BANK OF CHILE | CIK:0001161125 |

40.   Fair Value of Financial Assets and Liabilities:

 

Banco de Chile and its subsidiaries have defined a corporate framework for valuation and control related to the fair value measurement process.

 

The established framework includes the Product Control Unit (PCU), which is independent from the business areas and reports to the Financial Management and Control Division Manager. The Financial Risk Control and Management Area is responsible for independent verification of the results of trading and investment operations and all fair value measurements.

 

To achieve the appropriate measurements and controls, the Bank and its subsidiaries, take into account at least the following aspects:

 

(i)   Industry standard valuation.

 

To value financial instruments, Banco de Chile uses industry standard modeling; quota value, share price, discounted cash flows and valuation of options through Black-Scholes-Merton, in the case of options. The input parameters for the valuation correspond to rates, prices and levels of volatility for different terms and market factors that are traded in the national and international market.

 

(ii)   Quoted prices in active markets.

 

The fair value for instruments with quoted prices in active markets is determined using daily quotes from electronic systems information (such as Bolsa de Comercio de Santiago, Bloomberg, LVA and Risk America, etc). This quote represents the price at which these instruments are regularly traded in the financial markets.

 

(iii)   Valuation techniques.

 

If no quotes are available for the instrument to be valued, valuation techniques will be used to determine the fair value.

 

Due to the fact that the valuation models require a set of market parameters as inputs, the aim is to maximize information based on observable quoted prices or derived from similar instruments in active markets. To the extent there is no information available in active markets, data from external suppliers of market information, prices of similar transactions and historical information are used to validate the valuation parameters.

 

(iv)   Fair value adjustments.

 

Part of the fair value process consists of adjustment, to take into account bid/offer spreads. This adjustment is calculated and analyzed by the PCU and Risk Market areas.

 

The bid/offer spread adjustment reflects the expected impact on fair value due to close long or short positions in a specific market factor and term, valued at midpoint. For example, long positions in an asset will be impacted in order to reflect the fact that when selling the position it will be quoted at bid instead of midpoint. For the bid/offer spread adjustment, market quotes or indicative prices for each position, instrument, currency and term are used. Bid, mid and offer market quotes are also considered.

 

(v)   Fair value control.

 

A process of independent verification of prices and rates is executed daily, in order to control the market parameters used by Banco de Chile in the valuation of the financial instruments relating to the current state of the market and the best estimate of the fair value. The objective of this process is to control that the official market parameters provided by the respective business area, before being entered into the valuation, are within acceptable ranges of differences when compared to the parameters prepared independently by the Financial Risk Control and Management Area. As a result, value differences are obtained at the level of currency, product and portfolio, which are compared against specific ranges for each grouping level.

 

In the event significant differences exist, these differences are scaled according to the amount of individual materiality of each market factor and aggregated at the portfolio level, according to the grouping levels within previously defined ranges. These ranges are approved by the Finance, International and Financial Risk Committee.

 

Complementary and in parallel, the Financial Risk Control and Management Area generates and reports on a daily basis Profit and Loss (“P&L”) and Exposure to Market Risks, which allow for proper control and consistency of the parameters used in the valuation.

 

(vi)   Judgmental analysis and information to Management.

 

In particular, in cases where there are no market quotations for the instrument to be valued and there are no prices for similar transactions or indicative parameters, a specific controls and reasoned analysis must be carried out in order to estimate the fair value of the operation. Within the valuation framework described in the Reasonable Value Policy approved by the Board of Directors of Banco de Chile, a required level of approval is set in order to carry out transactions where market information is not available or it is not possible to infer prices or rates from it.

 

(a)   Fair value hierarchy

 

Banco de Chile and its subsidiaries, classify all the financial instruments among the following levels:

 

Level 1:   These are financial instruments whose fair value is realized at quoted prices (unadjusted) in active markets for identical assets or liabilities. For these instruments there are observable market prices (return internal rates, quote value, price), so that assumptions are not required to determine the value.

 

In this level, the following instruments are considered: currency futures, Chilean Central Bank and Treasury securities, mutual fund investments and equity shares.

 

For the instruments of the Central Bank of Chile and the General Treasury of the Republic, all those mnemonics belonging to a Benchmark corresponds with one of the following categories published by the Santiago Stock Exchange, will be considered as Level 1: Pesos-02, Pesos-03, Pesos-04, Pesos-05, Pesos-07, Pesos-10, UF-02, UF-04, UF-05, UF-07, UF-10, UF-20 and UF-30. A Benchmark corresponds to a group of mnemonics that are similar in duration and are traded in an equivalent way, i.e., the price obtained is the same for all the instruments that make up a Benchmark. This feature defines a greater depth of market, with daily quotations that allow classifying these instruments as Level 1.

 

In the case of debt issued by the Government, the internal rate of return (quoted price) is used to compute the fair value. In the case of mutual funds and equity shares, the current market price multiplied by the number of instruments results in the fair value.

 

The preceding described valuation methodology is equivalent to the one used by the Bolsa de Comercio de Santiago (Santiago Stock Exchange) and corresponds with the standard methodology used in the market and is in accordance with IFRS.

 

Level 2:   There are financial instruments whose fair value is obtained with variables other than the prices quoted in Level 1 that are observable for the asset or liability, directly (that is, as prices) or indirectly (that is, derived from prices). These categories include:

 

a)   Quoted prices for similar assets or liabilities in active markets.

b)   Quoted prices for identical or similar assets or liabilities in markets that are not active.

c)   Inputs data other than quoted prices that are observable for the asset or liability.

d)   Inputs data corroborated by the market.

 

At this level there are mainly derivatives instruments, debt issued by banks, debt issues of Chilean and foreign companies, issued in Chile or abroad, mortgage claims, financial brokerage instruments and some issuances by the Central Bank of Chile and the General Treasury of Chile.

 

To value derivatives, depends on whether they are impacted by volatility as a relevant market factor in standard valuation methodologies; for options the Black-Scholes-Merton formula is used; for the rest of the derivatives, forwards and swaps, net present value through discounted cash flows is used.

 

For the remaining instruments at this level, the valuation is done through the traditional discounted cash flows model by using an internal rate of return that can be derived or estimated from similar securities as mentioned above.

 

In the event that there is no observable price for an instrument in a specific term, the price will be inferred from the interpolation between periods that have observable quoted price in active markets. These models incorporate various market variables, including the credit quality of counterparties, exchange rates and interest rate curves.

 

 

Valuation Techniques and Inputs:

 

 

Level 3:   These are financial instruments whose fair value is determined using unobservable inputs. An adjustment to an input that is significant to the entire measurement can result in a fair value measurement classified within Level 3 of the fair value hierarchy if the adjustment is using significant unobservable data entry.

 

Instruments classified as level 3 correspond to Corporate Debt issued mainly by Chilean and foreign companies, issued both in Chile and abroad.

 

 

Valuation Techniques and Inputs:

 

 

(b)   Level hierarchy classification and figures:

 

The following table shows the figures by hierarchy, for instruments recorded at fair value in the statement of financial position.

 

 

 

(c)   Level 3 Reconciliation

 

The following tables show the reconciliation between the beginning and ending balances of instruments classified as Level 3, whose fair value is reflected in the financial statements.

 

 

 

 

 

(d)   Transfers between levels:

 

 

The following tables show transfers between levels for financial assets and liabilities whose fair value is recorded in the consolidated financial statements:

 

 

 

 

 

(e)   Sensitivity of level 3 instruments to changes in key assumptions of the input parameters for the valuation model:

 

 

The following table shows the impact on the fair value of Level 3 financial instruments using alternative assumptions that are reasonably possible.  It is believed that the positive and negative impacts are similar:

 

 

With the purpose to determine the sensitivity of the financial investments to changes in significant market factors, the Bank has made alternative calculations at fair value, changing those key parameters for the valuation and which are not directly observable in screens.  In the case of financial assets presented in the table above, which corresponds to bank bonds and corporate bonds, input prices, prices based on broker quotes or runs were used, considering that these instruments do not have current prices or observables.  Prices are generally calculated as a base rate plus a spread. For local bonds, this was determined by applying only a 10% impact on the price, while for offshore bonds this was determined by applying only a 10% impact on the spread because the base rate is hedged with instruments on interest rate swaps so-called hedge accounting. The impact of 10% is considered a reasonable move considering the market performance of these instruments and comparing it against the adjustment bid/offer that is provided for by these instruments.

 

(f)   Other assets and liabilities not measured at fair value:

 

The following table summarizes the fair values of the Bank’s main financial assets and liabilities that are not recorded at fair value in the Statement of Financial Position. The values shown in this note do not attempt to estimate the value of the Bank’s income-generating assets, nor forecast their future behavior. The estimated fair value is as follows:

 

 

 

Other financial instruments not measured at fair value in our statement of financial position, but for which the fair value is disclosed, are not managed on a fair value basis. These instruments include assets and liabilities such as loans and deposits to customers, bank borrowings, debt issued, and other financial assets and obligations with diverse maturities and features. Fair values of these assets/liabilities are estimated by applying the traditional Discounted Cash Flows (DCF) model and using diverse valuation inputs such as yield curves, credit risk spreads, etc. Also, since some of these assets/liabilities are not traded in the market, judgmental analysis is required in determining the adequacy of the inputs and fair values.

 

(g)   Levels of other assets and liabilities:

 

The table below sets forth the fair value of Financial Assets/Liabilities not measured at fair value on the balance sheet, for the years ended December 31, 2016 and 2017:

 

 

 

We estimate fair values for these assets/liabilities, as follows:

 

 

 

 

 

 

(h)   Offsetting of financial assets and liabilities:

 

In accordance with IAS 32 Financial Instruments: Presentation, the Bank should report financial assets and financial liabilities on a net basis on the balance sheet only if there is a legally enforceable right to set off the recognized amounts and there is intention to settle on a net basis, or to realize the asset and settle the liability simultaneously. Because Bank’s netting agreements do not qualify for balance sheet netting, it presents its financial instruments on a gross basis on the balance sheet.

 

The following table shows the impact of netting arrangements on all derivative financial instruments that are subject to enforceable master netting agreements or similar agreements (including financial collaterals), but do not qualify for balance sheet netting.

 

The “Net amounts” presented below are not intended to represent the Bank’s actual exposure to credit risk, as a variety of credit mitigation strategies are employed in addition to netting and collateral arrangements.

 

 

 

 

Derivative assets and liabilities

 

The “Financial Instruments” column identifies financial assets and liabilities that are subject to set off under netting agreements, such as the ISDA Master Agreement of derivative exchange or clearing counterparty agreements, whereby all outstanding transactions with the same counterparty could be offset and close-out netting applied across all outstanding transaction covered by the agreements if an event of default or other predetermined events occur (“early contract termination”).

 

Financial collateral refers to cash and non-cash collateral obtained, typically daily or weekly, to cover the net exposure between counterparties by enabling the collateral to be realized in an event of default or if other predetermined events occur (“early contract termination”).