Recital 65 of Regulation (EU) No 575/2013 (CRR) states:

‘The provisions on prudent valuation for the trading book should apply to all instruments measured at fair value, whether in the trading book or non-trading book of institutions. It should be clarified that, where the application of prudent valuation would lead to a lower carrying value than actually recognised in the accounting, the absolute value of the difference should be deducted from own funds.’

Accordingly, all fair valued positions, assets and liabilities, whether in the trading book or non-trading book (banking book) of institutions, are within the scope of the Commission Delegated Regulation (EU) 2016/101 (RTS). In particular, this includes all positions under the Fair Value Option and Available for Sale, though these two types of positions are normally included in the banking book. As per Recital 1 of the RTS, the term ‘positions’ is, however, understood as solely referring to financial instruments and commodities, which results, in particular, in the exclusion from the scope of the RTS of investment properties that may be measured at fair value in accordance with IAS40.

Throughout the RTS, ‘fair value’ (FV) should refer to the definition of fair value and the applicable measurement requirements under IFRS 13 and IAS 39 for banks that are required or chose to use the IFRS framework as endorsed by the EU (c.f. Regulation (EU) 1606/2002), or to the definition of fair value in national GAAPs as set out under Article 8(7) of Directive 2013/34/EU. The assumption is that trading book positions should always be fair valued but, in case national GAAPs allow for a different treatment, such positions will not be subject to the prudent valuation requirements if they are not measured at fair value.

In accordance with Recital 3 and Articles 4 & 8 of the RTS, a consistent treatment has to be applied for:

-          Determination of the threshold

-          AVA calculation

The approach should also be consistent in all cases: 1) exactly ‘matching, offsetting positions’, 2) positions subject to hedge accounting; and 3) positions subject to the use of prudential filters.

Exactly matching, offsetting positions

In accordance with the RTS, exactly matching, offsetting assets and liabilities are excluded from both the determination of the threshold and the AVAs calculations.

Exactly matching, offsetting assets and liabilities should be read strictly and hence are positions for which all contractual future cash flows are identical and in opposite direction under all circumstances.

Back to back derivative transactions are eligible as long as they fulfil the above criteria.

Positions subject to hedge accounting

The overarching criterion is the one established in Article 4(2) of the RTS and is applicable to all fair valued positions within the scope of the RTS, including positions under the Fair Value Option and Available for Sale:

‘For fair-valued assets and liabilities for which a change in accounting valuation has a partial or zero impact on Common Equity Tier 1 (‘CET1’) capital, their values shall only be included in proportion to the impact of the relevant valuation change on CET1 capital.’

Accordingly, if there is an accounting hedge, the bank must consider the proportion that the changes in the fair value of the hedging instrument(s) that are not offset by the symmetric change in the fair value of the hedged item(i.e. the FV change that would have an impact on CET1).

These changes in value must be computed by comparing the FV of the instruments at the current reporting date with the one obtained for the last CET1 reporting date, or since the instrument was originally traded if it occurred within the reporting period.  Accordingly, since this proportion will vary during the life of the accounting hedge, it must be updated on every CET1 reporting date.

Once the proportion that the residual impact in CET1 represents is determined, the institution should multiply it by the absolute value of the fair value of assets and liabilities/derivatives that comprise the accounting hedge to compute the simplified approach threshold. This proportion should also be used when computing the AVAs for the instruments included in the accounting hedge.

‘Economic’ hedges

It should be noted that, according to the RTS, only hedging recognised under accounting rules can be considered, hence ‘economic hedges’ are not recognised under this provision. Nevertheless, due to the way AVAs are computed under the core approach, ‘economic hedges’ may induce lower AVAs in practice, where positions are offset by one another, though it is clear that under the simplified approach all positions receive an AVA.

Cash flow hedges (according to Article 33(1)(a) CRR)

It should also be noted that only accounting hedges that reduce the impact of a market movement in CET1 are acceptable. Accordingly, the derivative instrument included in a ‘Cash flow hedge’ would have to be fully considered, since the establishment of a cash flow hedge generates an ‘impact’ on CET1 for a position that previously would not have had such an impact. In the end, due to the application of prudential filters, these positions are excluded, since, according to Article 33(1)(a) of the CRR, the fair value reserves related to gains or losses stemming from ‘cash flow hedges’ of financial instruments not valued at fair value are filtered out of CET1.

Hedging of an individual risk factor (‘valuation input’ in the RTS)

In the case that the accounting hedge is for a specific risk factor of the hedged instrument, (i.e. hedge only the interest rate component of a corporate bond, leaving the credit spread open) the bank must also perform a similar calculation as described in the general approach but at the level of the risk factor.

In this case, the proportion that the changes – i.e. the changes in the risk factors that had an impact on CET1 - represent when compared with all changes in the instruments’ risk factors, must be taken in absolute value (i.e. regardless of whether there was a loss or a gain) to determine the proportion for the threshold. This proportion should be used both to compute the threshold used for the simplified approach as well as to determine the AVAs according to the simplified approach.

However, the proportion of the AVAs to be applied under the core approach has to be computed by risk factor (‘valuation input’ according to the terminology of the RTS).

Application of prudential filters

The same procedure should be applied for prudential filters; in case the change in the value of an instrument (such as AFS assets) is filtered out of CET1, then the proportion that is filtered out should not be considered when computing the standardised threshold nor when calculating the AVAs.

In the case that it is not the change in value of the instrument as a whole, but only the change in a particular risk factor that is filtered out, such as with the bank’s own credit worthiness for a liability at FV (Article 33(1)(b) of the CRR), the percentage of the change for the risk factor would be the part which is not filtered out (under the current treatment 100% is currently filtered for own credit worthiness, so 0% would be considered).

Just like in the previous case (hedging of an individual risk factor), the proportion that the changes in the risk factors that had an impact on CET1 represent when compared with all changes in the instruments’ risk factors must be taken in absolute value (i.e. regardless of whether there was a loss or a gain) to determine the proportion for the threshold. This proportion should be used both to compute the threshold used for the simplified approach as well as to determine the AVAs according to the simplified approach.

However, the proportion of the AVAs to be applied under the core approach may be computed by risk factor (‘valuation input’ according to the terminology of the RTS). In the specific case of the own credit worthiness the proportion to be considered would be 0% since 100% is filtered out according to Article 33(1)(b) of the CRR.

Fallback treatment

Every time CET1 is reported, the above calculations have to be performed in order to apply any reduction in the computation of both the threshold and/or individual AVAs. In case it is not possible to perform the calculations, the institution shall apply the most conservative approach, i.e. compute 100% of the value of the instrument(s) and relevant AVAs.

Examples

Example 1 - accounting hedge of an individual risk factor (‘valuation input’ in the RTS): fixed coupon Corporate Bond bought for 100, the bank does an accounting hedge of the interest rate of the bond, but leaves the credit spread risk open.

At the end of the quarter the bond is worth 98, and the (bond + hedge) is worth 102 due to the following market changes:

Interest rate:            - 5 in the value of the bond        +4 in the value of the hedge

Credit spread:        + 3 in the value of the bond

Proportion to be used for threshold:

(ABS (-5 + 4) + ABS (+3)) / (ABS(-5) + ABS(+3)) = 50%  to be applied to the value of the bond at the end of the quarter (102)

Proportion to be used to determine AVAs by risk factor (‘valuation input’ according to the terminology of the RTS):

Interest rate: ABS ( -5 + 4) / ABS(-5) = 20%

Example 2 - application of prudential filters: 5 year fixed bond issued at 100 by the bank. Valued at FV (FV option)

At the end of the quarter the value of this liability is 101 due to the following movements:

Improvement in the firm’s own credit worthiness:        + 3 in the value of the bond (loss)

Increase in interest rates:                                                   - 2 in the value of the bond (gain)

The own credit worthiness is 100% filtered out, so the proportion to be used for threshold would be:

(ABS (3 - 3) + ABS (-2)) / (ABS(+3) + ABS(-2)) = 40% to be applied to the value of the bond at the end of the quarter (101)

Proportion to be used to determine AVAs by risk factor (‘valuation input’ according to the terminology of the RTS):

Interest rate: there is no filter for this ‘valuation input’, so 100%

Credit spread: 100% is filtered, so 0%

Example 3 - hedge accounting: fixed rate mortgage portfolio hedged using an interest rate swap that is held at fair value and is currently an asset worth €50m.

This is designated as a fair value hedge for accounting with an effective proportion of 90%.

The effect on CET1 of any change in value of the swap is only (100% - 90% =) 10% of that change in value. Therefore only 10% of the asset value (€5m) counts towards the threshold for the simplified approach.

Similarly any AVA on the full value of the swap is multiplied by 10% before being added to the total AVA for the bank.

See also Q&A 2013 213.