Can Loan Valuation Adjustment (LVA) approach immunize collateralized debt from defaults?

• Author: Rafal M. Wojakowski,Aziz Jaafar,Murizah Osman Salleh,M. Shahid Ebrahim
• DOI: http://doi.org/10.1111/fmii.12109
• Date: 01 May 2019
• Published date: 01 May 2019

DOI: 10.1111/fmii.12109

ORIGINAL ARTICLE

Can Loan Valuation Adjustment (LVA) approach

immunize collateralized debt from defaults?

Rafal M. Wojakowski1M. Shahid Ebrahim2Aziz Jaafar3

Murizah Osman Salleh4

1University of Surrey,Faculty of Arts and Social

Sciences, Surrey Business School, Guildford, GU2

7XH, UK

2Durham University Business School, Mill Hill

Lane Durham, DH1 3LB, UK

3Bangor Business School, Bangor University, Hen

Goleg, Bangor Gwynedd, LL57 2DG, UK

4Bank NegaraMalaysia (Central Bank of

Malaysia) Jalan Dato’ Onn, 50480, Kuala

Lumpur, Malaysia

Correspondence

RafalM. Wojakowski, University of Surrey,

Facultyof Arts and Social Sciences, Surrey

BusinessSchool, Guildford, GU2 7XH, UK.

Email:r.wojakowski@surrey.ac.uk

Theviews in the paper are solely the author's and

donot represent the Central Bank of Malaysia.

Abstract

This study focuses on structuring tangible asset backed loans to

inhibit their endemic option to default. We adapt the pragmatic

approach of a margin loan in the configuring of collateralized debt

to yield a quasi-default-free facility.We link our practical method to

the current Basel III (2017) regulatory framework. Our new concept

of the Loan Valuation Adjustment (LVA) and novel method to mini-

mize the LVA converts the risky loan into a quasi risk-free loan and

achievesvalue maximization for the lending financial institution. As a

result, entrepreneurial activities are promoted and economic growth

invigorated. Information asymmetry, costly bailouts and resulting

financial fragility are reduced while depositors are endowed with a

safety net equivalent to deposit insurance but without the associ-

ated moral hazard between risk-averselenders and borrowers.

KEYWORDS

agency cost, collateral, financial fragility, financial innovation,

financial regulation, loan default

JEL CLASSIFICATION

D53, G10, G20, G28

“Conflicts between debt and equity only arise when there is a risk of default. If debt is totally free of

default risk, debtholders have no interest in the income, value or risk of the firm.”

Myers (2001), p. 96

[Thecopyright line in this article was changed on 17 April 2019 after online publication.]

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and repro-

duction in anymedium, p rovidedthe original work is properly cited.

c

2019 The Authors. Financial Markets, Institutions & Instruments published by New YorkUniversity Salomon Center and Wiley Period-

icals, Inc.

Financial Markets,Inst. & Inst. 2019;28:141–158. wileyonlinelibrary.com/journal/fmii 141

142 WOJAKOWSKIET AL.

1INTRODUCTION

The relevant features of a collateralized loan are the current value of its collateraland the remaining balance and thus

the current exposure. The future value of the collateral is random and contingent on its prospective exposure. Risk

intensifies when the market value of the collateraldeclines and the borrower defaults.

As time progresses, the default risk is subject to two effects. First, uncertainty attached to the value of the collateral.

This becomes acute the closer the term, thereby exacerbating default. Second, loan contracts,such as corporate loans

or mortgages secured on the value of real estate property,involve cash flows that are paid over time. This reduces the

remainingbalances as the underlying loans amortize through time. As a result, the maximum exposure is unlikely to occur

in the first year.1Themaximum exposure is also unlikely to be in the last years since most of the payments will already

havebeen made by then. It is more likely that the maximum exposure will be in the middle of the tenure of the contract.

This paper proactively proposes a new method for tackling both risk shifting as well as underinvestment. This is

conducted by quantifying and modifying the maximum exposure to default risk by looking forward into the payment

schedule of a loan contract. We show that the probability of default can be minimized by making the initial loan-to-

collateral value ratio small enough. Since the maximum exposureis in most cases located in the middle of the contract,

a static model focusing on initial exposure or a specific default (terminal) date assumed ex-ante is inappropriate for the

task. An optimal levelof debt simultaneously addresses the underinvestment problem for the borrower. Thus, we need

a forward-looking, stochastic and intertemporalmodel to solve this issue. Consequently, we choose a framework which

is capable of incorporating the impact of: (a) the probability of default; (b) the present value of the maximum lifelong

exposure,on the initial permissible loan to value ratio; while (c) endowing financial flexibility to the borrower to expand

his venture.

Unlike prevailing practice, we go beyond the current exposureat origination approach. We also include the maxi-

mum life-long exposureinto our analysis. Therefore, our new method also integrates the potential future loss that may

occur over the lifetime of a contract due to a borrower defaulting on her/his loan. We are proactive and contribute

abovethe standard approach which normally only considers the current value of the collateral and/or a specific default

date.

Our approach is inspired by the Credit Valuation Adjustment (CVA)concept which is now an integral part of the

Basel III (2017) regulatory framework. CVA is the difference between the price of a default-free derivative and the

price of a default-prone derivative, to account for the expected loss from counterparty default. Followingthe crisis of

2007, CVAadjustments are now required daily by Basel III for exposures to derivatives in the context of counterparty

credit risk. What we essentially do is reverse the logic of CVA.In contrast, the CVA remains only a risk measuring tool.

Our enhanced framework can be applied to decrease (and, ideally, quasi-eliminate)the likelihood of default when

approving the size of collateralized loans. We define ‘LoanValuation Adjustment’ (LVA )as the difference between the

value of a risk-free loan and the value of a risky loan, such that a default-prone loan has a lower value than a risk-free

loan. This is because a borrower in a default-prone loan may renege on his/her obligations and the bank issuing such

a facility will not receive the scheduled payments, i.e. the amortized fraction of principal plus interest on remaining

balance.

This paper incrementally contributes to the extant literaturein four ways described below.

Our first contribution to the literature is to provide a method to minimize the LVA and thus to provide an answer to

the problem of converting a risky loan into a quasi-risk-free loan. Unlike the CVA,which is exogenously driven by the

state variables of the economy2and thus cannot be changed, our LVA can be proactively implemented and modified.

Our approach looks forward into future points in time for the lifetime of the loan. Weobtain potential future exposures

at each future time point. We then aggregate positions backwards, taking into account values of the collateral and

remaining balances. We then derive implications on the maximum allowable quasi-risk-free loan which can be granted

today,and thus maximize its value to the lending financial intermediary institution.

Our second contribution is to offer a method which is capable of mitigating the twin issue of risk-shifting (illustrated

in Figure 1) where the borrower defaults between periods t1and t2(when the equity is underwater) and underinvest-

ment (illustrated in Figure 2) when the borrower's cash-flows in period 2 are below its debt obligations. Tacklingthese