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A retained earnings consistent KVA approach and the impact of taxes

García Muñoz, Luis Manuel and Palomar Burdeus, Juan Esteban and de Lope Contreras, Fernando (2016): A retained earnings consistent KVA approach and the impact of taxes.

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Abstract

KVA represents the extra cost being charged by banks to non collateralized counterparties in order to remunerate banks' shareholders for the mandatory regulatory capital provided by them throughout the life of the deal. Therefore, KVA represents earnings charged to clients that must be retained in the bank's balance sheet and not be immediately paid out as dividends. Since retained earnings are part of core TIER I capital, future KVAs imply a deduction in today's KVA calculation.

Another key component of KVA is the fact that shareholder's returns (dividends and capital gains) are generated after taxes are paid. Therefore, taxes should be reflected in the KVA formula.

By treating KVA as retained earnings, we derive a pricing formula that is consistent with full replication of market, counterparty and funding risks, and that takes the effect of taxes into account.

We provide a numerical example where the KVA obtained under this new formula is compared with other approaches yielding significantly lower adjustments. This numerical example also helps us to assess the relevance of taxes.

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