5th Annual XVA Forum: Funding, Capital and ValuationLondon, 10th - 11th September 2015

The impact of XVAs on bank’s processes

Andrea GigliHead of XVA Desk

MPS Capital Services

Disclaimer_______________________________________________________________________________________________________

These are presentation slides only. The information contained herein is for general guidance on matters of interest only anddoes not constitute definitive advice nor is intended to be comprehensive.

All information and opinions included in this presentation are made as of the date of this presentation.

While every attempt has been made to ensure the accuracy of the information contained herein and such information has beenobtained from sources deemed to be reliable, neither MPS Capital Services, related entities or the directors, officersand/or employees thereof (jointly, “MPSCS") is responsible for any errors or omissions, or for the results obtained from the useof this information. All information in this presentation is provided "as is", with no guarantee of completeness, accuracy,timeliness or of the results obtained from the use of this information, and without warranty of any kind, express or implied,including, but not limited to warranties of fitness for a particular purpose. MPSCS does not assume any obligation whatsoever tocommunicate any changes to this document or to update its contents. In no event will MPSCS be liable to you or anyone else forany decision made or action taken in reliance on the information in this presentation or for any consequential, special or similardamages, even if advised of the possibility of such damages.

This document represents the views of the author alone, and not the views of MPSCS. You can use it at your own risk.

3

XVA challenge(s)

NDV

- CVA

+DVA

- FVA (LVA,

CollVA,

HVA)

- MVA

- KVA (MR,

CCR, CVA)

: Computational Effort

Degre

eof

Com

ple

xit

y

Timeline

• Pricing Model Specification

• Valuation Data Model

• Risk Management

• Accounting

• Trade Workflow

• …

4

Terminology

From the Bank’s point of view:

CVA: is the price of counterparty default risk we have in thederivatives book.

DVA: is the price of our own default risk we have in the derivativesbook.

FVA: is the extra funding risk that is not captured by DVA.

KVA: is the cost of funding a certain amount of capital to act as abuffer against unexpected losses.

*VA(i): is the marginal contribution of the i-th trade to the total *VA,

accordingly to a given Exposure Allocation methodology.

In the following, I’ll consider uncollateralized trades and the case of a

Derivative as an Asset mainly .

5

XVA challenge(s)

NDV

- CVA

+DVA

- FVA (LVA,

CollVA,

HVA)

- MVA

- KVA (MR,

CCR, CVA)

: Computational Effort

Degre

eof

Com

ple

xit

y

Timeline

• Pricing Model Specification

• Valuation Data Model

• Risk Management

• Accounting

• Trade Workflow

• …

6

The Market Price of a derivative is

� = ��� − ��� + ���1 + ���2 − ���If

a) liquidity risk = 0, and

b) funding cost instantaneously reflect the true risk of assets

� = ��� − ��� + ���1 +���2 − ���otherwise

- arbitrage opportunities may rise (theoretically)

- dealers with high funding cost would be net option seller and dealer with

low funding cost would be net option buyer

The Private Value or Production Cost of a derivative can differ because of

- Liquidity constraints

- Regulatory capital requirements

- Funding cost

Hull-White (2014)

7

A PDE for CVA with collateral and funding yields

� = ��� − ��� + ��� − ��� − �� ��where

F�� = � ���� � �(�)���(�)���(�)�� ��Š����(!) "!

#

$

• % is the risk-free rate,

• &� is the Bank’s intensity of default,

• &' is the counterparty’s intensity of default,

• (� is the Bank’s recovery rate,

• if the CDS-BOND basis is null 1 − (� &� = �) = %) − %, being %) the yield of a

risky bond, with zero recovery, issued by the Bank.

If a derivative can be posted as collateral (or a bilateral CSA is in place between

counterparties)

��� = 0

Burgard-Kjaer (2013, 2014)

if the derivative is uncollateralized

8

Green, Kenyon (2014, 2015)

They extended the BK (2013) model in order to take into account of the

adjustments for Initial Margins and Capital Requirements

� = ��� − ��� + ��� − ��� − �� �� −+�� − -��where

+�� = � �� ! − �. ! �� � �(�)���(�)���(�)�� ��/$ 0(!) "!

#

$

and �. ! = %. − %,being %. the grow rate of the Initial margin account.

Assuming capital cannot fund derivatives,

-�� = � 23(!)�� � �(�)���(�)���(�)�� ��/$ -(!) "!

#

$where 23 is the Bank’s cost of capital and

- ! = -45 ! + -''5 ! + -'67 ! +….

if uncollateralized

9

Albanese, Andersen (2014, 2015)

They define the FVA as the cost of funding for borrowing unsecured on short

term basis, for the purpose of pledging variation margins.

In the case of one single funding set

F��(8) = � �� ! �� � �(�)�� �� 9��8:�8;(!)<=>?@

;

�"!

?�$

where

• A� is the time of default of the Bank

• �� ! is the funding spread of the Bank

• A; is the time of default of the i-th counterparty

• ��8:�8; is the default-free value of the i-th Netting Set

• r is the OIS rate

No funding benefit is generated from excess collateral because they assume it

yields simply the risk-free rate (OIS rate).

Rehypotecation

Option

10

Albanese, Andersen (‘cntd)

FVA is an internal wealth transfer: a cost for shareholders and a benefit for

bondholders. The «twin» benefit for bondholders is the FDA.

They show that FDA=FVA so there is no impact on the Economic Value of the

trade.

Nonetheless, in order to preserve the CET1 (or RACET1), a charge equal tomarginal FVA (or FVA+KVA) should be charged to clients.

In particular, they show that a Funds Transfer Pricing policy designed to

a) preserve CET1, implies

� = ��� − CVA − FVAb) preserve Risk-Adjusted CET1, implies

� = ��� − CVA − FVA − KVA

11

XVA challenge(s)

• Pricing Model Specification

• Valuation Data Model

• Risk Management

• Accounting

• Trade Workflow

• …

NDV

- CVA

+DVA

- FVA (LVA,

CollVA,

HVA)

- MVA

- KVA (MR,

CCR, CVA)

: Computational Effort

Degre

eof

Com

ple

xit

y

Timeline

12

Valuation Data Model

Trade

Trade_id

ValuationDate

Currency

Counterparty

DealType

...ReferenceSet

Date_id

Contract

Trade_id

StartDate

EndDate

Notional

…

Counterparty

Ctp_id

BalanceShID

CreditFactID

...

Currency

Currency_id

ZeroCurve

VolatilitySurface

FXRates

...

DealType

DealType_id

DealTypeLabel

PricingModel

...

• Single Curve

• NDV

13

Trade

Trade_id

ValuationDate

Currency

Counterparty

DealType

...

Trade

Trade_id

ValuationDate

Currency

Counterparty

DealType

NettingSet

FundingSet

...

Valuation Data Model

ReferenceSet

Date_id

Contract

Trade_id

StartDate

EndDate

Notional

…

Currency

Currency_id

ZeroCurve

VolatilitySurface

FXRates

...

DealType

DealType_id

DealTypeLabel

PricingModel

...

DealType

DealType_id

DealTypeLabel

PricingModel

Breakclause

…

CSA

Csa_id

CtpLabel

Threshold

CollType

...• Double Curves

• NDV

• CVA/DVA/FVA/…

XVAs require X-Aggregation Sets

Counterparty

Ctp_id

BalanceShID

CreditFactID

...

Counterparty

Ctp_id

BalanceShID

CreditFactID

CSAid

...

14

XVA challenge(s)

NDV

- CVA

+DVA

- FVA (LVA,

CollVA,

HVA)

- MVA

- KVA (MR,

CCR, CVA)

: Computational Effort

Degre

eof

Com

ple

xit

y

Timeline

• Pricing Model Specification

• Valuation Data Model

• Risk Management

• Accounting

• Trade Workflow

• …

15

Economic Impact of XVAs (1 Derivative as an Asset)

Asset Liabilities

NDV0-CVA0-

FVA0+DVA0-

KVA0

0

Equity

0

Asset Liabilities

NDVt-CVAt-

FVAt+DVAt-

KVAt

0

Equity

HV(0,t)=HNDV(0,t)-HCVA(0,t)

-HFVA(0,t)+HDVA(0,t)-HKVA(0,t)

The impact on the Equity is

HNDV(0,t) - HCVA(0,t) - HFVA(0,t) + HDVA(0,t) - HKVA(0,t)

Easy to Hedge

CVA0

CVAt

HMarket

HCredit

EE

time

Forward

BorrowingHard to

Hedge

t=0 t=1

16

Hedging CVA

ECredit:

• Can be hedged only if a liquid CDS termstructure exists.

• Otherwise, it can be «smoothed» through

• bucket hedging, or

• CDS index trading

accordingly to a given model specification

CVA0

CVAt

HCre

dit

HMarket

EMarket:

• Can be hedged, accordingly to a givenmodel specification

Model

Risk

Account

17

Hedging CVA: rating change

0%

20%

40%

60%

80%

100%

0 5 10 15

A B C D DF

0%

20%

40%

60%

80%

100%

0 5 10 15

A B C D DF

Hcredit(0,t)

FCredit

FCurve� HCurve�(0,t)

FCredit

FRatingCurveHRatingCurve(0,t)

In order to compute CVA risk metrics (e.g.

CVADV01), banks sometime use Internal

Rating Curves instead of CDS.

In that case HCredit depends on:

1) Variability of the Rating Curve and

2) Changes in the Rating Curve Assignment

Model

Risk

Account?

18

Hedging FVA

The Funding desk has the role ofproviding liquidity to investmentbanking activities and managing theexcess liquidity.

Usually the Funding desk faces aTreasury Desk which applies alending rate l(t) and a borrowing rateb(t), where l(t)≤b(t)

ENE

timeForward

BorrowingEPE

time

EE=EPE+ENE

time

Forward

Lending

l(t) = b(t)

l(t) ≠ b(t)

Forward

Borrowing

Forward

Lending

For the FVA Desk is not always feasible lending orborrowing forward from the Treasury Desk. Often the bestyou can do is hedging «exactly» short term cash exposuresand «approximately» long term cash exposures.

This generate Funding Desk PL variability (or Treasury PLvariability)

19

KVA management

KVA management is strongly related with

capital optimization activities:

• Portfolio/BS downsizing (e.g.

Compression)

• Portfolio/BS rebalancing, (e.g. Trade

Novation & Trade Re-Assignment)

• Stress Test Analysis (e.g. Replacement

or Hedging of trades which are

sensitive to stressed-scenario)

• …

Capital (and KVA) Management depends on risk-appetite of the Bank, which

should be defined by Bank’s top managers and passed down to the whole

organization through appropriate

• Performance Measurement

• Incentive Schemes

20

XVA challenge(s)

NDV

- CVA

+DVA

- FVA (LVA,

CollVA,

HVA)

- KVA (MR,

CCR, CVA)

: Computational Effort

Degre

eof

Com

ple

xit

y

Timeline

• Pricing Model Specification

• Valuation Data Model

• Risk Management

• Accounting

• Trade Workflow

• …

21

Accounting XVAs for a Derivative as an Asset

XVAs are computed at level of netting

set, funding set, portfolio or balance

sheet.

Assuming we can allocate to each

trade its contribution to total*VA, we

can define CVA(i), DVA(i), FVA(i) , KVA(i).

Asset Liabilities

NDVt-CVAt-

FVAt+DVAt-KVAt

0

Equity

HV(0,t)=HNDV(0,t)-HCVA(0,t)+

-HFVA(0,t)+HDVA(0,t)-HKVA(0,t)

Asset Liabilities

NDV(i)t-CVA(i)

t-

FVA(i)t+DVA(i)

t-

KVA(i)t

0

Equity

HV(i)(0,t)=HNDV(i)(0,t)-HCVA(i)(0,t)+

-HFVA(i)(0,t)+HDVA(i)(0,t)-HKVA(i)(0,t)

In the following we assume a bank prices uncollateralized derivative using

V(i)t = NDV(i)

t - CVA(i)t - FVA(i)

t + DVA(i)t - KVA(i)

t

It’s easy to extend the reasoning to the case a bank want to preserve CET1

(RACET1) using

V(i)t = NDV(i)

t - CVA(i)t - FVA(i)

t ( - KVA(i)t )

22

Unwinding in the Bonis Case

At the derivative termination date TC, a cash position will replace the derivativeentry on the balance sheet.

This means

V(i)

G'= NDV(i)

G'- CVA(i)

G'- FVA(i)

G'+ DVA(i)

G' - KVA(i)

G'

Derivative is

terminatedDerivative

Expiry

Derivative

Closing

G' G0

Asset Liabilities

V(i)TI

0

Equity

HV(i)(0,TI) -HHS(i)(0,TI)

is replaced by Cash(i)TI= V(i)

TI

HHS(i)(0,TI) is the economic result of the

hedging strategy

Asset Liabilities

Cash(i)TI

0

Equity

HV(i)(0,TI)-HHS(i)(0,TI)

23

Unwinding in the Default Case (1/2)

Counterparty stops

paying

Derivative is

Terminated

Derivative

Liquidation

Counterparty

Default

If a counterparty stops paying at 8', at Termination date TC the Balance sheet

will contain:

• a credit for past due payments

• a derivative valued V(i)

G'• the PL of the hedging strategy

Derivative

Closing

G' A'8' GJ0

Asset Liabilities

V(i)TI

PastDue(i)(tC,TC)

Equity

HV(i)(0,TI)-HHS(i)(0,TI)

24

Unwinding in the Default Case(1/2 ‘cntd)

Given the derivative entry i-th we split it in two components

V(i)

G'= NDV(i)

G'- CVA(i)

G'+ DVA(i)

G'- FVA(i)

G' - KVA(i)

G'

Credit(i)

TI - Reserve(i)

TI

The derivative will be unwound at NDV(i)

TI and a credit Credit(i)

TI= NDV(i)

TIwill

replace the derivative entry.

The XVA desk will be charged by Reserve(i)

TIin order to offset V(i)

G'- NDV(i)

G' and

fund an extra equity reserve.

Asset Liabilities

Credit(i)TI= NDV(i)

TIPastDue(i)(tC,TC)

Reserve(i)TI= CVA(i)

TI-

DVA(i)TI+ FVA(i)

TI+ KVA(i)TI

Equity

HV(i)(0,TI) -HHS(i)(0,TI)

25

Unwinding in the Default Case (2/2)

Counterparty stops

paying

Derivative is

TerminatedDerivative

Liquidation

G' A'

Counterparty

Default

8' GJIf the counterparty Defaults at time A' a process for determining the liquidationvalue of the Derivative will start.

The Derivative will be liquidated in GJ at (�N�O�P(i)#R.The economic impact of the liquidation process on the balance sheet will be

S (;) G' , GJ = (�N�O�P(i)#R− �%�"T8(i)#� + SO�8�!� ; (8' , G') − (���%U�(i)#�

Derivative

Closing

0

Asset Liabilities

RecCash(i)TI

0

Equity

HV(i)(0,TI) -HHS(i)(0,TI)+PL(i)(TI, TV)

Attributed to

XVA Desk &

Model Risk

Account

Attributed to

Recovery Office

& Legal Risk

Account

26

XVA challenge(s)

NDV

- CVA

+DVA

- FVA (LVA,

CollVA,

HVA)

- MVA

- KVA (MR,

CCR, CVA)

: Computational Effort

Degre

eof

Com

ple

xit

y

Timeline

• Pricing Model Specification

• Valuation Data Model

• Risk Management

• Accounting

• Trade Workflow

• …

27

Trade Workflow 1/3

Trading

Desk(s)

Collateral

Lenders /

Market

Dealers &

Exchange

Funding

Desk

Other

Banking

Depts.

Treasury

Dept.

Uncollateralized

Counterparty

28

Trade Workflow 2/3

Trading

Desk(s)

Collateral

Lenders /

Market

Dealers &

Exchange

CVA

Desk

Funding

Desk

Other

Banking

Depts.

Dealers &

Exchange

Treasury

Dept.

CVA(t) FVA(t)

CVA(t)+FVA(t)

EVM

VM(t)*b(t)* Et

VM(t)*b(t)* Et EVM

VM(t)*OIS(t)* Et

EVM

Uncollateralized

Counterparty

CVA(t)

29

Trade Workflow 3/3

Trading

Desk(s)Dealers &

Exchange

XVA

Desk(s)

Treasury

Dept.

Other

Banking

Depts.

Collateral

Lenders /

Market

EVM

VM(t)*b(t)* Et

VM(t)*b(t)* Et EVM

CVA(t)+FVA(t)+KVA(t)

VM(t)*OIS(t)* EtEVM

Uncollateralized

Counterparty

CVA(t)

30

XVA challenge(s)

NDV

- CVA

+DVA

- FVA (LVA,

CollVA,

HVA)

- MVA

- KVA (MR,

CCR, CVA)

: Computational Effort

Degre

eof

Com

ple

xit

y

Timeline

• Pricing Model Specification

• Valuation Data Model

• Risk Management

• Accounting

• Trade Workflow

• …

31

Summary

• The impossibility to lend/borrow indefinitely or to post a derivative ascollateral jointly with regulatory and structural constraints are some of thereasons for pricing VAs in order to adjust the «risk-free pricing» ofderivatives and avoid a loss for bank’s shareholders.

• Awareness on XVAs increased the complexity of Pricing Models, Data Models,Trade Workflow, Risk Management, Accounting and other crucial aspects wehaven’t discussed due to limited time (e.g. IT requirements, DeskPerformance Measurement, Incentive Schemes …)

• We’ve seen some VAs can be hedged, some VAs can be “smoothed”, someVAs require portfolio exposure management, while others require the XVADesk to take strategic decision with other Bank’s departments to managethem.

• VAs increased the interconnections between some key Bank’s departmentsand new challenges had arisen. Hence, the need of detecting in XVA Desksthe hybrid structure in charge of coordinating activities and requirementsaround VAs, beside pricing and managing the related risks.

Thanks

Andrea GigliHead of XVA Desk

MPS Capital Services