new regulations and external shocks such as the C
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Since the last financial crisis, banks have been struggling in reaching their return on capital targets. Continuous change in the business landscape, new regulations and external shocks such as the COVID-19 pandemic has increased the volatility of portfolio adjustments such as FVA.
The problem with Funding Valuation Adjustment (FVA)
Recent market turmoil due to the COVID-19 pandemic increased the volatility of FVA with some banks reporting hundreds of millions of losses in the first quarter of 2020 and lower but substantial gains in the subsequent quarter.
FVA is driven by a bank’s uncollateralised and partially collateralised derivatives transactions that require funding over their lifetime. Banks charge FVA upfront without any consideration of term or maturity of the transaction. As new similar transactions are booked, FVA is charged in the same way without taking into account of the overall portfolio.
During periods of normal market conditions this practice tends to even out the adjustments taken to P&L throughout the year. However, during stress conditions the portfolio composition changes fast and the derivatives transactions rapidly turn from asset to liabilities and vice versa.
This shift leads to fresh funding demands by banks that push their cost of funding higher and results in higher P&L adjustments.
A key issue with not looking at FVA holistically is the fact that banks are not set up for estimating FVA over the lifetime of their derivatives portfolios.
Following the 2008 Financial Crisis, banks focused even more on estimating and hedging potential losses as a result of counterparty default. As a result, all simulation of potential future exposure at the portfolio level were done at the counterparty netting set level.
There has been quite a lengthy debate among academics and practitioners on how to estimate and manage FVA. More recently there has also been talk of removing the FVA altogether simply because banks cannot manage this quantity efficiently.
The root cause of this problem resides in the symmetric approach that most banks adopt to estimate FVA, which is consistent with the Credit Valuation Adjustment (CVA) approach and regulatory capital requirements.
Under this approach, two opposite trades under the same margin terms must represent a zero-funding cost strategy as the rate of interest charged and paid is assumed to be the same. That may be the case for these two trades, but it is substantially different at the portfolio level. Another disadvantage of this approach is that there are no distinction between uncollateralised, partially collateralised or one-way collateralised trades. Furthermore, this method assumes that there are no other constraints such as LCR and NSFR exist at the portfolio level.
New approach
Most banks’ portfolios tend to have an asymmetric funding profile. Asymmetry of funding profile can also emerge from market movements such as the recent COVID-19 extreme market moves that shifted individual portfolios from asset-heavy to liability-heavy.
Looking into how the real world works, we can see that the assumption of cash arising from derivatives variation margin is stable funding is utopian.
An alternative school of thought suggests that excess cash from derivatives variation margin is an unstable source of funding and should be assumed to yield only the risk-free rate.
This asymmetric type of approach can only be adopted if the simulation that produces the expected exposure is not the result of a netting set type of simulation (see diagram), but the result of funding set simulation with the funding set being the legal entity. At that level, excess variation margin can be recycled and reinvested at the risk-free rate.
This new type of simulation of the entire funding set will prove challenging for most banks as for the pricing of one transaction the bank would have to simulate the whole funding set.
From a technology point of view, the demands of such simulation are steep given current legacy technologies.
Capital saving through the use of asymmetric FVA - a case study
Consider two out of the money netting sets where one is an asset and the other a liability.
Example portfolio variations:
Two out of the money netting sets, one is an asset and the other a liability.
Unsecured liability dominates.
Liability is sensitive to correlation.
Volatility is adjusted to account for a longer-term.
SFVA contributes to the P&L while the FCA is the capital deduction, creating a discrepancy in incentives in the current method.
FSFBA is the FBA computed at the funding set level represents the non-existent funding benefit occurring when the bank is a net receiver of variation margin (VM).
VM cannot be monetised as it is not considered as stable funding capital saving is the difference between the current FCA computed at the netting set level (current CET1 capital deduction) and the asymmetric FCA.
The Benefits of Modern Modelling on FVA
Current legacy technology required to make traditional valuations require an extensive IT department, quant analysis and input. In addition, the discrepancies between banks often lead to miscommunication between the front and back desks.
A consistent, FVA framework that can support all derivatives portfolios can optimise capital usage over time while reducing FVA volatility. Rather than calculate FVA using a CVA based simulation, a single numerical solver would allow calculations on a trade-by-trade basis with a standardised formula. This would not only significantly reduce inaccuracies but also ensure speedy pricing. Such a solution would take the guesswork out of FVA calculations, and ensure provide seamless collaboration between the back and front desks.
Once you add automation and artificial intelligence, and you no longer need quants or a large IT network to maintain and resolve issues with your pricing and risk technology.
In other words, the future of FVA calculations is focused on forward-looking technology that establishes not only consistent and reliable pricing and valuations but also provides accurate analytics for future growth.
While integrating new technology and regulations appears time-consuming and expensive, they will allow financial organisations to scale to new heights in the long-run.
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