Erik Buch Olesen
Marking to market is believed to have been contributing to frequent recessions, yet it’s still in practice in major banks. Erik Buch Olesen, Graduate in Counterparty Credit Risk Management at Nordea, predicts that financial institutions will need to find new valuation methods in order to manage liquidity risk in the future.
Fair value accounting can drive a large portion of financial institutions’ P&L. Markets and capital regulation have significantly reduced derivative liquidity since the great financial crisis. At the same time as pricing and valuation complexity increased, we strayed further from arbitrage free conditions. As a result, it is likely financial institutions will need to look for alternative valuation methods as markets further develop.
It all starts with a reversing of accounting standards by banks in the 80’s. In the 1800’s, marking to market was the common practice among bookkeepers in the US. This accounting practice has been blamed for contributing to frequent recessions up to the great depression and collapse of banks. Franklin Roosevelt got rid of this practice in 1938, but it was reintroduced by major banks in the 1980’s.
Fair valuation of derivatives is done using arbitrage free pricing, under a given set of boundary conditions. Most prominently that risk can be fully hedged. However, with the passage of time the conditions are somewhat violated and we end up with model-based accounting. As an example, the day after we trade a 10Y SWAP, the position on our book is now a 9Y and 251 day SWAP. However, the market instrument we have available for hedging is still a 10Y SWAP, which means that risk cannot be fully removed and we end up with a model-based valuation. In the most extreme case, xVA risks can usually only be delta hedged as much of the convexity and idiosyncratic credit risk is unhedgable.
Banks in the derivatives market have become more and more sophisticated in regard to their fair valuation adjustments frameworks, also known as the xVAs. The point of the xVAs in pricing of derivatives is mainly to capture factors outside the scope of standard pricing, for example funding (FVA) and counterparty credit risks (CVA) on derivatives. However, the rules of arbitrage free pricing have been stretched and often the input prices can be from instruments that have fairly limited tradability.
Separately, capital and market regulation has increased costs and is slowly taking the air out of the derivatives market by reducing the OTC market liquidity. Central counterparties (CCPs) do, however, offer some answers to cost reduction and liquidity but come with their own collateral funding considerations.
In combination, regulation has reduced liquidity in a number of markets, at the same time as xVA models make use of an increasing number of unobservable inputs or prices with limited tradability.
In conclusion, banks will likely need a more realistic valuation treatment to handle the part of the portfolio where hedging instruments are impacted by reduced liquidity, in particular regarding the xVAs. Otherwise, institutions are at of risk of booking large paper losses to the point of bankruptcy where the corruption of arbitrage free concepts as well as the illiquidity of input prices leaves a significant gap to the economic risks the bank actually faces.
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