2018 Registration document and annual fi nancial report - BNP PARIBAS 205
4CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEAR ENDED 31 DECEMBER 2018
4
Notes to the fi nancial statements
Valuation process
BNP Paribas has retained the fundamental principle that it should have a unique and integrated processing chain for producing and controlling the valuations of fi nancial instruments that are used for the purpose of daily risk management and fi nancial reporting. All these processes are based on a common economic valuation which is a core component of business decisions and risk management strategies.
Economic value is composed of mid-market value, to which add valuation adjustments.
Mid-market value is derived from external data or valuation techniques that maximise the use of observable and market-based data. Mid-market value is a theoretical additive value which does not take account of i) the direction of the transaction or its impact on the existing risks in the portfolio, ii) the nature of the counterparties, and iii) the aversion of a market participant to particular risks inherent in the instrument, the market in which it is traded, or the risk management strategy.
Valuation adjustments take into account valuation uncertainty and include market and credit risk premiums to refl ect costs that could be incurred in case of an exit transaction in the principal market. When valuation techniques are used for the purpose of deriving fair value, funding assumptions related to the future expected cash fl ows are an integral part of the mid-market valuation, notably through the use of appropriate discount rates. These assumptions refl ect what the Bank anticipates as being the effective funding conditions of the instrument that a market participant would consider. This notably takes into account the existence and terms of any collateral agreement. In particular, for non- or imperfectly collateralized derivative instruments, they include an explicit adjustment to the interbank interest rate (Funding Valuation Adjustment FVA).
Fair value generally equals the economic value, subject to limited adjustments, such as own credit adjustments, which are specifi cally required by IFRS standards.
The main valuation adjustments are presented in the section below.
Valuation adjustments
Valuation adjustments retained by BNP Paribas for determining fair values are as follows:
Bid/offer adjustments: the bid/offer range refl ects the additional exit cost for a price taker and symmetrically the compensation sought by dealers to bear the risk of holding the position or closing it out by accepting another dealer s price.
BNP Paribas assumes that the best estimate of an exit price is the bid or offer price, unless there is evidence that another point in the bid/offer range would provide a more representative exit price.
Input uncertainty adjustments: when the observation of prices or data inputs required by valuation techniques is diffi cult or irregular, an uncertainty exists on the exit price. There are several ways to gauge the degree of uncertainty on the exit price such as measuring the dispersion
of the available price indications or estimating the possible ranges of the inputs to a valuation technique.
Model uncertainty adjustments: these relate to situations where valuation uncertainty is due to the valuation technique used, even though observable inputs might be available. This situation arises when the risks inherent in the instruments are different from those available in the observable data, and therefore the valuation technique involves assumptions that cannot be easily corroborated.
Credit valuation adjustment (CVA): the CVA adjustment applies to valuations and market quotations whereby the credit worthiness of the counterparty is not refl ected. It aims to account for the possibility that the counterparty may default and that BNP Paribas may not receive the full fair value of the transactions.
In determining the cost of exiting or transferring counterparty risk exposures, the relevant market is deemed to be an inter-dealer market. However, the determination of CVA remains judgemental due to:
■ the possible absence or lack of price discovery in the inter-dealer market;
■ the infl uence of the regulatory landscape relating to counterparty risk on the market participants pricing behaviour; and
■ the absence of a dominant business model for managing counterparty risk.
The CVA model is grounded on the same exposures as those used for regulatory purposes. The model attempts to estimate the cost of an optimal risk management strategy based on i) implicit incentives and constraints inherent in the regulations in force and their evolutions, ii) market perception of the probability of default and iii) default parameters used for regulatory purposes.
Own-credit valuation adjustment for debts (OCA) and for derivatives (debit valuation adjustment DVA): OCA and DVA are adjustments refl ecting the effect of credit worthiness of BNP Paribas, on respectively the value of debt securities designated as at fair value through profi t or loss and derivatives. Both adjustments are based on the expected future liability profi les of such instruments. The own credit worthiness is inferred from the market-based observation of the relevant bond issuance levels. The DVA adjustment is determined after taking into account the Funding Valuation Adjustment (FVA).
Thus, the carrying value of debt securities designated as at fair value through profit or loss is increased by EUR 244 million as at 31 December 2018, compared with an increase in value of EUR 452 million as at 1 January 2018, i.e. a EUR -208 million variation recognised directly in equity that will not be reclassifi ed to profi t or loss.
Instrument classes and Classification within the fair value hierarchy for assets and liabilities measured at fair value
As explained in the summary of significant accounting policies (note 1.e.10), fi nancial instruments measured at fair value are categorised into a fair value hierarchy consisting of three levels.
5.d MEASUREMENT OF THE FAIR VALUE OF FINANCIAL INSTRUMENTS
