United States: Basel III Framework: The Credit Valuation Adjustment (CVA) Charge For OTC Derivative Trades

The credit valuation adjustment charge in Basel III appears, at first glance, to be the preserve of quantitative analysts and the like. However, while complex, the CVA charge requires more widespread attention as it materially increases the required capital for OTC derivative trading activities and is driving significant change in that sector. The divergence between the US and EU approaches to the adoption of the CVA charge highlights how the Basel standards have been interpreted differently in this important area, creating uncertainty and opportunities for arbitrage.

Two-thirds of counterparty credit losses in the financial crisis were suffered not as a result of actual defaults of the counterparty, but because credit market volatility negatively impacted bank earnings. In response, the Basel Committee on Banking Supervision ("Basel Committee") introduced a new capital charge in Basel III, the credit valuation adjustment (the "CVA") charge, aimed at improving banks' resilience against potential mark-to-market losses associated with deterioration in the creditworthiness of counterparties to non-cleared derivatives trades.1 The CVA charge applies to non-cleared trades as exposures toward central counterparties ("CCP") are exempt from the CVA charge.2

As described in the following, banks face two key issues as a consequence of the CVA charge. Firstly, regulatory and accounting rules do not precisely mirror each other with respect to the meaning of "CVA" and its relationship to DVA, which poses challenges to banking models and strategies for managing CVA risk. Secondly, the US and EU have adopted the CVA charge differently which, as a result, is causing market uncertainty and creating potential opportunities for arbitrage.

Divergent Accounting and Regulatory Standards for CVA Calculation

Background: Accounting standards (including IFRS and US GAAP) require credit risk to be reflected in the fair value measurement of derivatives. The Basel Committee has described the CVA as the difference between the value of a derivative assuming the counterparty is default risk-free and the value of a derivative reflecting the default risk of the counterparty. The "flipside" of the CVA, the debt value adjustment ("DVA"), reflects the debit side of the transaction, i.e., the difference between the value of the derivative, assuming the bank itself is default-risk-free, and the value of a derivative reflecting the default risk of the bank.3 Additionally, some banks price further elements into the valuation of derivatives, including a funding valuation adjustment ("FVA") to capture the impact of funding and liquidity on the cost of a trade that is uncollateralised by taking into account a banking organization's own cost of funding collateral on a hedge where collateral is required to be posted. The FVA is seen by some banks as a means of ensuring that the cost of posting collateral to support the entry into any hedge in the interdealer market is appropriately accounted for (specifically where there is no collateral posted on the trade that is being hedged). The way in which banks manage the economics of CVA, DVA and FVA risk and the extent to which such methodologies can also be assimilated and appropriately calibrated within fair value accounting continues to attract industry and academic attention.

Calculating the CVA charge: Basel III specifies that the CVA may be calculated by using one of the following two methods: (i) the advanced approach; or (ii) the standardised approach. To the extent that banks have regulatory approval to use the Internal Model Method ("IMM") for calculating counterparty credit risk capital and have specific interest rate risk value at risk model approval for bonds, then the advanced approach must be used. All other banks are required to use the standardised approach, which is based on the external credit rating of the counterparty.

Hedging CVA Risk: Banks are permitted under both the advanced and standardised approaches to reduce their CVA exposures by entering into certain defined credit default swaps ("CDS"). Specifically, banks may enter into single name CDS, single name contingent CDS, other equivalent hedging instruments which reference the counterparty directly and index CDS. Tranched or nth to default CDS are not, however, eligible CVA hedges. Other types of counterparty risk hedges must not be reflected within the CVA calculation and must be treated as any other instrument in the bank's inventory for regulatory capital purposes. Although CCPs are considered to pose negligible credit risk and transactions with CCPs are excluded from the CVA capital charge, in practice, however, many banks currently view and seek to quantify their exposure to the default fund of a CCP as representing a complex CVA with regards to the CCP's clearing members.

Divergences in Meaning of CVA under Accounting and Regulatory Approaches: Industry participants report a dissonance between the meaning of CVA under accounting and regulatory approaches which serves to increase uncertainty and the likelihood of losses as a result of miscalculations (e.g., by encouraging banks to take more risk by unusual hedging strategies, which may work from a regulatory perspective but not an accounting perspective, or vice-versa). One of the principal areas of divergence between accounting and regulatory approaches to CVA risk arises in respect of the treatment of own credit-related adjustments. Basel III no longer permits the offsetting of CVA with DVA although this prohibition is not mirrored in relevant accounting standards.4 The prohibition was effected by the amendment of paragraph 75 of the original Basel III text to require banks to "derecognize all accounting valuation adjustments arising from the bank's own credit risk. The offsetting between valuation adjustments arising from the bank's own credit risk and those arising from its counterparties' credit risk is not allowed".5 The adoption of the Basel III standards in the EU reflects the revised Basel III position.6

Divergent Approaches to US and EU CVA Adoption

The CVA charge has been adopted differently in the US and EU, which compounds the uncertainty which exists between accounting and regulatory understandings of CVA.

US CVA Adoption: In July 2013, the Board of Governors of the Federal Reserve System and other bank regulatory agencies approved final rules ("Final US Rules") that codify the US Federal regulatory agencies' regulatory capital rules into a single, comprehensive regulatory framework, adopting Basel III as well as relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Final US Rules adopt the CVA in a way which is broadly consistent with Basel III.

EU CVA Adoption: The EU has adopted the Basel III standards through two legislative acts, the Capital Requirements Regulation ("CRR") and Capital Requirements Directive ("CRD") (together, "CRD IV"), published in the Official Journal of the European Union on 27 June, 2013. The CVA is defined in Article 381 CRR as: "an adjustment to the mid-market valuation of the portfolio of transactions with a counterparty [which] reflects the current market value of the credit risk of the counterparty to the institution, but does not reflect the current market value of the credit risk of the institution to the counterparty." Consistent with Basel III, institutions are required to calculate a capital requirement for CVA risk for all OTC derivative instruments in respect of all their business activities, other than credit derivatives recognised to reduce risk weighted exposure amounts for credit risk mitigation purposes. CRD IV contains additional provisions which give national regulators discretion in respect of the CVA charge to: (i) require an institution's CVA risk exposures arising from material securities financing transactions to be included within the capital calculation; and/or (ii) require intragroup transactions to be included in capital requirements for CVA risk in the event that the relevant EU Member State undertakes bank structural separation measures.7 Various requirements relating to calculation of the CVA are to be "fleshed out" by the European Banking Authority ("EBA") in the form of regulatory technical standards ("RTS").8 Permitted hedges in Article 386 CRR broadly mirror the Basel III standards discussed above.

The CVA Exemption in CRD IV: The EU has diverged from Basel III (and the US adoption of Basel III) by adopting the CVA charge in a form which exempts transactions from the capital calculation for CVA risk where such transactions are between EU-based banks and a: (i) non-financial corporate;9 (ii) sovereign; or (iii), for a limited period, pension funds ("CVA-Exempted Entities"). Subject to meeting certain requirements, non-financial corporates are exempted under the European Market Infrastructure Regulation ("EMIR")10 from the obligation to centrally clear derivative transactions which effectively allows such entities to enter into OTC derivatives trades without the cost of posting collateral. Trades with such non-financial corporates are exempted from the CVA charge to ensure that those entities are treated consistently with the approach under EMIR and that the benefits in terms of avoiding collateral costs is not undermined by the cost of the CVA charge. Further, transactions with pension funds are excluded for a limited period11 to encourage usage of private pension funds, and to ensure that existing funding shortfalls in the pensions sector are not further exacerbated. Transactions with sovereigns are excluded so as not to cause further disruption to an already volatile sovereign debt market. Currently, there has been no indication at the EU level that the CVA exemption is to be significantly amended. The European Commission intends to conduct its first review of the calibration of the CVA at a general level by 1 January 2015, in light of international regulatory developments,12 although this review is likely to impact more on the way the CVA charge is calculated rather than to limit the scope of the exemption. The EU CVA exemption has been criticised for a number of reasons:

  • Departure from Internationally Agreed Standards: Basel III does not include a similar exemption to the EU for certain defined entities and the adoption of Basel III globally is largely consistent with this approach. Divergent approaches in adoption of measures to address counterparty credit risk are inconsistent with Basel Committee aims for a globally harmonised approach in this area.
  • Unlevel Playing Field: A key concern for non-EU banks is that banks in the EU are at a competitive advantage compared to non-EU entities which face a CVA requirement. For example, an Asian corporate, a CVA-Exempted Entity, may find it cheaper to hedge its interest rate risk with an EU dealer, than with a US dealer.
  • Potential for "Gaming" the CVA: Concern exists that banks in the EU are able to evade the CVA charge by structuring a trade so that, for a fee, a CVA-exempt entity stands in the middle of an OTC derivative trade between the bank and a non-exempt bank. Such a concern would, however, be over-stated given that the volume of clearable trades that a CVA-Exempted Entity could take on would be restricted, and potential returns therefore limited, by the clearing threshold under EMIR in relation to which both sides of the trades would be counted.

CVA Exemption: Possible Capital "Add on": In light of various concerns relating to the CVA exemption, some EU Member States are reportedly considering imposing a capital "add on" in respect of under-capitalised risks to effectively circumvent the CVA exemption. This could, in theory, be achieved by using "Pillar 2" powers contained in the CRD which allow national supervisors to impose a wide range of measures topping up Pillar 1 requirements in order to ensure sound management and coverage of risks following a supervisory review and evaluation.11 The measures may be extended to types of institutions that, belonging to the same region or sector, face and/or pose similar risks. However, it is arguable that such a course of action could be difficult to reconcile with the European Commission's clearly enunciated position that super-equivalence or "gold plating" of capital requirements under CRD IV is not permitted.12 EU Member States are not, for example, permitted to increase common equity Tier 1 capital requirements at a national level owing to concerns that this would foster regulatory arbitrage with risky activities migrating to EU Member States with the least stringent capital rules. A Pillar 2 capital "add-on" in this case has the potential to add to these concerns.

Conclusion

Addressing counterparty credit risk through the CVA has been elevated to the forefront of accounting and regulatory agendas following mark-to-market volatility and defaults during the global financial crisis. Differences in US and EU adoption of the CVA have created significant potential for arbitrage between US and EU banks in turn directly impacting profitability of existing OTC business lines within banks globally. Further, accounting and regulatory disparities in the meaning of CVA and its relationship to DVA currently compounds banks' difficulty in understanding the scope of their obligations in the CVA context. Unclear at present is the extent to which a further layer of arbitrage will emerge within the EU, further complicating the Basel puzzle, if certain EU Member States interpret CRD IV to allow the imposition of a capital "add on" for CVA exempted trades under Pillar 2 rules.

Footnotes

1 For a comparative analysis of the adoption of the US and EU Basel III standards, see our Client Publication: "Basel III Framework: US/EU Comparison", September 2013.

2 Article 382 Capital Requirements Regulation ("CRR") states that transactions with a "qualifying central counterparty" (i.e., a central counterparty which has been authorised in (in accordance with Article 14, EMIR ("Authorisation of a CCP")) or recognised (in accordance with Article 25, EMIR ("Recognition of a third-country CCP")) are, subject to certain conditions contained in Article 382 CRR, exempt from the own funds requirement for CVA risk.

3 Basel Committee Publication "Application of Own Credit Risk Adjustments to Derivatives", December 2011.

4 See for example: IFRS 13 - Fair Value Measurement.

5 Basel Committee Press Release: "Regulatory Treatment of Valuation Adjustments to Derivative Liabilities: Final Rule Issued by the Basel Committee". July 25, 2012.

6 Article 33, Article 273(6) CRR.

7 Some EU Member States, including France and Germany, have passed legislation implementing legal separation measures for retail and investment banking operations within banking organizations, and similar proposals are being considered in the UK and other EU Member States.

8 The EBA has, to date, published draft RTS relating to the CVA in respect of: (i) determination of a "proxy" spread for the determination of capital requirements; and (ii) elements of the calculation of own funds requirements for calculation of CVA risk.

9 When such transactions do not exceed relevant thresholds specified in EMIR.

10 Regulation No 648/2012.

11 Transactions with pension funds are excluded from the own funds requirements for CVA risk until the "transitional provisions" in Article 89(1) EMIR cease to apply.

12 Art 382(5) CRR.

11 Several EU Member States have indicated that they intend to use Pillar 2 powers to address a range of risks not limited to the CVA exemption.

12 See the European Commission CRD IV FAQ of 16 July 2013: http://europa.eu/rapid/press-release_MEMO-13-690_en.htm.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Barnabas W.B. Reynolds
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.