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European banks haven't always welcomed regulatory change since
the Great Financial Crisis. More often than not it raises costs and
can have a material impact on balance sheet structure; the
reduction in risk weighted assets being a notable example. But
regulators have a responsibility to ensure the stability of
individual banks and the financial system as a whole. The interests
of banks and wider society should be aligned as much as
possible.
Yet we are in strange times, and the advent of a terrible
pandemic shows that regulators can take prudential measures that
support - rather than punish - banks. A slew of actions, ranging
from softening the leverage ratio to a more flexible approach to
IFRS 9, are aimed at helping banks perform their fundamental
intermediary role - lending to consumers and businesses.
One such measure relates to Prudent Valuation, an EU regulation
that has been in force since 2016. This requires banks to calculate
Additional Valuation Adjustments (AVAs) on fair valued instruments,
which are accretive and result in Prudent Valuation Adjustments
(PVAs). In other words, the AVA is the difference between fair
value and prudent value, leading to deductions from core equity
tier one capital (CET1). Essentially, Prudent Valuation introduces
an extra layer of conservatism to valuation: after the AVAs there
should be 90% confidence in exiting the position at the adjusted
level.
This all seems relatively uncontroversial and in keeping with
prudential regulation post-GFC. Yet the EBA felt that it was
necessary to make changes to the regulatory
technical standard (RTS) on April 22. Specifically, under the core
approach for Prudent Valuation (used by larger banks), the
aggregation factor of 50% defined in the RTS was increased by the
EBA to 66%. The aggregation factor allows for diversification due
to overlap of individual AVAs when they are aggregated at the
category level. An increase in the factor will reduce the overall
AVA.
This applies to three of the nine AVAs: Market Price
Uncertainty; Close Out Cost and Model Risk. Figure 1. shows HSBC's
Prudent Valuation Adjustments, as published in the Pillar 3
disclosures for 2019 (this is purely for illustrative purposes -
all banks covered under the regulation publish similar documents).
The total of the mid-market adjustments (market price uncertainty)
is by far the largest and this is typically seen in all banks.
Fig.1 Example of bank Prudent Valuation
reporting (source: HSBC)
So it is clear that the amendments made by the EBA will have a
material effect. The justification for this is the "extreme
volatility" seen during the recent stressed period has resulted in
the regulation having an "excessive procyclical impact". The
transmission mechanism is dispersion among market prices for
instruments, which is largely what market price uncertainty and
close out costs reflect.
There is little doubt that during this crisis weak liquidity and
uncertainty, amplified by technical factors, have resulted in
fractured markets and impaired price formation. The evidence of
this heightened dispersion is apparent in the data.
Figure 2 is taken from IHS Markit's Price Viewer platform. It
shows dispersion of contributions that form the composite CDS curve
for Glencore International (April 28). Note that this is a highly
liquid constituent of the Markit iTraxx Europe and the dispersion
measured is of contributions that pass stringent data quality
tests.
The chart shows standard deviations and 10th/90th percentiles;
both metrics are commonly used to calculate MPU and close out cost.
It shows that dispersion is significantly higher at the short- and
long-end compared to the "belly" of the curve. The 5-year is by far
the most liquid tenor in CDS, so a tighter distribution of
contributions is expected. But the large dispersion at either end
of the curve is materially larger than "normal" for an IG name like
Glencore and the 5-year hasn't escaped either - at January
month-end the standard deviation was 2, not 4.
The increase in dispersion due to the crisis is underlined by
figure 3. It shows the average range between minimum and maximum
CDS contributions for 2020 month-ends (we have taken a
pre-month-end snapshot for April).
Fig. 3 CDS spread dispersion has
increased since the beginning of the year (source: IHS
Markit)
The chart provides ample evidence that there has been a
considerable rise in dispersion, particularly at March month-end
(Prudent Valuation is reported quarterly). The five-year dispersion
has risen but the increase is more dramatic at the short-end and
long-end (as we saw with Glencore). It also demonstrates that
dispersion has remained stubbornly high, despite the rally in
April.
The uncertainty pervading the market is also reflected in the
bid-ask spread (fig.4), which is a component of the close out cost
calculation. Taking the Glencore example again, we see that up
until March it traded with a relatively constant bid-ask spread of
about 8bps. This ballooned to over 50bps at the peak of the crisis
but has since settled around 30bps - still highly elevated for this
name.
Similar patterns are observed in other asset classes, both cash
and synthetic. Given the clear evidence of unusually high levels of
dispersion and the potential implications for lending provision,
the EBA's pragmatic approach to Prudent Valuation is
understandable. It is also a timely reminder that access to
detailed, instrument level dispersion data is crucial for banks.
Regulators will require increased transparency to AVA calculations,
during this crisis and when we emerge in the aftermath.
IHS Markit provides metrics for Prudent Valuation across several
asset classes, including CDS, bonds and derivatives. Please contact Sales@ihsmarkit.com for
further details.
Posted 01 May 2020 by Gavan Nolan, Director – Business Development and Research, Fixed Income Pricing, IHS Markit
IHS Markit provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.
