The add-on to a derivatives contract’s fair value to account for the cost of capital, known as the capital valuation adjustment (KVA), is already arguably the most complex of the suite of adjustments out there. But US Treasury secretary Steven Mnuchin’s review of bank regulation, released on June 13, looks set to send quants further down the rabbit hole.
The review recommends that the US Federal Reserve Board’s annual stress test – the Comprehensive Capital Analysis and Review (CCAR) – be amended so that, if a bank fails the qualitative element, it cannot be the ‘sole basis’ for the Fed to object to dividend payments.
The dividend question is already vexing US banks that are trying to work out how much KVA to charge for a trade. In a world without CCAR, a bank can set, for example, a 10% return on equity (ROE) hurdle for a new trade, and if it misses, there’s an implicit assumption it can hand back the capital it didn’t allocate to the trade to shareholders through buybacks or dividends.
Under CCAR though, some banks take into account the likelihood they may fail the test and be unable to hand back that unused capital, trapping it in the bank and earning no return for shareholders. In this situation, a dealer may respond by lowering its ROE hurdles to guarantee it will win more trades, ensuring it can generate at least some returns for shareholders, and lowering the risk of having trapped capital lying around.
“These are all embedded assumptions that could be critical to the KVA calculations. So any change in affecting the assumption would move the numbers, such as the capital release and distribution to shareholders in dividends,” says a derivatives quant at a US bank.
This activity, along with similar reductions in ROE hurdles by some European banks, is said to have contributed to the increased competition for corporate derivatives trades since the beginning of the year.
But, if the US Treasury’s recommendation that a CCAR qualitative fail does not automatically trigger a ban on capital distribution to shareholders is implemented, this calculation gets even more complicated. If a model showed that the bank is headed for a CCAR fail, there is now uncertainty about whether ROE hurdles should be amended, and therefore how much KVA should be priced into a trade.
For some, this could be a step too far. KVA has always been more art than science, so trying to incorporate the probability that the regulator will allow a capital distribution, even if the bank fails its CCAR qualitative test, may be taking perfectionism to the extreme.
In 2016, quants were confident KVA would follow in the footsteps of the funding valuation adjustment and require accounting fair values of derivatives portfolios to be amended. But, given the difference in practice between banks and the ever-evolving nature of the calculation methodology, that may be some time away.
The week on Risk.net, September 8-14, 2018Receive this by email