Counterparty Risk And CVA Survey: Current Market Practice Around Counterparty Risk Regulation, CVA Management And Funding

PREFACE

It is with great pleasure that we present this Counterparty Risk and CVA Survey, the result of a collaborative effort by Deloitte UK and Solum Financial Partners in conjunction with Deloitte Germany, Deloitte Italy and Deloitte Norway. Counterparty risk management has been a key area of focus for financial institutions over the past few years, and the aim of this survey is to take stock of the industry's response to the numerous theoretical issues and operational challenges raised as a result of the evolving regulatory, accounting and risk management environment.

We would like to express our thanks to the institutions and individuals who participated in the survey. The time and dedication put in by the respondents in articulating their views was a key contributing factor to its success.

We trust you will find this survey topical and insightful, and we hope the contents will help you navigate this rapidly changing environment.

EXECUTIVE SUMMARY

Counterparty risk is a topic which has been elevated to the forefront of the front office, risk management and regulatory agendas following mark-to-market volatility and defaults over the global financial crisis.

Universal acknowledgement of credit valuation adjustment (CVA) and debt valuation adjustment (DVA) as essential components within the fair-value of derivatives and securities financing transactions has reinforced the importance of counterparty risk management across a much broader spectrum of financial services firms. As a result, banks are facing a much stricter regulatory environment, the impact of which will have far-reaching implications for the way they manage their counterparty credit risk (CCR) through CVA and how they ensure that they are generating sufficient return on capital. There are additional requirements on financial reporting under revised international accounting standards. Finally, the uncertainty in the international financial markets has also resulted in sizeable increases in the cost and scarcity of funding available to banks.

Since the previous survey conducted by Solum Financial Partners in 2010 there have been significant changes to the regulatory framework governing financial institutions, and we see such supervisory considerations permeate almost every area of the survey responses. We have adopted an approach that provides three different analysis perspectives: a regulation point of view, a CVA standpoint and finally a focus on trading and valuation challenges related to counterparty risk modelling. The first part of the survey in particular focuses on the implementation challenges associated with the new regulations, and how respondents are managing the capital cost and the operational and methodological challenges of transitioning to the new regime.

The forthcoming Basel III revisions to the counterparty risk capital standards represent a meaningful departure from the existing regime, and the introduction of CVA VaR will materially increase the capital held against bilateral credit exposure.

The survey found that the perceived capital savings that could come from leveraging the advanced CVA approach is incentivising a new set of respondents to pursue advanced 'internal model method (IMM)' approval from their respective supervisory bodies and existing IMM banks to expand their product coverage.

The introduction of a low risk weight to central counterparties (CCPs) will force banks to hold capital for exposures to CCPs which was not required before and would require the modelling of exposures to CCPs as well as default fund contributions. Emerging securities markets legislation which is designed to mandate the use of CCPs for standardised derivatives and requires robust margining for bilateral trades, has placed renewed emphasis on banks' ability to model collateralised exposure.

The ability to model collateral has also come under regulatory scrutiny with Basel III introducing additional conservatism into the so-called shortcut method, on which a quarter of those IMM banks surveyed were reliant. The responses revealed that banks have a considerable way to go in this space, with a large majority of the respondents unable to perform full collateral modelling over the entire duration of the trade, and fewer still capturing other credit support annex (CSA) specific features, FX mismatches or price variation in non-cash collateral. There is however, an acute awareness amongst those surveyed that this is fast-becoming an urgent priority in order not only to allocate capital efficiently, but also to price these instruments correctly.

The valuation challenges presented by collateral agreements were explored within the survey, especially as consensus is emerging amongst practitioners for the need to move away from LIBOR discounting for secured funding trades – and in fact survey responses indicated the overwhelming majority of participants are moving towards overnight index swap (OIS) discounting. A smaller, but growing subset of those respondents also commented that they had the capability to capture the optionality associated with multi-currency CSAs within the discount rate.

It is however not just collateralised exposures for which participants have recognised the need to integrate more closely the funding costs and benefits into pricing. Such considerations are encapsulated within what is known as a funding valuation adjustment (FVA) for their uncollateralised equivalent; a theme explored throughout the survey. Virtually all participants acknowledged the necessity of such an adjustment, even if the accounting standard setters appear to be less convinced. Furthermore, the majority of respondents already claim to charge for FVA at the trade level and charge it to the relevant trading desks, analogous to CVA and DVA. That said, the extent to which all three components can be simultaneously incorporated within the fair-value and in what proportion, is something which is still the subject of much debate and academic interest.

The widespread acknowledgement that such considerations materially impact the price, must then necessitate an integrated framework within which banks can adequately risk manage their exposure to each component. The final part of the survey explores the operational and organisational challenges faced by banks and looks at how they are overcoming such difficulties and implementing solutions within the context of their own operations.

What is clear is that the regulatory, accounting, front office and risk-management perception of counterparty risk has changed dramatically in recent years, bringing to the forefront new technical challenges for banks. In particular, areas such as OIS discounting, collateral optimisation and funding have become increasingly important. This survey is designed to capture market practices in these new areas, and in particular to highlight the heterogeneity in how these risks are measured, managed and mitigated given the unique set of organisational constraints specific to each participant.

Despite having much more clarity as to the final form and substance of the emerging banking and securities markets regulations, and the fact that banks are further advanced in developing their CVA risk management capabilities, future trends remain very hard to predict. Certainly, we expect CVA, DVA and FVA to remain at the forefront of the risk, regulatory and accounting agenda for some time to come.

What is clear is that the regulatory, accounting, front office and risk-management perception of counterparty risk has changed dramatically in recent years, bringing to the forefront new technical challenges for banks.

GLOSSARY

SURVEY METHODOLOGY

This survey has been conducted jointly by Deloitte UK and Solum Financial Partners, alongside Deloitte Germany, Deloitte Italy and Deloitte Norway. The survey examines the approaches used to manage CCR in light of the financial crisis and increased regulatory focus covering CVA, DVA and FVA. We surveyed 21 banks in 2012 and their responses were given as a current state of the situation that existed at that time. Subsequent changes may have occurred.

This survey report is based solely upon the responses received from the participant banks. Not all participants have provided the same level of detail in relation to all sections and questions. In addition, the participants represent a wide cross-section of the industry and, as such, the extent and granularity of their responses will be limited by the extent of their operations.

The approach involved having each of the participating banks complete the survey. In some instances follow up interviews were conducted for consistency and completeness. The answers were anonymised and analysed for key trends.

Within the survey the number of banks represented can be broadly described in two ways. The first are those banks who already have much of their CVA infrastructure in place in terms of models, systems, CVA desks and regulatory approvals. These banks are focusing more on enhancing their capabilities across FVA, CVA hedging and capital optimisation. The second group of banks are in the process of developing their CVA infrastructure with respect to accounting rules, trade pricing, CVA desk setup and obtaining advanced regulatory approval.

INTRODUCTION

There continue to be significant shifts in the financial landscape as a result of increased regulatory scrutiny and the tougher operational environment for banks. The extent of change is evident when comparing results of this survey to the one carried out by Solum Financial Partners in 2010. The scope is broader primarily as a result of the growing importance of CVA in light of accounting requirements and Basel III capital rules. The survey questions were designed to span a broad spectrum of topical issues, including how banks are positioning themselves ahead of the revised Basel III counterparty risk requirements, CVA pricing and risk-management solutions; and their integration within the existing architecture, valuation challenges for collateralised counterparties and the incorporation of funding costs. Before analysing the results, we first consider the key background areas and themes that are the subject of this survey.

Accounting

International Financial Reporting Standard (IFRS) 13 'Fair Value Measurement' is effective from 1 January 2013. It is based largely on the accounting standard applied in the U.S. One of the aims of IFRS 13 is to harmonise the definition of fair value and in doing so harmonise the approaches to determining fair value in accounting. Fair value is characterised as an exit price, which is described as the price that would be received or paid in an orderly transaction between market participants. An important but complex component of fair value is the CVA (and DVA).

There appears to be market consensus that the reference to an exit price in the accounting standards will necessitate a move from historically-based to risk-neutral (market-implied) parameters in CVA quantification. This is very significant in terms of default probability estimation. Whilst many large banks have for a number of years used market implied default probabilities to calculate their CVA, this practice has been less common in smaller banks that have not been subject to the U.S. accounting standard, FAS 157 (generally those domiciled outside the U.S. and Canada). A natural consequence of the remaining banks moving to risk neutral CVA is that overall accounting CVA numbers will be significantly higher and more volatile. This is due to the well-known existence of a significant risk premium within a credit spread, making the proportion of risk-neutral default probabilities significantly larger than real world ones, especially for high quality ratings.

The CVA profit and loss resulting from the systemic component in a credit spread can be essentially offset with the analogous component within a bank's own credit spread. This latter component is contained within the DVA component which is also a requirement of IFRS 13. IFRS 13 requires an institution to account for the fair value of the non-performance risk (also referred to as the entity's own credit risk) of their liabilities. Some banks question the use of DVA as it implies they profit from their own declining credit quality and leads to hedges which may create wrong way and systemic risk. Other banks see DVA as a completely logical component, alongside CVA, which can be monetised (albeit with some difficulty). Some banks see DVA more as a funding benefit and therefore the links between DVA and funding must be considered carefully.

Regulatory capital

The first version of the Basel III capital requirements had a large focus on CCR and CVA, and left little doubt that the associated capital requirement needed to be substantially increased. It explicitly mentioned that essentially two-thirds of the risk, due to CVA volatility, was not capitalised at all. The Basel Committee introduced the concept of a new capital requirement for CVA VaR which makes a clear reference to credit spreads as the driver of default probability in the CVA formula. Under Basel III, this risk-neutral default probability requirement is explicit. It should also be noted that, although DVA is an accounting requirement under the fair value measure, the benefit arising from it must be removed from Tier 1 equity and is therefore not allowable in quantifying capital requirements under Basel III. This represents a double blow as Basel III forces the use of comparatively high risk-neutral default probabilities without giving the associated benefit of own default risk. Furthermore, Basel III does not consider market factors other than credit spreads (for example interest rates and FX rates) which limits the scope for potential capital relief through hedging.

Basel III gives two possible frameworks for the calculation of CVA VaR: the standardised and the advanced. The framework used depends on whether a bank currently has IMM and specific interest rate risk approval for bonds. Capital relief is given for hedging with single name and index credit default swaps (CDS) and it seems that Basel III is intending to push banks to hedge their CVA credit component where possible.

This is potentially controversial as the CDS market is not particularly liquid for all counterparties, and it is not clear to what extent banks hedging their CVA relating to illiquid counterparties with credit indices represents a reasonable form of risk transfer. Furthermore, the more straightforward CVA related underlying asset hedges may actually consume, rather than reduce, capital. The unintended consequences of CVA hedging have already created problems in terms of market instability such as in spiralling sovereign CDS spreads driven by CVA desk hedging. This, together with the need to reduce CVA VaR charges for sovereign exposures (resulting from interest rate hedging of large debt issuance), has led to an exemption in Europe for sovereign CVA VaR (under CRD IV covering the implementation of Basel III capital rules). A further exemption for European non-financial counterparties is also under consideration. Possible capital relief achieved through other hedging strategies, such as that provided by synthetic securitisation for example, is another possibility for potentially improving efficiency.

Implementing changes in capital rules will clearly represent a very significant cost for banks (and therefore their clients). However, the complexity of capital methodologies, together with the uncertainty around specific rules and possible exemptions, makes the overall magnitude of this hard to gauge.

Alignment of front office, accounting and regulatory practices

Within a given bank, there can exist multiple definitions of CVA. The most obvious examples are accounting CVA (for books and records), front office CVA (for pricing new transactions) and regulatory CVA (for defining capital requirements). This is particularly important to consider as misalignment between CVA definitions can lead to inappropriate trading decisions, incorrect assessment of risk and mismanagement of capital. For example, if accounting and front office CVA definitions do not match then apparently profitable trades may not appear that way to shareholders, and profit & loss (P&L) volatility as seen by a CVA desk may not be equivalently represented in earnings volatility. Another example would be that if front office and regulatory CVA were misaligned then a reduction in capital may increase CVA volatility and vice versa.

Whilst accounting standards and regulatory capital rules appear likely to create more uniformity over CVA quantification (for example by use of risk-neutral parameters such as credit spreads), they also create ambiguity (for example in terms of DVA benefit). It is therefore not clear how rapid and complete the convergence will be, and to what extent a bank should attempt to align these calculations.

CVA, DVA, funding and risk-free valuation

Since CVA and DVA should adjust the non-credit risk value of a trade or portfolio, it is crucial to determine the correct way to perform a benchmark risk-free valuation. In recent years, the significant rise in short and long term funding rates has seen attention placed on both risk-free valuation and funding costs. LIBOR rates, previously seen as a close proxy for risk-free rates, are now seen as inadequate discount rates due to their credit and funding component divergences with respect to both tenor and cross currency basis effects. This has driven the need to use dual curve, or OIS discounting (at least for valuing collateralised derivatives). There has been a trend to switch to these more sophisticated valuation methods, led by CCPs and banks. Related to this discounting issue there is a need to account for currency and type of collateral posted under the CSA (or other) agreement and ideally the optionality inherent in collateral posting requirements and substitution rights.

The financial crisis has driven short-term rates such as LIBOR away from benchmark risk-free rates. Additionally, banks are being required to rely less on short-term funding and more on longer-term, more costly borrowing. These aspects have led to the notion of FVA due to the need to assess funding costs and benefits in the valuation alongside other elements such as CVA and DVA. There is controversy over whether or not FVA should form a component of pricing and also to what extent it overlaps with the existing notion of DVA. Coupled with the fact that there are no specific accounting and regulatory requirements governing the use of FVA, this leads to very different treatments of funding benefits and costs.

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