Wednesday, April 11, 2012

Two articles on Debit Value Adjustment (DVA) worth reading

A number of readers have asked about the concept of Debit Value Adjustment (DVA) as well as the background and the controversy around hedging DVA. Two articles should answer most of these questions. The first one is a Bloomberg story that takes the reader back to 2008 as the concept of DVA was hotly debated (just before the failures of the GSEs, Lehman, Merrill, AIG, Citi, Wachovia, etc.). Both the supporters and the opponents of the rule are quoted there. The article highlights the lobbying efforts that had taken place on behalf of the financial firms to institute DVA accounting. Here is a quote:
Bloomberg (Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math): The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to the rule before its passage, saying in a joint 2006 letter to the FASB that it would ``have the contrary effect'' of increasing a bank's net worth at the same time its ``financial condition is deteriorating.''
The second article is by Laurie Carver written for Risk Magazine. This is a thorough and well written discussion on the topic dealing with DVA hedging (unfortunately requires a subscription to Risk Magazine). Here is a quote:
Risk (Show me the money: banks explore DVA hedging): In the US, DVA is tackled by Financial Accounting Standard 157, which requires own-credit related effects to be included in profits or losses for all derivatives liabilities, and gives banks the option to extend that treatment to other liabilities. Canadian banks are subject to similar rules. For countries that use standards drawn up by the International Accounting Standards Board – which includes the European Union – the treatment is a little more ambiguous. But under the board’s new International Financial Reporting Standard 13, due to come into force in 2013, practice will be more aligned with the US.

The concept is simple enough – when a bank’s credit spreads widen, DVA increases, reflecting a reduction in the value of its liabilities resulting from the increased probability of default. This means a paper profit is booked....

Update: Also see comment/link below from Philip Koop.
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