The New CVA-Risk Approaches – Out With the Old and In With the New

Background

The Basel IV framework, which was published in 2017, introduced three new ways to
calculate the capital requirements for credit valuation risk CVA. The new package will
replace all current methods in calculating CVA.

Concerns were raised by banks and supervisors that the 2011 standards for CVA did not
appropriately capture the actual CVA risk banks were exposed to. Three specific criticisms
were raised with respect to those standards, the current approaches lack risk sensitivity,
they do not recognize CVA models developed by banks for accounting purposes and the
approaches do not capture the market risk embedded in the derivative transactions with the
counterparty.

To address those concerns, the BCBS published revised standards in December 2017, as a
part of the final Basel III reforms, and further adjusted their calibration in a revised
publication in July 2020. To better align with the 2020 BCBS standards, several amendments
are to be made to the CRR.

A revised definition of the meaning of CVA risk is introduced to capture both the credit
spread risk of an institution’s counterparty and the market risk of the portfolio of
transactions traded by that institution with that counterparty. Moreover, the new methods
increase transparency and comparability of CVA for regulators.

What’s ahead?

In EBAs amendment to Regulation (EU) No 575/2013 the European Commission introduces
three new methods for calculating CVA risk, the Standardised Approach SA-CVA, the Basic
Approach BA-CVA, and the Simplified approach. The three new approaches will replace all
current CVA models and remove the possibility to apply internal models in measuring CVA
risks, the new methods will enter into force 2025-01-01.

The upcoming methods for calculating CVA risk are more complex than the current Original
Exposure method and the current simplified approach. SA-CVA method considers new
inputs of data which consequently will be burdensome to set up for institutions. The new
approach allows for more granularity and is more risk sensitive. Institutions, therefore,
need to consider new aspects of their CVA risk in terms of market volatilities, correlation
and credit spread risk. Despite the effort setting up and considering new aspects the new
approach incorporates recognition of internal hedges, which will allow institution to
mitigate some of their CVA-risk.

Institutions need to request approval from competent authorities to use SA-CVA, without
approval from the supervisory authority the institution needs to use the Basic Approach.
After approval for using the SA-CVA institutes are allowed to combine the SA-CVA and BACVA
approach for different counterparties and for different netting sets with the same party.

Institutions will also have the option of setting its CVA capital requirement to 100 % of the
CCR capital requirement, this is possible for institutes that have an aggregated notional
amount of non-OTC equal or less than 100 BN EUR. The simplified method will in similarity
to the current alternative to OEM method be less burdensome to calculate, however, the
new simplified method will in most cases drive a higher CVA capital requirement than SACVA
and the BA-CVA.

Basic approach

The Basic approach considers elements such as correlation between credit risk spread
between any counterparties. In similarity to current methods, the calculation of the CVA is
across netting sets with each counterparty. Applicable risk weight needs to be assigned
depending on the sector of the counterparty and investment grade. The supervisory risk
weight will range from 0,5 % to 12 %, FX-derivatives and IR-swaps with financial
counterparties of credit quality step 1 to 3 will be set to 5%. The risk weight reflects the
volatility of the credit spread. The effective maturity also needs to be considered, for
institutes that do not use internal models the effective maturity is equal to the weighted
average maturity of cashflows within a netting set, an additional consideration is that the
effective maturity needs to be discounted with a supervisory discount factor. The exposure
at default will remain the same as in current regulation, meaning that the EAD will be equal
to CCR EAD.

Capital requirement for CVA without hedges

NS = Relevant netting set
M = The effective maturity of a netting set
EAD = Exposure at Default
RW = The applicable risk weight for a specific counterparty
DF = Discounting factor
α = 1.4

Simplified approach

In line with its name the Simplified approach is what is sounds like, Simple. Institutions can
simply take their CCR capital requirement and apply the same requirement for CVA risk.

Standardised approach

Before approval for using SA-CVA the institution needs to assess whether they comply with
the requirements to use the method. One of the requirements are that the institute has a
distinct unit that is responsible for the overall management of CVA risk, in addition the
institution needs to develop a regulatory CVA model for each counterparty.
The new method is far more sensitive for various risk factors, such as interest rate curves,
inflation, exchange rates and credit spreads. This in turn will require institutes to consider
new aspects of risk and will be more burdensome in terms of the implementing complex
methodology.

What path to choose?

The choice of method depends on the complexity of the institution and the most suitable
approach depending on the implementation cost and most sufficient capital requirement.
Category 3 and 4 institutes will most likely choose the Basic Approach or the Simplified
approach. Institutes that currently use the SA-method can benefit from implementing the
Basic Approach due to some similarities in the calculation.

How can FCG assist

FCG can help you navigate the new CVA framework and evaluate the most suitable method
for the CVA risk calculation taking your specific business model into consideration. Due to
the complexity of the new calculation’s institutions will need to adapt their data collection
and set up new processes for consolidating and reconciling results. FCG have extensive
experience in implementing new regulations in complex data environments, enhancing the
regulatory reporting and treasury functions. We can also help you in your application to the
authorities to assess if your institution complies with the requirements set out for usage of
SA-CVA.