Barclays 2011 Annual Report Download - page 237

20 Fair value of financial instruments continued
Model valuation adjustments
New valuation models are reviewed under the firm’s model governance framework. This process identifies the assumptions used and any model
limitations (for example, if the model does not incorporate volatility skew). Where necessary, fair value adjustments will be applied to take these factors
into account. Model valuation adjustments are dependant on the size of portfolio, complexity of the model, whether the model is market standard and
to what extent it incorporates all known risk factors. All models and model valuation adjustments are subject to review on at least an annual basis.
Credit and debit valuation adjustments
Credit valuation adjustments (CVAs) and debit valuation adjustments (DVAs) are incorporated into derivative valuations to reflect the impact on fair
value of counterparty credit risk and Barclays’ own credit quality respectively. These adjustments are modelled for OTC derivatives across all asset
classes. Calculations are derived from estimates of exposure at default, probability of default and recovery rates, on a counterparty basis. Counterparties
include (but are not limited to) corporates, monolines, sovereigns and sovereign agencies, supranationals, and special-purpose vehicles.
Whereas in 2010 certain highly-rated sovereigns, supra-nationals and government agencies were excluded from the CVA calculation, following the
sovereign debt crisis it has been considered appropriate to include these entities, for which the impact of doing so was a £79m increase in the CVA.
Exposure at default is generally based on expected positive exposure, estimated through the simulation of underlying risk factors. For some complex
products, where this approach is not feasible, simplifying assumptions are made, either through proxying with a more vanilla structure, or using current
or scenario-based mark-to-market as an estimate of future exposure. Where strong collateralisation agreement exists as a mitigant to counterparty risk,
the exposure is set to zero.
Probability of default and recovery rate information is generally sourced from the CDS markets. For counterparties where this information is not
available, or considered unreliable due to the nature of the exposure, alternative approaches are taken based on mapping internal counterparty ratings
onto historical or market-based default and recovery information. In particular, this applies to sovereign related names where the effect of using the
recovery assumptions implied in CDS levels would imply a £300m increase in CVA.
Correlation between counterparty credit and underlying derivative risk factors may lead to a systematic bias in the valuation of counterparty credit risk,
termed “wrong-way” or “right-way” risk. This is not incorporated into the CVA calculation, but is monitored regularly via scenario analysis and has been
found to be immaterial.
Own credit adjustments
The carrying amount of issued notes that are designated under the IAS 39 fair value option is adjusted to reflect the effect of changes in own credit
spreads. The resulting gain or loss is recognised in the income statement. For funded instruments such as issued notes, mid-level credit spreads on
Barclays issued bonds are the basis for this adjustment.
At 31 December 2011, the own credit adjustment arose from the fair valuation of Barclays financial liabilities designated at fair value. Barclays credit
spreads widened during 2011, leading to a profit of £2,708m (2010: £391m) from the fair value of changes primarily in own credit itself but also
reflecting the effects of foreign exchange rates, time decay and trade activity.
Unrecognised gains as a result of the use of valuation models using unobservable inputs
The amount that has yet to be recognised in income that relates to the difference between the transaction price (the fair value at initial recognition) and
the amount that would have arisen had valuation models using unobservable inputs been used on initial recognition, less amounts subsequently
recognised, is as follows:
Year ended 31 December 2011
£m
2010
£m
Opening balance 137 99
Additions 93 56
Amortisation and releases (113) (18)
Closing balance 117 137
Critical accounting estimates and judgements
Quoted market prices are not available for many of the financial assets and liabilities that are held at fair value and the Group uses a variety of
techniques to estimate the fair value. The above note describes the more judgemental aspects of valuation in the period, including: credit valuation
adjustments on monoline exposures, commercial real estate loans, private equity investments, and fair value loans to government and business and
other services. The following sensitivity analysis is performed on products with significant unobservable parameters (Level 3) to generate a range of
reasonably possible alternative valuations. These numbers are calculated before taking advantage of any diversification in the portfolio.
Barclays PLC Annual Report 2011 www.barclays.com/annualreport 235
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