RBS 2012 Annual Report Download - page 399

RBS GROUP 2012
397
Risk data are used as the primary sources of information within bid-offer
calculations and are aggregated when they are more granular than
market standard buckets. Bid-offer adjustments for each risk factor
(including delta (the degree to which the price of an instrument changes
in response to a change in the price of the underlying), vega (the degree
to which the price of an instrument changes in response to the volatility in
the price of the underlying), correlation (the degree to which prices of
different instruments move together) and others) are determined by
aggregating similar risk exposures arising on different products.
Additional basis bid-offer reserves are taken where these are charged in
the market. Risk associated with non-identical underlying exposures is
not netted down unless there is evidence that the cost of closing the
combined risk exposure is less than the cost of closing on an individual
basis.
Bid-offer spreads vary by maturity and risk type to reflect different
spreads in the market. For positions where there is no observable quote,
the bid-offer spreads are widened in comparison to proxies to reflect
reduced liquidity or observability. Bid-offer methodologies also
incorporate liquidity triggers whereby wider spreads are applied to risks
above pre-defined thresholds.
Netting is applied on a portfolio basis to reflect the level at which the
Group believes it could exit the portfolio, rather than the sum of exit costs
for each of the portfolio’s individual trades. For example, netting is
applied where long and short risk in two different maturity buckets can be
closed out in a single market transaction at less cost than by way of two
separate transactions (calendar netting). This reflects the fact that to
close down the portfolio, the net risk can be settled rather than each long
and short trade individually.
Vanilla risk on exotic products is typically reserved as part of the overall
portfolio based calculation e.g. delta and vega risk on exotic products are
included within the delta and vega bid-offer calculations. Aggregation of
risk arising from different models is in line with the Group's risk
management practices; the model review control process considers the
appropriateness of model selection in this respect.
Product related risks such as correlation risk, attract specific bid-offer
reserves. Additional reserves are provided for exotic products to ensure
overall reserves match market close-out costs. These market close-out
costs inherently incorporate risk decay and cross-effects (taking into
account how moves in one risk factor may affect other inputs rather than
treating all risk factors independently) that are unlikely to be adequately
reflected in a static hedge based on vanilla instruments. Where there is
limited bid-offer information for a product, the pricing approach and risk
management strategy are taken into account when assessing the
reserve.
The discount rates applied to derivative cash-flows in determining fair
value reflect any underlying collateral agreements. Collateralised
derivatives are generally discounted at the relevant OIS rates at an
individual trade level. Uncollateralised derivatives are discounted with
reference to funding levels by applying a funding spread over benchmark
interest rates on a portfolio basis (funding valuation adjustment).
Amounts deferred on initial recognition
On initial recognition of financial assets and liabilities valued using
valuation techniques incorporating information other than observable
market data, any difference between the transaction price and that
derived from the valuation technique is deferred. Such amounts are
recognised in profit or loss over the life of the transaction; when market
data becomes observable; or when the transaction matures or is closed
out as appropriate. At 31 December 2012, net gains of £153 million (2011
- £161 million; 2010 - £167 million) were carried forward. During the year,
net gains of £39 million (2011 - £89 million; 2010 - £62 million) were
deferred and £47 million (2011 - £95 million; 2010 - £99 million)
recognised in the income statement.
Own credit
The Group takes into account the effect of its own credit standing when
valuing financial liabilities recorded at fair value in accordance with IFRS.
Own credit spread adjustments are made to issued debt held at fair
value, including issued structured notes, and derivatives. An own credit
adjustment is applied to positions where it is believed that counterparties
would consider the Group's creditworthiness when pricing trades.
For issued debt and structured notes this adjustment is based on debt
issuance spreads above average inter-bank rates (at a range of tenors).
Secondary senior debt issuance spreads are used in the calculation of
the own credit adjustment applied to senior debt.
The fair value of the Group's derivative financial liabilities has also been
adjusted to reflect the Group's own credit risk. The adjustment takes into
account collateral posted by it and the effects of master netting
agreements.
The own credit adjustment for fair value does not alter cash flows, is not
used for performance management, is disregarded for regulatory capital
reporting processes and will reverse over time as the liabilities mature.
The reserve movement between periods will not equate to the reported
profit or loss for own credit. The balance sheet reserves are stated by
conversion of underlying currency balances at spot rates for each period
whereas the income statement includes intra-period foreign exchange
sell-offs.
The effect of change in credit spreads could be reversed in future
periods, provided the liability is not repaid at a premium or a discount.