CVA as a Value-add for Banks

In the aftermath of the recent financial crisis, governments and regulators have responded by strengthening financial regulation, supervision and market infrastructure. Much of this regulation has focused on better managing and understanding the risk position of financial institutions. Risk, in particular counterparty credit risk, has largely been blamed for both contributing to the financial crisis and the ensuing economic instability which is facing much of Europe today. Triggered by the collapse of Lehman Brothers in 2008, the industry has been forced to accept that traditional risk management methods were not up to scratch.

Over the past two years, regulators have been making reforms and introducing new requirements to provide more transparency to stakeholders and give better oversight of banks’ exposure to credit risk. In particular, the Basel Committee has been working on reforms to strengthen bank capital and liquidity requirements, and in December 2010 the committee finalised its Basel III package.

Under this new Basel III package, the committee has modified the methodology for the new credit value adjustment (CVA) capital charge. The revised approach takes into account changes in counterparty credit spreads and introduces a new standardised approach for calculating the CVA capital charge for those banks without approval to model specific value at risk (VaR) or use the internal models method (IMM). Trades cleared through a central counterparty (CCP) will be subject to the CVA capital charge as well.

So, what do these modifications mean for banks and how can the new approach to calculating the CVA capital charge provide risk managers with better oversight of their exposure to counterparty risk?

What is CVA?

CVA is a measure of credit risk and is defined as the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of default by a counterparty. In other words, CVA represents the monetised value of the counterparty credit risk.

The CVA charge is part of a collection of measures aimed at improving banks’ resilience to counterparty risk. According to the Basel Committee, two-thirds of credit risk losses during the financial crisis were caused by CVA volatility, rather than actual defaults.

Following this claim, the Basel Committee presented a reform for calculating CVA in December 2009. This proposal faced criticism, with many arguing that the methodology was not sensitive to changes in credit spreads and so, in response, the regulators have addressed the CVA charge once again.

What Does it Mean for Banks?

The modified methodology, which is intended to address such criticism as outlined above, will make the CVA calculation more complex. What’s more, all firms are now subject to the new standardised capital charge rather than just those firms which have an approved VaR model. The CVA calculation now involves projecting thousands of scenarios and then aggregating them in a non-linear fashion. This requires banks to lay down scenarios that are valid for all trade types, build calculation capacity and then undertake nimble analysis of these broad data sets.

The new approach is also more scientific and quantitative in nature and will allow banks to measure their exposure more accurately, to both limit and reduce it. However, while the new CVA methodology can provide risk managers with better oversight of their exposure to counterparty risk, it has also raised the question of return on investment (ROI) owing to the associated costs of calculating the new CVA.

Since the CVA is not static – it measures changes in exposure as the market moves – it presents banks with the ability to better predict the future. Analytics can be placed on top of CVA to get a precise picture of a bank’s risk position. By doing this, banks and financial institutions can overcome the hefty costs of meeting this change and instead see CVA as an opportunity to go beyond the basic regulatory reporting requirements and add real value to the business.

While financial institutions have come to recognise the importance of having up-to-date and accurate information for credit risk, more time is arguably needed for risk managers to realise the opportunities that the new CVA approach offers. As we’ve seen with market risk, forward-looking banks will take CVA beyond a simple measuring and reporting method and use it as a simulation tool to make more informed decisions in real time to optimise the impact on the total exposure and capital requirements.

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