In April 2021, generally accepted accounting principles in Japan (JGAAP) will incorporate the credit assessment adjustment (HOW ARE YOU) and debt value adjustment (DVA) the pricing of portfolios of derivative products. With several challenges ahead and the looming deadline, companies have little time to act. Banks need to prepare JGAAP HOW ARE YOU change now
Adopt HOW ARE YOU reflecting the fair value of derivatives has been done more slowly in banks in Japan than in Europe, the Middle East and Africa, and the Americas. However, in April 2021 JGAAP will require companies to account for their derivative exposures using both HOW ARE YOU and DVA for the first time.
Large Japanese financial institutions have incorporated a series of valuation adjustments (xVAs) into their pricing and risk management processes in recent years, but adoption by smaller entities has been slower. According to Hiroyuki Yoshizawa, Executive Director, Price Reviews and Benchmarks, IHS Markit Group Japan, April 2021 JGAAP the deadline is a “significant change for local and regional Japanese banks who will use HOW ARE YOU and DVA for the first time”.
When Mizuho Bank restated its profits using Basel III methodologies for the first time in March 2019, the mega-bank was forced to write down the value of its derivatives portfolio in JPY30 billion ($ 270 million). But, according to Yoshizawa, the problems facing small financial institutions in Japan in implementing HOW ARE YOU and DVA price for JGAAP is the adoption of technological and operational processes rather than market issues.
With larger institutions having implemented HOW ARE YOU in their business structures, they already have the systems, market data and, most importantly, the people in place to absorb changes in business. JGAAP rules. However, this is not the case for regional banks in Japan. According to IHS Markit, several Japanese institutions will have to start accounting for their HOW ARE YOU and DVA exhibits for the first time in April 2021. Yoshizawa says the majority of them face five challenges in implementing the updated requirements in their pricing and risk management protocols.
The first of these challenges is technology.
amended JGAAP will require HOW ARE YOU/DVA figures measured at fair value and the calculation of final results will lead to a significant increase in the technological infrastructure required by financial institutions. Market standard HOW ARE YOU/DVA the calculation will require an increase in computing power compared to the traditional value-at-risk of market risk; while calculating xVA sensitivity requirements for coverage increases requires a similar increase in technology capacity.
To help businesses overcome this challenge, IHS Markit offers daily and real-time credit default swaps (CDS) price data, which is a basic data for HOW ARE YOU pricing and modeling. It also offers a monthly plan HOW ARE YOU/DVA calculation service using a risk engine that has been tested and proven in top tier banks for their internal model method (IMM) approvals. This range of capabilities means that banks looking to meet their JGAAP HOW ARE YOU/DVA requirements can use IHS by Markit CDS data service to fuel their calculations, or they can choose to outsource the entire process using IHS Markit’s analytical service.
2. Model risk
Once the technological problem is solved, banks face model risk. A key aspect of HOW ARE YOU/DVA the calculation calibrates models to ensure that companies’ prices are in line with consensus and market behavior, and this applies to an external supplier as well as an internal system, explains Yoshizawa.
“If they outsource their calculation, banks need to assess whether the supplier can calculate the appropriate scenarios. The optimal way is to validate the transactional data available when banks are performing in the market and compare it with their HOW ARE YOU pricing. IHS Markit offers consensus service for over-the-counter products (OTC) global derivative valuations and backtest the output to validate model calibration. IHS Markit also offers a HOW ARE YOU pricing tool, which has the same model and input data and is part of the HOW ARE YOU calculation service.
3. Accurate market data
The third challenge is to ensure that the model contains accurate market data. In order to get the right HOW ARE YOU and DVA numbers, banks should calculate the probability of default (PD) as well as the default loss (ACL).
Those who treat OTC derivatives transactions must offer securities for transactions with a maturity covering the short end of the credit curve (less than six months) up to 30 years. Given the wide range of CDS tenors in portfolios, it is essential that they use CDS price data with a term structure based on market consensus figures and available liquidity.
A lack of liquidity in Japan CDS market, especially with regard to unique names, is a well-known and even greater challenge for banks which have CDS exhibitions. However, it is possible for companies to find “proxy curves”, which are calculated from CDS data using IHS Note the CDS Sector curves tool. These figures are derived from the best CDS data that uses the three fundamental ideas of rating, sector and region within its factor model.
“Banks should select suppliers based on those who can provide a specific consensus or the market PD and ACL numbers – something IHS Markit can do this thanks to his CDS Data service pricing, ”says Yoshizawa.
An additional advantage of adopting an outsourced approach to HOW ARE YOU/DVA calculation to meet the requirements of JGAAP is that banks will already have the systems in place to cope with subsequent regulatory standards.
“Our risk engine is able to meet the general requirements of Basel so that banks that outsource HOW ARE YOU/DVA calculation for us can also use our platform for future regulatory calculations, as well as to answer JGAAP requirements, ”says Yoshizawa.
4. Operational challenges
The penultimate challenge is operational. Concretely, the new JGAAP obligation to calculate HOW ARE YOU Consensus-compliant means offering a market exit price for each derivative transaction using qualified market data, such as volatility, skewness and correlation. Large Japanese banks already have this capacity due to their regulatory obligations IMMs, but small regional businesses in Japan need to acquire this skill set quickly. An obvious solution to this problem is to use IHS Markit, who can easily provide a pricing platform that calculates values according to market consensus.
The final and most difficult challenge is that of timelines. Local banks have historically used packaged software to establish pricing OTC derivatives. However, upgrading these systems to meet the increased demands of HOW ARE YOU and DVA calculation for JGAAP will be expensive or, in some cases, impossible because existing software cannot handle the new requirements. If banks seek to outsource this calculation process, they will need to provide transaction data and counterparty data – as well as the underlying legal documentation related to each transaction – in order to replenish the full cash flow on the platforms. providers.
Japanese local banks with a relatively large derivative portfolio typically have thousands of derivative transactions, and the process of outsourcing them HOW ARE YOU and DVA the calculations will be complex and could take several months.
“Outsourcing is not easy: information stores have to provide a lot of information, which can be time consuming given the resources and development that may be required,” Yoshizawa explains. “My message to the market is that it should make decisions quickly and minimize all operational risks as much as possible. These five challenges must be addressed in a timely manner, which will contribute to a smooth transition to the April 2021 deadline. ”