Regulations for banks and financial institutions are transforming radically with various forces shaping the new landscape. In this article, Frankie Phua, Head of Group Risk Management, UOB, explores the challenges of credit value adjustment (CVA) and what roles the CVA desk can play to help banks to get ready for the Basel IV implementation deadline in Jan 2022.
Under the new Basel IV CVA risk capital framework, a bank must adopt the Basic Approach if it cannot adopt the FRTB CVA (or SA-CVA) approach. CVA risk capital is expected to increase significantly under the new Basic Approach when considered together with the new SA-CCR rules. If a bank is able to adopt the new FRTB CVA, the impact is expected to be much less significant. If a bank hedges the CVA sensitivity to market risk factors (e.g. FX, interest rates), the CVA capital can be reduced further. To adopt FRTB CVA, one of the minimum criteria is that a bank must have a CVA desk responsible for risk management and hedging of CVA.
To understand CVA capital, we have to first understand what is accounting CVA.
Accounting CVA is the credit reserve adjustment for derivative transactions to account for counterparty credit risk. This is also known as the Expected Loss (EL) for derivative transactions. Accounting CVA is not static and will fluctuate over time due to changes in the counterparty’s credit and market risk factors. Accounting CVA fluctuation will in turn lead to profit and loss (P&L) volatility.
During the global financial crisis, however, roughly two-thirds of losses attributed to counterparty credit risk were due to fluctuations in accounting CVA and only about one-third were due to actual defaults. Therefore, under Basel III, banks are required to set aside additional CVA capital.
CVA capital is the additional capital banks are required to hold to absorb P&L volatility arising from fluctuations in accounting CVA. Under Basel II, the risk of counterparty default and credit migration risk were addressed but mark-to-market losses due to fluctuations in accounting CVA were not.
The intent of accounting CVA is to reflect the market price of hedging the counterparty credit risk of derivative transactions. CVA represents a credit charge based on the difference in price between the mark-to-market value of a transaction with a hypothetical risk-free counterparty and the actual “risky” counterparty. In other words, CVA is market value of counterparty credit risk. Simply put, CVA is the “price” a bank should charge for counterparty credit risk. For example, suppose a bank enters into an SGD IRS trade with the Government of Singapore which has almost zero risk of default. The P&L is S$1,000. If the same trade is done with a Singapore corporate, the P&L should be “S$1,000 minus CVA” to reflect the risk of the corporate counterparty defaulting.
Under IFRS 13, there are two accounting requirements relating to CVA:
- Paragraph 9: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”, also referred to as an “exit price”
- Paragraph 42: “The fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, an entity’s own credit risk”
The implications of the above accounting requirements are that CVA and DVA adjustments should be made to the value of derivatives and that such adjustment should be reflected in the likely exit price. The concept of exit price in turn implies the use of market-implied (i.e. risk-neutral) parameters. For example, the probability of default (PD) for CVAs should ideally be implied from CDS spreads quoted in liquid, actively traded markets.
CVA in Asia
For the Asian region, one key challenge is the lack of a liquid CDS market. Compared to US and Europe, CDS liquidity is worse in Asia. For example, in Japan, the automotive giant Bridgestone traded during only one week in 2017 and one week in 2018 according to Kamakura. Donald van Deventer, Kamakura’s CEO was quoted in Risk.net : “If someone were forced to do a CVA on Bridgestone, they would be using data made up by dealers. It is just a matter of sheer luck if a particular name has trade volume that week”. In addition, if the market is hit by a rush of demand for credit protection but there is no supply, bid/offer spreads may widen and that would increase the cost of hedging.
Finding the right spread to use as an input to calculate accounting CVA is one thing, but a bank also has to hedge it to avoid P&L volatility. While hedging with index CDS offers a more liquid alternative, the lack of liquidity in single names also has implications. If a bank uses single-name CDS to calculate accounting CVA but hedges it using index CDS due to illiquidity in single-name CDS, this may expose the bank to basis risk.
In Asia, most of the counterparties do not have a liquid, actively traded CDS. However, to fulfil accounting requirements, the CVA for such counterparties has to be estimated using market-implied proxies, resulting in artificial volatility of CVA. In addition, proxy credit hedges would not protect a bank against jump-to-default risk since the CDS pay-out (for the proxy hedge) may not be triggered if the bank’s actual counterparty defaults.
For commercial banks, the core business mostly involves underwriting of credit risk and setting aside a reserve to buffer against expected credit losses arising from defaults. Therefore, for commercial banks in Asia, instead of incurring costs to hedge such artificial CVA volatility arising from counterparty credit spread risk, the CVA desk should proactively manage and hedge the market risk of CVA to minimise P&L volatility and optimise regulatory capital. The CVA desk can also help to provide transparency on the full range of credit, funding, capital and margin costs which are collectively known as “XVAs”.