01 DECEMBER 2017

The financial crisis in 2007 was a lesson we all hope that we have learnt from. Up until the crisis, the idea of a counterparty defaulting was unheard of and counterparties were deemed as ‘too big to fail’. As we all saw, the reality was very different. Hence why the Basel committee has been busy creating new regulations to ensure similar situations like those that led to the crisis, will not reoccur.

Every participant of an OTC derivative transaction is exposed to counterparty risk. This is the risk of the exposure to loss of earnings as a result of a counterparty failing to meet their obligations due to default. For many years banks have been using the credit value adjustment (CVA) to cover the cost of a counterparty defaulting. “During the financial crisis, roughly two-thirds of losses attributed to counterparty credit risk were due to CVA losses and only about one-third were due to actual defaults”, Basel committee on Banking supervision (BCBS). CVA considers only the exposure if a counterparty defaults and not the consequence on the exposure if the credit worthiness of a counterparty changes during the duration of the contract, known as CVA losses.

Consequently, Basel III attempted to address the significant CVA losses suffered by banks by introducing an additional CVA charge, a requirement to set aside capital to cover the variability in CVA that arises due to changes in the credit worthiness of counterparties. In July 2015, the Basel committee published a paper concerning a revision of the CVA framework and introduced a new FRTB-CVA framework. Within this article, we will define what CVA is and give a high level description of what the recent changes include.

What is CVA?

CVA is a function of the expected exposure due to the derivative as well as the probability of default of the counterparty.

Simplified CVA formula,

CVA=(1-R)∑_(n=1)^N▒〖EPE(t_n ) PD(n)〗

• R is the recovery rate
• EPE is the expected positive exposure
• PD is the probability of default

For bilateral instruments such as interest rate swaps, the value of the derivative changes over time. This means that either counterparty is in an asset or liability position, they are exposed to one another. Positive exposure is an asset position, in other words it means you are owed money. Therefore, the counterparties are at risk of loosing this asset position and they have a positive exposure.

The value of the derivative in the future is unknown as it is dependent on market conditions. Therefore, the future positive exposure needs to be predicated, which is known as the expected positive exposure (EPE). EPE is the market implied expected positive exposure as result of a derivative contract. Mathematical and statistical tools (such as Monte Carlo simulations) help estimate this measure by considering scenarios where a counterparty will owe money as result of a derivative contract and the associated probability with such a scenario.

The probability of default can be calculated from observed CDS prices in the market. A CDS is a credit derivative that fundamentally behaves in the same way as insurance. It allows lenders to insure themselves against changes in borrowers’ credit worthiness. The seller agrees to pay the buyer if an underlying loan or security defaults. Essentially the value of a CDS captures what the market believes the credit worthiness of a debt security to be. The probability of default is backed out of the CDS spread as the difference between a risk free derivative and the risky CDS. The recovery rate is the percentage value of a security that can be recovered at default.

CVA comes with many drawbacks but the obvious one is that CVA depends on the CDS spreads. It doesn’t consider the exposure variability due to the CDS spreads changing which can cause significant losses. During the financial crisis, the credit quality of most participants in the global market declined. Therefore, the banks suffered significant losses due to the spreads changing and not being appropriately prepared for it. To address this gap, the Basel committee introduced the variability capital charge to address the CVA risks in 2010. They introduced two methods for calculating the charge, the advanced approach and the standardised approach. Both methods seek to capitalise against the counterparties credit quality. The standardised method is the mandatory method if banks are not internal models method (IMM) approved. The risk charge was widely criticised and banks argued the methods did not coincide with the CVA models they use. This is an issue as it means the CVA risk for the charge is calculated differently to the metrics the banks use to mark, measure and hedge their CVA, therefore the capital charge does not correctly capture the CVA risk and creates non-real risks. The CVA charge also does not consider when banks attempt to hedge their CVA market risks. Hence, this makes hedging costly and pointless, which means the exposure to CVA variability is exposed and potentially at more risk.

In a response to the criticism, in July 2015 the Basel Committee issued a consultative document “Review of the credit Valuation Adjustment Risk Framework”. The revised CVA framework should provide a better alignment between the economic risk and the capital charge for CVA and reduce the incentive banks currently have to leave some of their risks unhedged. Within the paper, Basel introduced two new types of risk models, Basic Approach (BA-CVA) and the Fundamental Review of the Trading Book (FRTB-CVA). FRTB-CVA framework is available to banks that satisfy several fundamental conditions related to the calculation and the risk management of their CVA. To use the FRTB-CVA framework, a bank would need to demonstrate to the satisfaction of its supervisors that it meets these conditions.

Putting away capital to cover risks can be costly, as its money that could be use to generate profit. IHSMarkit recently did a study and found that using the SA-CVA instead of BA-CVA could reduce CVA risk capital by 71%. Therefore,it is clear that Banks would prefer to use FRTB SA-CVA models. However to do this, they will need the robust technology infrastructure in place to be able to compute the SA-CVA. The SA-CVA requires banks to be able to calculate CVA sensitivities, which is computationally heavy and requires sophisticated technology in place. The technology demands has created a market for new and readily available technology. Many FinTech companies have started developing products that are able to calculate these models and provide the analysis that banks need to prepare themselves for the capital charges.

To conclude, CVA is a complicated measure that banks have used for many years to insure themselves against any credit losses. However, like all risk measures, it is not sufficient enough during stressed times, as we saw during the crisis. The Basel committee has since been busy creating new regulations that mitigate these risks and better prepare banks in the future. This is a huge change for banks, as it requires them to completely reformat the way they currently calculate their OTC derivative risks. To prepare themselves adequately without incurring unobtainable costs banks will be required to invest into advanced technology or work with third party financial technology companies.

Credit Default Swaps and the Financial Crisis. (2017). Available at: http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch09_CDS.pdf.
Eba.europa.eu. (2017). Available at: https://www.eba.europa.eu/documents/10180/950548/EBA+Report+on+CVA.pdf.
En.finance.sia-partners.com. (2017). CVA calculation: the Basel Committee is re-opening the discussion | Banking & Insurance. Available at: http://en.finance.sia-partners.com/cva-calculation-basel-committee-re-opening-discussion.
Markit.com. (2017). FRTB-CVA: Are you ready for the next piece of the FRTB puzzle? | Markit Commentary. Available at: http://www.markit.com/Commentary/Get/03052017-In-My-Opinion-FRTB-CVA-Are-you-ready-for-the-next-piece-of-the-FRTB-puzzle.
Review of the Credit Valuation Adjustment Risk Framework. (2015). Basel Committee on Banking Supervision. Available at: http://www.bis.org/bcbs/publ/d325.pdf .