IFRS 13 Fair value non-performance risks

IFRS 13 Fair value non-performance risks – One of the key challenges for many reporting entities in estimating fair value in accordance with the fair value standards has been determining and incorporating the impact of non-performance risk, including credit risk, into the fair value measurement. Non-performance risk is the risk that an entity will not perform on its obligation. This risk should be incorporated into a fair value measurement using a market-based estimate that follows the framework of the fair value standards and should be measured from the perspective of a market participant. The concept of non-performance risk incorporates credit risk and other risk factors, including regulatory, operational, and commercial risks.

Credit risk is often the largest component of non-performance risk, and at times, the risks are referenced interchangeably. Although non-performance risk, including credit risk, may have been a factor in determining the price of certain instruments, the price of the risk may not be separately observable, making it difficult to determine an appropriate measurement methodology and the inputs necessary to make a reasonable fair value estimate.

This focuses on key considerations for incorporating credit risk into the measurement of fair value. Reporting entities should also consider the other components of non-performance risk in developing fair value measurements.

Incorporating credit riskIFRS 13 Fair value non-performance risks

The incorporation of counterparty credit risk (predominantly for asset or “positive” exposure positions) and the reporting entity’s own credit risk (predominantly for liability or “negative” exposure positions) is a key component in fair value measurements in the fair value standards.

Excerpt from IFRS 13 B16

A fair value measurement should include a risk premium reflecting the amount that market participants would demand as compensation for the uncertainty inherent in the cash flows. Otherwise, the measurement would not faithfully represent fair value.

IFRS 13 44 explicitly requires that reporting entities consider the effect of non-performance risk, including credit risk, in determining the fair value of both assets and liabilities. In evaluating the credit risk component of non-performance risk, reporting entities should consider all relevant market information that is reasonably available. Factors that may impact the credit risk exposure include:

  • Master netting arrangements or other netting arrangements
  • Collateral and other credit support
  • Structure of the transaction
  • Specific characteristics of the instrument being measured

In general, the credit risk incorporated in the fair value measurement will vary depending on the exposure as follows:

  • Positive exposures – The credit risk of the counterparty should be incorporated into the calculation of the credit risk adjustment. The reporting entity would incorporate the effect of the obligor’s credit risk in determining the price that a market participant would be willing to pay for the asset.
  • Negative exposures – The reporting entity should incorporate its own credit risk as a component of the fair value measurement.

Market participants may use a number of different approaches to estimate the impact of credit risk on fair value measurement, which range from very complex to relatively straightforward. Any approach should consider factors such as:

  • How the underlying exposure will behave over time – For example, certain instruments, due to their nature, could be both assets and liabilities over time as their fair value changes. These scenarios complicate the process of estimating the impact of credit risk on fair value measurement.
  • How the credit risk of a position is dependent on the remaining life of the exposures – For example, a higher credit risk adjustment is typically required for longer-dated risk, and hence the credit risk associated with the position may decrease between reporting periods as the remaining maturity of the exposure decreases.
  • How credit mitigants will affect the net exposure – For example, if the credit risk related to a group of assets and liabilities is measured together (i.e., legal right of offset exists between assets and liabilities, resulting in a net exposure based on the eligible portfolio), how will the portfolio exposure change over time? If collateral is required, the thresholds in the contractual agreements governing the collateral posting are relevant to how the net exposure behaves over time and how market participants would assess credit exposure.

The sophistication of a reporting entity’s calculation of the impact on fair value of credit risk may be affected by the nature and extent of its activities. For example, reporting entities with material, complex derivatives portfolios may need to apply sophisticated, scenario-based approaches that consider market-based predictions of their potential future exposure. Reporting entities with limited and less complex derivative activities may be able to demonstrate that a simplified approach provides a sufficiently accurate estimate of the impact of credit risk on fair value.

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Reporting entities should continue to monitor market developments to ensure that their methodologies remain appropriate as derivatives valuations, including the incorporation of credit risk, continue to evolve to address market and regulatory impacts. Reporting entities should also document both the methodology applied and the rationale for the decisions made in determining an appropriate methodology for incorporating credit risk into their fair value measurements under the fair value standards.

Other considerations

For some instruments, no separate measurement of credit risk is required as the quoted prices of these instruments incorporate the risk of non-performance. In general, a reporting entity will not be required to separately measure non-performance risk for assets and liabilities with observable prices in active markets. Such prices already reflect a market participant’s view of value including credit risk to the extent it is applicable.

Instruments whose prices incorporate the risk of non-performance and as such, require no separate measurement of credit risk, include:

  • Publicly traded equity securitiesEquity securities often have observable prices in active markets. As equity represents the residual value in a company, credit risk per se is not measured. However, the market view of the company’s potential cash flows and the riskiness of those potential cash flows (including credit risk) are inherent in the market price. Therefore, no separate measurement of credit risk is required.
  • Publicly traded debt – The fair value of a reporting entity’s public debt can generally be determined based on available market prices. If quoted information is available for the same issue, no separate measurement of credit risk is required.
  • Cleared contracts – Generally, clearing houses will require the posting of margin or collateral in order to manage counterparty credit risk. For example, on the Chicago Mercantile Exchange, margin postings are required daily on futures contracts in order to mitigate the risk that the holder will not perform. As a result, the valuation of a financial derivative contract cleared through a clearing house that requires a maintenance margin or another form of collateral arrangement would reflect an adjustment of the loss assumptions to include this collateral protection. Therefore, no separate measurement of credit risk is required.
  • Fully collateralized transactions – Certain contracts may be fully collateralised on both sides if the terms of the CSA require collateral that is posted daily and not subject to any threshold value. In that case, no separate measurement of credit risk is required.

In cases in which quoted prices that incorporate credit risk are not available due to the lack of a liquid market for a particular instrument, the reporting entity should consider the risk of non-performance, including credit risk, in developing its fair value measurement.

The determination of credit risk adjustments can be complex, and may require the consideration of future expectations of exposure, credit risk, and mitigating factors.PPE - Components and parts

The remainder of this section will consider credit risk measurement under the following simplified assumptions:

  • The market value of a position at a point in time approximates the exposure
  • Assets approximate positive exposures, and liabilities approximate negative exposures
  • Any collateral posted daily is assumed to be instantaneously posted, with no potential for default by the posting entity
  • Any collateral posted is done so in accordance with the requirements of the CSA

Market participants should consider and memorialize the rationale, appropriateness, and support for any assumptions made in their assessment and quantification of the credit risk adjustment.

Timing

The credit risk adjustment should be reconsidered in each period in which fair value measurements are reported, because the market view of credit risk will vary depending on the credit quality of the counterparties, the value of the underlying asset or liability, market volatility, and other factors that are dynamic. The following discussion highlights some of the questions that may arise in practice as reporting entities consider measurement of the credit risk adjustment.

Q: For assets and liabilities reported at fair value, is an evaluation of credit risk required each reporting period if there has been no change in credit rating since origination?

Yes. A credit risk adjustment should reflect all changes in the price of credit as well as changes in the creditworthiness of the reporting entity or the counterparty, as applicable, which may not be reflected in their credit ratings. For example, a decline in the reporting entity’s credit default swap rate, or an overall change in the credit spreads for the reporting entity’s industry sector may indicate a change in the market price of its credit.

Credit spreads and risk can change without a change in credit ratings. The credit risk adjustment should incorporate all available market information, including changes in the company’s standing within its credit category, changes in the market price of credit or the market value of the asset or liability being measured, as well as other factors.

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Excerpt from IFRS 13 IE34

On January 1, 20X7, Entity A, an investment bank with a AA credit rating, issues a five-year fixed rate note to Entity B. The contractual principal amount to be paid by Entity A at maturity is linked to the Standard & Poor’s 500 index [an equity index].

No credit enhancements are issued in conjunction with or otherwise related to the contract (that is, no collateral is posted and there is no third-party guarantee).

Entity A designated this note as at fair value through profit or loss. The fair value of the note (that is the obligation of Entity A) during 20X7 is measured using an expected present value technique. Changes in fair value are as follows:

b. Fair value at March 31, 20X7. By During March 20X7, the credit spread for AA corporate bonds widens, with no changes to the specific credit risk of Entity A. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the treasury yield [government bond] curve at March 31, 20X7, plus the current market observable AA corporate bond spread to treasuries [government bonds], if non-performance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (that is, resulting in a credit-adjusted risk-free rate).

Entity A’s specific credit risk is unchanged from initial recognition. Therefore, the fair value of Entity A’s obligation changes as a result of changes in credit spreads generally. Changes in credit spreads reflect current market participant assumptions about changes in non-performance risk generally, changes in liquidity risk, and the compensation required for assuming those risks.

As this example illustrates, a reporting entity is required to assess credit risk each period, even if there is no change in the related credit rating, because adjustments for credit are not triggered solely by a change in credit rating. In fact, the credit risk to the entity changes simply because of the passage of time. Because there is less time for the parties to default, absent other changes to the counterparty credit standing, the default probabilities will typically be lower.

Q: In estimating fair value at a point in time, can entities assume the effect of credit risk on a financial instrument’s fair value is immaterial?

No. However, an entity may be able to demonstrate that for some financial instruments the effect of credit risk is immaterial, provided it has sufficient evidence to support this. For example, this might be the case if:

  • any credit risk is substantially mitigated, for example, by the posting of collateral or netting arrangements; or

  • there is persuasive evidence that the credit riskiness of the parties to the transaction has not changed and that all parties continue to have low credit risk.

What comprises sufficient evidence that the effect of credit risk is immaterial will vary depending on the facts and circumstances. Such evidence could be qualitative or quantitative. A numerical calculation may not be required in all cases.

The assessment should take into account the effect on both the financial instrument’s carrying amount and on hedge effectiveness for derivatives in hedging relationships. For example, if a hedge relationship is near 100% effective before considering the effect of credit risk, it may be easier to demonstrate that any adjustment would not materially affect the financial statements than if a hedge is, say, close to 80% effective before considering the effect of credit risk. This is important because even a minor change could result in the hedge not meeting the 80%—125% practice-accepted threshold to qualify for hedge accounting.

Q: If the original contract price included an adjustment for credit risk, does the reporting entity need to continue to evaluate the credit risk adjustment each period?

Yes. The effect of non-performance risk, including credit risk, is typically priced into the terms of a contract at inception, but should be re-evaluated each reporting period. For example, credit risk may be incorporated into the pricing of a derivative instrument through an adjustment to the interest rate, other pricing terms, or contractual credit enhancements (such as requirements to post collateral or letters of credit).

Similarly, credit risk is priced into long-term debt through the credit spread, which may vary depending on seniority of debt and other factors that impact credit risk. Because those terms are established as part of the contractual arrangement and dictate the contractual cash flows, some reporting entities have questioned whether an ongoing evaluation of credit risk is necessary in connection with the fair value measurement process at each reporting date.

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Typically, commercial contract terms do not include provisions that reset pricing or cash flows due to changes in credit spreads or the credit standing of the issuing entity. As a result, credit risk should be reconsidered each period to incorporate contractual and market changes that may impact the credit risk measurement. Note that some contracts may require the posting of additional collateral or other credit enhancements for credit deterioration or other changes in fair value. This type of protection may impact the calculation of the credit risk adjustment but does not eliminate the requirement to re-evaluate the potential exposure to credit risk at each reporting date.

Q: If a reporting entity intends to settle a non-prepayable liability shortly after the end of the reporting period (i.e., the borrower intends to negotiate with the lender an early termination of the agreement after the reporting date), can settlement value be used as a proxy for fair value?

No. The basic premise in the calculation of the fair value of a non-prepayable liability pursuant to the fair value standards is that the liability remains until its maturity. Therefore, fair value should be determined based on the transfer value of the liability, inclusive of non-performance risk. Any difference between the settlement amount and the fair value measurement of the liability should be recognized in the period of settlement.

If the liability includes a prepayment option that was not separated as an embedded derivative, the terms of the prepayment option would impact the calculation of fair value. For example, if the prepayment option is deep in-the-money, the fair value may be close to the strike price as market participants would anticipate the prepayment of the liability by the borrower in the near term and therefore value the prepayment option considering such a possibility.

Market participant perspective

The measurement of credit risk should be based on market participant assumptions.

IFRS 13 22 – 13 23

A reporting entity shall measure the fair value of an asset or a liability using the assumptions that market participants would use in pricing the asset or liability, assuming that market participants act in their economic best interest. In developing those assumptions, a reporting entity need not identify specific market participants. Rather, the reporting entity shall identify characteristics that distinguish market participants generally, considering factors specific to all of the following: (a) the asset or liability, (b) the principal (or most advantageous) market for the asset or liability, and (c) market participants with whom the reporting entity would enter into a transaction in that market.

Consistent with this guidance, credit risk should be measured based on market participant assumptions about the risk of default and how that risk will be valued. Market-based assumptions take priority over the reporting entity’s point of view of its own credit risk or the credit risk associated with a specified counterparty. Accordingly, in calculating the credit risk adjustment, a reporting entity should consider all sources of information, available without undue cost or effort, that market participants would consider when determining how much they would pay to purchase an asset or demand to assume a liability.

Available information can be adjusted and weighted based on facts and circumstances if the reporting entity believes it is not reflective of the characteristics of the liability being valued or market conditions. This will require the use of professional judgment, which is a key element in fair value measurements. The rationale for the approach used for assessing credit risk and the basis for adjustments made in measuring fair value should be documented as part of the reporting entity’s credit risk assessment.

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IFRS 13 Fair value non-performance risks

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