RBS 2011 Annual Report Download - page 349

RBS Group 2011 347
Valuation reserves
When valuing financial instruments in the trading book, adjustments are made to mid-market valuations to cover bid-offer spread, liquidity and credit
risk. The following table shows the valuation reserves and adjustments.
2011
£m
2010
£m
2009
£m
Credit valuation adjustments
Monoline insurers 1,198 2,443 3,796
Credit derivative product companies 1,034 490 499
Other counterparties 2,254 1,714 1,588
4,486 4,647 5,883
Bid-offer, liquidity and other reserves 2,704 2,797 2,814
7,190 7,444 8,697
Key points
xThe exposure to monolines reduced primarily due to the
restructuring of some exposures, partially offset by lower prices of
underlying reference instruments. The credit valuation adjustments
decreased due to the reduction in exposure partially offset by wider
credit spreads.
xThe exposure to credit derivative product companies has increased,
primarily driven by wider credit spreads of the underlying reference
loans and bonds. The credit valuation adjustments increased in line
with the increase in exposure.
Credit valuation adjustments (CVA)
Credit valuation adjustments represent an estimate of the adjustment to
fair value that a market participant would make to incorporate the credit
risk inherent in counterparty derivative exposures.
Monoline insurers
The Group has purchased protection from monoline insurers
(“monolines”), mainly against specific Asset-backed securities. Monolines
specialise in providing credit protection against the principal and interest
cash flows due to the holders of debt instruments in the event of default
by the debt instrument counterparty. This protection is typically held in the
form of derivatives such as credit default swaps (CDSs) referencing
underlying exposures held directly or synthetically by the Group.
The gross mark-to-market of the monoline protection depends on the
value of the instruments against which protection has been bought. A
positive fair value, or a valuation gain, in the protection is recognised if
the fair value of the instrument it references decreases. For the majority
of trades the gross mark-to-market of the monoline protection is
determined directly from the fair value price of the underlying reference
instrument However, for the remainder of the trades the gross mark-to-
market is determined using industry standard models.
The methodology employed to calculate the monoline CVA uses market
implied probability of defaults and internally assessed recovery levels to
determine the level of expected loss on monoline exposures of different
maturities. The probability of default is calculated with reference to
market observable credit spreads and recovery levels. CVA is calculated
at a trade level by applying the expected loss corresponding to each
trade’s expected maturity, to the gross mark-to-market of the monoline
protection. The expected maturity of each trade reflects the scheduled
notional amortisation of the underlying reference instruments and
whether payments due from the monoline are received at the point of
default or over the life of the underlying reference instruments.
Credit derivative product companies (CDPC)
ACDPC is a company that sells protection on credit derivatives. CDPCs
are similar to monoline insurers however, they are not regulated as
insurers.
The Group has purchased credit protection from CDPCs through
tranched and single name credit derivatives. The Group's exposure to
CDPCs is predominantly due to tranched credit derivatives (“tranches”). A
tranche references a portfolio of loans and bonds and provides protection
against total portfolio default losses exceeding a certain percentage of
the portfolio notional (the attachment point) up to another percentage (the
detachment point).
The Group has predominantly traded senior tranches with CDPCs, the
average attachment and detachment points are 13% and 47%
respectively (2010 - 13% and 49%; 2009 - 15% and 51%), and the
majority of the loans and bonds in the reference portfolios are investment
grade.
The gross mark-to-market of the CDPC protection is determined using
industry standard models. The methodology employed to calculate the
CDPC CVA is different to that outlined above for monolines, as there are
no market observable credit spreads and recovery levels for these
entities. The level of expected loss on CDPC exposures is estimated with
reference to recent market events impacting CDPCs (including
communication activity); risk mitigation strategies (including analysing the
underlying trades and the cost of hedging expected default losses in
excess of the available capital); and the total notional of trades transacted
by each CDPC together with the level of resources available to settle
default payments.
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