Under Article 8(3), is day one profit deferral eligible to offset the AVAs under Articles 9, to 17 of Regulation (EU) No. 2016 / 101?
In order to address valuation uncertainty in the context of the application of prudential requirements, the CRR specifies prudent valuation requirements to be applied by institutions to their fair-valued positions. Accordingly, Delegated Regulation (EU) 2016/101specifies a methodology for the calculations of AVA.
The accounting standard IFRS 9.B5.1.2A requires deferral of the difference between the transaction price and the fair value modelled using unobservable inputs, which in effect defers recognition of the Day One Profit (DOP).
The CRR does not contain specific provisions on the interaction between AVAs and DOP deferral, resulting in different approaches implemented by major SSM banks: while some banks do not consider any netting among DOP deferral and AVA, others allow for some – partial or total – offsetting.
Against this backdrop this question is aimed to clarify what is the expected approach to be adopted by institutions among:
a. DOP deferral and AVAs are addressing the same valuation uncertainties and therefore should be netted, or
b. DOP deferral and AVAs should be considered as different valuation uncertainties and therefore the netting is not possible.
The following paragraphs explain four arguments leading to the proposed answer not to allow the netting between DOP deferral and AVAs.
According to article 8.3 of Regulation (EU) No. 2016 “AVAs shall be considered to be the excess of valuation adjustments required to achieve the identified prudent value, over any adjustment applied in the institution's fair value that can be identified as addressing the same source of valuation uncertainty as the AVA. Where an adjustment applied in the institution's fair value cannot be identified as addressing a specific AVA category at the level at which the relevant AVAs are calculated, that adjustment shall not be included in the calculation of AVAs”.
The day one profit is defined in the IFRS9.B5.1.2A: “The best evidence of the fair value of a financial instrument at initial recognition is normally the transaction price. If an entity determines that the fair value at initial recognition differs from the transaction price the entity shall account for that instrument at that date as follows:
a. At the measurement if that fair value is evidenced by a quoted price in an active market for an identical asset or liability (i.e. Level 1 input) or based on a valuation technique that uses only data from observable markets. An entity shall recognise the difference between the fair value at initial recognition and the transaction price as a gain or loss;
b. In all other cases, defer the difference between the fair value at initial recognition and the transaction price. After initial recognition, the entity shall recognise that deferred difference as a gain or loss only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability.”
While acknowledging that there is no clear definition of “any adjustment” in the delegated regulation, there is however an explicit reference to “the institution's fair value”. Since the introduction of IFRS 13 in 2013, the DOP is not identified as an adjustment included in the determination of the fair value because the recognition of that initial gain is not determined by IFRS 13 (apart from the cases of IFRS 13.64). IFRS 13 defines fair value as an exit price both for assets and liabilities (i.e. price received to sell an asset or paid to transfer a liability).
This is now explicit in the new COREP reporting as of December 31, 2018, where in sheets 32.2 and 32.3, the DOP are reported in separated columns than fair value adjustments. Moreover, in Annex 2 related to the own funds requirements, the “deferral of day one gains and losses” is excluded from the fair value adjustment definition.
In addition, the DOP deferral is addressing a specific category of uncertainties i.e. those arising from unobservable inputs and cannot be used to offset the uncertainties coming from the existence of a range of observed prices for equivalent instruments, market parameter input to a valuation technique or model risk arising from existence of a range of different models or model calibrations used by market participants. In particular, the prudent valuation framework applies to all fair-valued positions regardless of the fair value hierarchy.
From an accounting point of view, after initial recognition, institutions might recognise the deferred difference as a gain or loss if it arises from a change in a factor including time. From a prudential point of view, the change in time does not guaranty that market inputs are systematically becoming observable and therefore institutions might register uncertain revenues. This is an additional reason not to offset the DOP deferral with the AVAs.
Under of Regulation (EU) No. 2016 / 101, the deferral of day one gains and losses cannot be identified as an adjustment to the institution's fair value addressing a specific AVA category. It follows that the deferral of day one gains and losses is excluded from the calculation of AVAs and is not eligible to offset any of the AVAs under Articles 9 to 17 of that Regulation.