Loan Fair Value Approaches Revisited
22 Pages Posted: 22 Jan 2017 Last revised: 2 Nov 2017
Date Written: November 2, 2017
In this paper we discuss practices for fair value estimation of banking book items. While fair value principles are not new they have gained in importance recently with new accounting regulations (e.g., IFRS 9) and banks are also considering market best practices to disclose banking book valuations focusing on market implied views rather than potentially biased internal views. A core part of the fair value estimation is the extraction of the risk-neutral market implied view on risk spreads using either directly observable or approximate market spreads. Such extraction can be based on the available credit markets and one can either extract a spread or premia directly from the market or start with a real-world model of credit risk as the basis and add a market induced risk premia. In the latter case there is the benefit of relating real-world expected loss models to risk-neutral. Regardless of approach - using the actual spread or risk premium extracted from the market in discounting of cash flows is of course central in fair value and the foundation of the market valuation principle. As for the bulk of the banking book items there are no active quote markets the fair value estimation often uses the discounted cash flow principle similar to bonds. Loans may however have rating or credit state dependent cash flow features that require a valuation using a state transition matrix setting. Similarly, loans may be exposed to statistical prepayment models that require adjustments to simple bond valuation schemes. In our valuation scheme we strip the cash flows of financial engineering valued embedded options and value such embedded optionality separately. This definition of the valuation cash flows is consistent with the new regulation for interest rate risk in the banking book which is an advantage as such banking book cash flows should already be available in banks.
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