8NOVEMBER 2022CFO TECH OUTLOOK1. IntroductionAfter the economic crisis of 2008 starting with the default of Lehman Brothers, the hypotheses that big banks could not default and funding liquidity was assured did no longer hold. Therefore, adjustments of financial derivative prices had to be added in the valuation to consider these effects. Credit, Debit and Funding adjustments (CVA, DVA and FVA) arose along the years after 2008 and margin and capital value adjustments (MVA and KVA) more recently. This big family of adjustments has been denominated XVA. On the other hand, Counterparty Credit Risk functions were incorporated to manage the risk of bilateral transactions between one party, "the bank", and another, "the counterparty", in which the counterparty could default . A continuous debate has taken place among institutions and regulators on how these adjustments should be calculated and reported to comply with accounting standards and to properly foster internal management. After more than a decade, the CVA has settled down as an accepted adjustment, DVA and FVA are still under debate and the rest are still far from being standardized.The CVA is the price reduction of a transaction due to the risk that the counterparty may default. It accounts for the hedging cost of this risk and is generated by positions in favor of the bank which may not be paid back if the counterparty defaults. Therefore, the CVA depends on the positive expected exposure and the credit quality of the counterparty. The bigger the exposure and the lower the credit quality of the counterparty, the bigger the CVA and the loss for the bank.The DVA is the increment of price that the bank should reasonably accept to pay when closing a transaction given the fact that the bank may also default (if a bank has a poor credit quality, the price it should pay is higher). It accounts for the hedging cost of the counterparty to cover the default of the bank. It can also be interpreted as the bank liabilities not paid back to the counterparty when the bank defaults (the DVA can only be realized when the bank defaults). Therefore, the DVA depends on the negative expected exposure and the credit quality of the bank. The higher liabilities of the bank and the lower its credit quality, the bigger the DVA and the benefit for the bank.Regulators have fostered the reduction of counterparty credit risk through collateralization and closing operations through clearing houses. Since 2008, collateralization has been generalized among big/medium financial institutions but for corporate non-financial institutions, transactions are closed over-the-counter and in some situations without collateralization (corporates may not have infrastructure to exchange collateral).2. Interaction of CVA, DVA and FVAThe FVA mainly appears because uncollateralized operations closed with corporates are hedged with collateralized operations with major banks. Uncollateralized bank asset positions with corporates generate CVA but their hedges are collateralized bank liabilities which consume collateral. On the other hand, uncollateralized bank liability positions closed with corporates (e.g. the Equity business selling options paid upfront but creating future bank liabilities) generate DVA but their hedges are collateralized assets which provide collateral.IN MY OPINIONX-VALUE ADJUSTMENTS: ACCOUNTING VERSUS ECONOMIC MANAGEMENT PERSPECTIVESBy Alberto Elices, Head of XVA Model Validation, Banco SantanderAlberto Elices
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