Deloitte Valuation Conference

Deloitte Valuation Conference Valuation challenges in credit institutions and investment firms June 2015 January 2015 2015 Deloitte Tax & Consulting 1

Agenda 1. Introduction Valuation challenges in credit institutions and investment firms 2. Case study 1: Interest Rate Swap 3. Case study 2: Structured Product 4. Panel discussion Zoom on structured products 2015 Deloitte Tax & Consulting 2

Valuation challenges can arise in various businesses of credit institutions and under various forms 1 3 Structured note issuance (e.g. EMTN Programme) PB Client Credit facilities Hard-to-measure asset used as collateral (PE, structured, etc.) 2 4 Investment in Level 3 assets Capital Markets Coupon / Formulabased Floating Hedging with OTC derivative (TRS or equivalent) 2015 Deloitte Tax & Consulting 3

which not only imply complying with different set of regulations but also with other stakeholders expectations Customers Fair and transparent pricing of assets held in portfolios Potential performance enhancer Limited capacity to challenge prices provided by counterparts and blind reliance on those values for hard-to-measure assets is no longer a viable option. Governing bodies Accountable for sound business (and risk) oversight Adequate valuation processes provide extra assurance and serve as evidence of sound governance practice Regulators Daily valuation of items in the trading book (CRD) Counterparty credit risk and CVA (CRD, IFRS) Collateral management (EMIR, CRD) Prudent valuation (CRD, IFRS) Pricing transparency (MIFID) Shareholders Overpriced products can negatively impact P&L and harm the performance of the institution 2015 Deloitte Tax & Consulting 4

Example for wealth management Valuation issues related to illiquid investments Illiquid Investments Client Wealth management agreement Private Bank? Investment Structuring Client Portfolio Valuation Issues Option 1 Option 2 Option 3 SOPARFI Insurance Policy Dedicated Fund Listed Securities Company A Portfolio management-related concerns: o Asset allocation (portfolio weights?) o Liquidity of investment? Related cash-flows? o Level of risk of the investment? (maturity, industry, etc.) o Collateral / pledge agreement o Tax Structuring Regulatory and accounting issues: o Regulated fund (AIF, SIF, SICAR, etc.) o Unregulated vehicle (SOPARFI) o Insurance policy o IFRS, LUX GAAP, other? 2015 Deloitte Tax & Consulting 5

Valuation challenges in credit institutions and investment firms Case study 1 Interest rate swaps IR Swaps Other IR FX The most frequent type of OTC by far CDS Equity Commodity Unallocated OTC derivatives by notional Dec2014 (source: Bank for International Settlements) Representation of an Interest Rate Swap etc. Rec. Notional (if cross-currency) Rec. Fix that looks apparently straightforward to value Start Pay LIBOR Maturity Valuation by discounting the future cash flows Pay Notional (if cross-currency) 2015 Deloitte Tax & Consulting 7

Valuation challenges in credit institutions and investment firms Case study 1 The changing environment of IRS valuation Since the crisis, rate of collateralized Overnight-Indexed Swap is seen as the true risk-free rate instead of Libor. The yield curve built upon OIS is the new standard for discounting. DERIVATIVES (SWAPS) VALUATION Incorporation of new market realities into pricing Multi-curve framework (depending on collateralization) Inclusion of proper valuation adjustments Valuation of derivatives as part of a whole portfolio Sub-prime crisis (2007-2010) Start Mid-2007 Euro sovereign debt crisis (2011-2012) VALUATION ADJUSTMENTS CVA (Credit) accounts for the counterparty credit risk if no collateral DVA (Debit) accounts for own counterparty credit risk if no collateral FVA (Funding) accounts for P&L of cash management in derivatives business 3M EUR Libor-OIS spread Close to 0 until credit crisis TRANSPARENCY Essential to know precisely the exposures of the bank with respect to each individual counterparty High standards of transparency to guarantee investors protection and best execution within MiFID COUNTERPARTY CREDIT RISK Importance of proper collateral management Inclusion of Credit Support Annexes (CSA) in swap contracts Inclusion of proper valuation adjustments Challenges of collateral include the operational costs, the complex management of threshold and netting agreements, the determination of cheapest-to-deliver assets, etc. 2015 Deloitte Tax & Consulting 8

Valuation challenges in credit institutions and investment firms Case study 1 Valuation of a cross-currency swap Before the 2007 crisis Classical valuation framework Two yield curves are required: - 1 single standard curve for forward and discount in ccy1-1 single standard curve for forward and discount in ccy2 and after the crisis Multi-curve valuation framework Four yield curves are required: 1 forward curve in ccy1 corresponding to the right Libor tenor 1 discount curve in ccy1: - OIS if collateralized - Standard Libor curve otherwise 1 forward curve in ccy2 corresponding to the right Libor tenor 1 discount curve in ccy1: - OIS if collateralized - Standard Libor curve otherwise - Cross-currency and maybe tenor basis adjustments Ccy1 is the collateral currency, ccy2 is the other one! Recall small effects on large notional amounts lead to big impacts! Example: Libor OIS = 20 bps 20 bps 10 mio EUR = 200,000 EUR!! Regulatory and practical obligations Report to a trade repository (EMIR) Ensure there is a Credit Support Annex for collateral definition and practical details Fulfil MiFID transparency obligations Collateral management: operations, netting agreement, thresholds, etc. If not collateralized trade: - Compute CVA/DVA/FVA - Take netting into account - Consider other trades in portfolio 2015 Deloitte Tax & Consulting 9

Valuation challenges in credit institutions and investment firms Case study 2 Bank issuing a structured product for its customers Structured product = combination of a bond and (vanilla/exotic) options Challenges are similar as for swaps Notional Par Value Cost of equity option (premium) Issue price of risk free zero-coupon bond Issue date Equity Vanilla Option Zerocoupon bond Equity vanilla option value at maturity Maturity price of risk free zerocoupon bond (known at time of issue) Maturity date Valuation methodology But more critical here Regulatory Monitor secondary (counterparty) prices Risk & Transparency 2015 Deloitte Tax & Consulting 11

Valuation challenges in credit institutions and investment firms Case study 2 Valuation reconciliation Payoff Credit Risk Interest rates Volatility Models $ A range of possible valuations can be obtained by twisting the different elements Counterparty prices outside of this range are probably non-plausible!! 2015 Deloitte Tax & Consulting 12

Valuation challenges in credit institutions and investment firms Case study 2 Real-world example of valuation reconciliation Counterpart price: 99,28 Price Independent valuation: 86,34 101,00 99,00 97,00 95,00 93,00 91,00 89,00 87,00 85,00 Difference of roughly 13% at issue date Observations and facts As from product issue date, the counterparty price was outside a reasonable valuation range Investigation lasted a month, during which the valuation difference gradually decreases but remains larger than accepted thresholds (indicative of original overprice) CONTROL FRAMEWORK throughout the product s life is crucial External Provider Issuer Price 2015 Deloitte Tax & Consulting 13

Valuation challenges in credit institutions and investment firms Case study 2 Valuation control framework for structured products Product Set Up On going monitoring Deal closing Tasks Tasks Tasks Design payoff Get quotes from counterparties Daily valuation of the structured product vs. counterparty price Market data cleansing and analysis Ensure arm s length transaction Ensure smooth process Get pre-quote before deal closing Controls Controls Controls Due diligence Definition of valuation model Validation of the model Price comparisons Escalation process Discussions with various stakeholders Periodic model review Back testing prices Ensuring prices are aligned with independent valuation 2015 Deloitte Tax & Consulting 14

Panel discussion Today s panelists Georges ELIAS Senior Wealth Management Advisor, MENA & Emerging Markets Fuchs & Associés Patrick FELTEN Chief Risk Officer Banque de Luxembourg Karim MARRAKCHI Head of Equity & Multi Assets Structuring ING Belgium Patrick PALZER Chief Risk Officer Nomura Bank Luxembourg 2015 Deloitte Tax & Consulting 16

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