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This consultative paper presents a proposed revision of the Credit Valuation Adjustment (CVA) framework set out in the current Basel III capital standards for the treatment of counterparty credit risk.
CVA is an adjustment to the fair value (or price) of derivative instruments to account for counterparty credit risk (CCR). Thus, CVA is commonly viewed as the price of CCR. This price depends on counterparty credit spreads as well as on the market risk factors that drive derivatives’ values and, therefore, exposure. The purpose of the Basel III CVA capital charge is to capitalise the risk of future changes in CVA.
During the financial crisis, banks suffered significant counterparty credit risk (CCR) losses on their OTC derivatives portfolios. The majority of these losses came not from counterparty defaults but from fair value adjustments on derivatives. The value of outstanding derivative assets was written down as it became apparent that counterparties were less likely than expected to meet their obligations.
Under the Basel II market risk framework,2 firms were required to hold capital against the variability in the market value of their derivatives in the trading book, but there was no requirement to capitalise against variability in CVA. The counterparty credit risk framework under Basel II was based on the credit risk framework and designed to capitalise for default and migration risk rather than the potential accounting losses that can arise from CVA.
To address this gap in the framework, the BCBS introduced the CVA variability charge as part of Basel III. The current CVA framework sets forth two approaches for calculating the CVA capital charge, namely the “Advanced CVA risk capital charge” method (the current Advanced Approach) and the “Standardised CVA risk capital charge” method (the current Standardised Approach). Both approaches aim at capturing the variability of regulatory CVA that arises solely due to changes in credit spreads without taking into account exposure variability driven by daily changes of market risk factors.
Accordingly, the only CVA hedges that the current framework recognises are those that pertain to credit spread risk. Among those hedges, the only types that the framework deems eligible are single-name credit instruments that reference the counterparty directly and, under certain conditions, CDS index hedges.
The current Advanced Approach is available only to banks that have approval to use the Internal Model Method (IMM) for calculating exposure at default (EAD) for CCR capital calculations. This condition is necessary because the Advanced Approach employs a pre-defined formula for defining regulatory CVA that is based on market-observed credit spreads and IMM expected exposure time profiles for each counterparty. The capital charge for CVA risk is then determined by running the bank’s internal model for specific credit spread risk on the portfolio of these regulatory CVAs and eligible CVA hedges, keeping IMM exposures that enter regulatory CVA calculations fixed.
Under the current Standardised Approach, a regulatory formula supplemented with a table of ratings-based supervisory risk weights is used to calculate the CVA risk capital charge. Bank-provided inputs to the formula include EADs used in the CCR framework, counterparty ratings, and the notional values of eligible CVA hedges.