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  • 7 NET Present Value Models

    • 7.1 Scope

      7.1.1
             		The concept of Net Present Value (“NPV”) is commonly used to estimate various metrics for the purpose of financial accounting, risk management and business decisions. This section focuses on standalone NPV models employed for the purpose of general asset valuation, covering, amongst others, investment valuation, collateral valuation and financial modelling to estimate the cost of facility rescheduling (or restructuring). The discounting component embedded in ECL, LGD and CVA models is discussed in other sections.
       

    • 7.2 Governance

      7.2.1
             		Standalone NPV models should be included in the scope of models managed by institutions. These models should be included in the model inventory and subject to the life-cycle management articulated in the MMS. The management of these models should be governed by the Model Oversight Committee.
       
      7.2.2
             		These models are deterministic in substance as they do not need statistical calibrations. Therefore the recalibration step of the life-cycle does not apply to them. However, the suitability of inputs and the assumptions embedded in the model construction should be reviewed on a regular basis, or whenever there is a significant change in assumptions.
       
      7.2.3
             		Institutions should establish a general consistent methodology for standalone NPV computation that follows the entire model life-cycle management, including the validation step. Independent model validation should follow the principles articulated in the MMS.
       
      7.2.4
             		In addition to the regular generic validation of the approach and usage, institutions should define materiality thresholds, beyond which the valuation of specific transactions should be subject to modelling review by an independent model validator. The threshold of materiality should be clearly documented.
       
      7.2.5
             		For NPV computation in the context of facility rescheduling (restructuring), the choice of methodology, inputs and assumptions should follow accounting principles.
       

    • 7.3 Methodology

      7.3.1
             		The methodology surrounding NPV computation can be split into two parts: (i) the mathematical mechanistic considerations and (ii) the choice of inputs. The mathematical considerations surrounding NPV computation are well documented in accounting rulebooks, practitioner guidelines and academic literature. Consequently, institutions have limited room to deviate from these rules and are expected to apply rigorously these principles in a transparent fashion. Institutions can exercise some judgement regarding the choice of inputs, although a tight framework is generally provided by accounting standards.
       
      7.3.2
             		Mechanics: In addition to generally accepted principles, institutions should pay attention to the following:
       
       (i)
             		The cash-flows from the facility or asset to be valued should reflect the contractual obligations of all parties.
       (ii)Contractual mechanical optionality should be reflected in the cash flow structure.
       (iii)Behavioural optionality should be tested.
       (iv)
             		The granularity of the time buckets should closely reflect the granularity of the cash flows. This is particularly relevant for large facility restructuring, for which cash-flows occurring at different dates cannot be grouped in the same time bucket.
       (v)
             		For the purpose of estimating the present cost of rescheduling a facility, institutions should compute the difference between the NPV of the original and the newly issued facility. The modelling mechanics described above should be identical for both the original facility and the new facility.
       
      7.3.3
             		Inputs: For a given set of mechanistic rules in place, the choice of inputs has a materia impact on the NPV values produced by the model. In particular:
       
       (i)
             		The discount factor should be chosen to reflect the opportunity cost of lending or investing the same notional elsewhere at a similar level of risk. It should reflect the contractual obligations of all parties involved in the transaction.
       (ii)
             		In the context of facility rescheduling (or restructuring), the discount factor employed to compute the NPV of the original and the new facilities should be based on the same effective interest rate as the contractual obligations of the original facility.
       (iii)
             		In addition, if there is evidence that the creditworthiness of the obligor has deteriorated, a credit premium should be added to the discount factor of the newly rescheduled facility. The calibration of this credit premium should be substantiated by market analysis and comparables. If no credit premium is added, justification should be provided.
       (iv)
             		In the context of facility rescheduling (or restructuring), the cash-flows of the original and new facilities should reflect the original and the new contractual obligations, respectively. This is applicable to the principal repayment flows and interest rate payments. In particular, if the interest of a restructured facility has been dropped, the received cash-flows should include lower interest payments.
       (v)
             		In the case of assets and facilities with floating interest rates or resetting rates, the source of the input rates should be clearly identified. Assumptions regarding forward rates should be based upon the term structure or interest rate at the date of valuation.
       (vi)
             		In the context of facility restructuring (or rescheduling) with floating rates or resetting rates, the reference interest rates should be identical for both the original facility and the new facility.
       (vii)
             		If several choices of inputs are envisaged for the same asset, institutions should perform several valuations under a different set of inputs and choose the most appropriate one. This choice should be clearly justified, documented and validated. The chosen set of assumptions are not necessarily those leading to the lower P&L impact.
       

    • 7.4 Documentation

      7.4.1
             		All standalone NPV models should be fully documented. The documentation should address the methodology, the assumptions and the principles behind the choice of inputs.
       
      7.4.2
             		For each valuation exercise deemed material, institutions should produce dedicated documentation at the time of the exercise in order to justify the model inputs. Institutions should provide the business rationale, the economic context and the background for such valuations in order to justify the choice of inputs. This is particularly relevant for facility rescheduling (or restructuring).
       

    • 7.5 Validation of NPV Models

      7.5.1
             		All NPV models should be included in the scope of the validation exercise undertaken by the institution and in line with the principles articulated in the MMS and, in particular, the validation checks related to deterministic models.
       
      7.5.2
             		The validation process should cover, at a minimum, the assumptions, inputs and usage of the general NPV methodology. In addition, the review should cover specific valuations deemed material on a sample basis to ensure that the choice of inputs are coherent with the principles articulated in the general NPV methodology documentation.
       
      7.5.3
             		The general principles of the NPV computation methodology should be reviewed on a regular basis. The choice of inputs and assumptions in the context of material valuations should be reviewed for each material restructuring events.
       
      7.5.4
             		The validation exercise should ensure that the model inputs reflect accurately the legal terms of both the original agreement and the new agreement. It should also ensure that the model outputs meet economic and business intuitions. This is particularly relevant for restructurings over a long time horizon where material uncertainty arises. Finally, the validation exercise should pay particular attention to the calibration of the credit spread premium in the context of a deterioration in the obligor’s creditworthiness.