Barclays 2009 Annual Report Download - page 302

300 Barclays PLC Annual Report 2009 www.barclays.com/annualreport09
Notes to the accounts
For the year ended 31st December 2009
continued
50 Fair value of financial instruments continued
Model valuation adjustments
New models used for valuing the firm’s positions are reviewed under the firm’s Model Validation Policy. This assesses the assumptions used in modelling
and recommends any model fair value adjustments. Such adjustments take account of any model limitations which may include additional model factors
such as volatility skew or uncertainties such as prepayment rates. These adjustments calibrate the carrying value to fair value. The magnitude of the
valuation adjustment is 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. Models and model value adjustment recommendations are subject to an annual review process.
Credit and debit valuation adjustments
Credit Valuation Adjustments (CVAs) and Debit valuation adjustments (DVAs) are incorporated into derivative valuations to reflect the impact on the
fair value of counterparty risk and Barclays’ own credit quality. These adjustments are modelled for OTC derivatives across all asset classes.
Probability of Default (PD) and Loss Given Default (LGD) are applied to expected exposures at a counterparty level to arrive at a CVA and DVA adjustment.
Monoline credit valuation adjustments
Expected exposure is calculated by simulating default losses on the underlying assets, calibrated to market observable parameters and forward looking
market research. This exposure is then adjusted for any spread between prices derived from observable proxies and expected exposure based on the PD or
regulatory intervention.
The PD used to calculate the CVA is derived from external ratings cross referenced to internal default grades and is based on internal simulations of credit-
factor indices by region and industry designations, calibrated to historical time-series and forecast on the basis of current values. The LGD used to calculate
the CVA is a function of available historical data, the monoline’s credit quality and risk concentration.
Other credit and debit valuation adjustments
CVAs and DVAs for non Monoline exposures are calculated using Monte-Carlo simulation to generate an expected exposure profile. The expected exposure
is calculated at a counterparty level after netting and collateral are applied.
For counterparties with an observable credit market, the PD and LGD are derived from single name credit default swap prices. For all other counterparties,
PDs are derived from a combination of industry curves; indices; and loan/note pricing taking into account geographic factors, internal credit ratings, loss
assumptions and ratings agency data. Where the curve is unobservable and the CVA is significant to the overall value of the underlying derivative, the full
value of the derivative and its associated credit valuation adjustment has been deemed unobservable.
CVAs are not incorporated into the fair value of certain counterparties where the market does not apply a credit charge. The categories of counterparties
excluded are as follows:
– Strongly collateralised counterparties – this is any counterparty with a collateral agreement with minimum weekly calls and the collateral threshold plus
minimum transfer amount below a defined level;
– Certain highly-rated sovereigns, supra-nationals and government agencies; and
– Liquidity providers – when trading on the interbank market with certain collateralised market making counterparties no counterparty spreads are applied.
Where counterparty credit quality and exposure to that counterparty are linked, wrong way risk may arise. In these instances, wrong way risk suggests that
exposure to the counterparty is likely to increase as counterparty credit quality deteriorates. Exposure to ‘wrong way risk’ is limited via internal governance
processes and deal pricing.
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, credit spreads on Barclays issued bonds represent the most appropriate basis for this adjustment. However,
from 30th September 2007 to 30th June 2009, Barclays credit default swap spreads were used to calculate the carrying amount of issued notes, since there
were insufficient observable own credit spreads through secondary trading prices in issued bonds. From 1st July 2009, the carrying amount of issued notes
has been calculated using credit spreads derived from secondary trading in Barclays issued bonds.
At 31st December 2009, the own credit adjustment arose from the fair valuation of £61.5bn of Barclays Capital structured notes (31st December 2008:
£54.5bn). Barclays credit spreads improved during 2009, leading to a loss of £1,820m (2008: gain £1,663m) from the fair value of changes in own credit.
If Barclays had calculated the carrying amount of issued notes using credit default swap spreads at 31st December 2009, the fair value of changes in own
credit would have been a loss of £2,448m in the year.
Barclays Capital also uses credit default swap spreads to determine the impact of Barclays own credit quality on the fair value of derivative liabilities.
At 31st December 2009, cumulative adjustments of £307m (31st December 2008: £1,176m) were netted against derivative liabilities. The impact of
these adjustments in both periods was more than offset by the impact of the credit valuation adjustments to reflect counterparty creditworthiness that
were netted against derivative assets.