RBS 2012 Annual Report Download - page 398

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Notes on the consolidated accounts continued
11 Financial instruments - valuation continued
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)
A CDPC 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 16% and 49%
respectively (2011 - 13% and 47%; 2010 - 13% and 49%), 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. Trade restructurings during the second half of
2012 provided market evidence of the fair value of certain CDPC
exposures resulting in valuation adjustments of £279 million at
31 December 2012. These adjustments are also included in the table
above. For trades facing other CDPCs, 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 these CDPC exposures is
estimated with reference to risk mitigation strategies.
Other counterparties
The CVA for all other counterparties is calculated on a portfolio basis
reflecting an estimate of the amount a third party would charge to assume
the credit risk.
Where exposure exists to a counterparty that is considered to be close to
default, the CVA is calculated by applying expected losses to the current
level of exposure. Otherwise, expected losses are applied to estimated
potential future exposures which are modelled to reflect the volatility of
the market factors which drive the exposures and the correlation between
those factors. Potential future exposures arising from vanilla products
(including interest rate and foreign exchange derivatives) are modelled
jointly using the Group's core counterparty risk systems. The majority of
the Group's CVA held in relation to other counterparties arises on these
vanilla products together with exposures to counterparties which are
considered to be close to default. The exposures arising from all other
product types are modelled and assessed individually. The potential
future exposure to each counterparty is the aggregate of the exposures
arising on the underlying product types.
The correlation between exposure and counterparty risk is also
incorporated within the CVA calculation where this risk is considered
significant. The risk primarily arises on credit derivative trades where the
default risk of the referenced entity is correlated with the counterparty
risk. The risk also arises on trades with emerging market counterparties
where the gross mark-to-market value of the trade, and
therefore the counterparty exposure, increases as the strength of the
local currency declines.
Collateral held under a credit support agreement is factored into the CVA
calculation. In such cases where the Group holds collateral against
counterparty exposures, CVA is held to the extent that residual risk
remains.
Bid-offer, liquidity and other reserves
Fair value positions are adjusted to bid or offer levels, by marking
individual cash based positions directly to bid or offer or by taking bid-
offer reserves calculated on a portfolio basis for derivatives exposures.
The bid-offer approach is based on current market spreads and standard
market bucketing of risk.