Japanese megabanks and securities firms have over the past 12 months begun to price the cost of counterparty credit risk into corporate derivatives trades, according to dealers, bringing them more into line with their international peers.
Local banks only recently agreed to account for an adjustment to the fair value of a derivatives portfolio for counterparty credit risk, known as a credit valuation adjustment (CVA). As a result, this cost, and in some cases even the cost of funding imperfectly collateralised trades, known as a funding valuation adjustment (FVA), is now routinely being incorporated in Japanese banks’ pricing for new swap trades.
“Relatively recently in Japan a CVA market has taken root and the result last year is that CVA and FVA are being reflected in the pricing of our corporate business,” Naoki Kasai, general manager of the credit office in asset liability management at Mizuho Bank, said in a panel at Risk.net’s Collateral Management Japan forum in Tokyo on June 5. In March, the bank revealed a ¥30 billion ($280 million) loss from the introduction of CVA into its accounts, and more banks are eventually expected to make the move.
Corporate derivatives trades are usually long dated and uncollateralised, meaning they generate significant counterparty credit risks. As the trades are usually hedged in the interdealer market with cleared swaps, which are fully collateralised, they can generate a funding requirement if the corporate leg is out-of-the-money.
Until this year, only Nomura had accounted for CVA. Bank capital regulations require dealers to hold capital against CVA, but if banks do not account for it, under local Japanese accounting rules they don’t have to pass these costs on to clients.
Absorbing the CVA cost helped Japanese banks dominate the local corporate swap market, as international rivals that factored in these charges were forced to quote more than 10 basis points higher on derivatives trades. Over the past year, the difference in spread quoted by local and international banks is said to have halved, according to people familiar with the market.
The banks are said to have begun pricing in CVA following discussions with regulators and industry bodies as part of a working group convened by the Japanese Bankers Association in 2017, where it was agreed that a credit default swap-based measure of CVA should be phased in across the participating banks.
The CVA adoption is already impacting the competitiveness of the megabanks and securities firms relative to international banks, said Satoshi Kumeta, director of the fixed income currency and commodity department at Daiwa Securities in Tokyo, on the same panel.
At Daiwa, which established its derivatives valuation adjustment desk in 2017, CVA’s impact on pricing has required some explanation internally, particularly with respect to sales executives.
“With CVA included in the pricing process, sometimes we lose in competition with our peers, and the sales side will raise objections to that,” Kumeta said. “I belong to the front office, so I feel a dilemma, but without consideration of the risk or offering whatever price we can to get the business, we might be sorry for that in the future.”
Mizuho’s Kasai believes the loss of competitiveness on certain trades has a silver lining. He hinted that the competitive advantage the Japanese megabanks and securities firms have long enjoyed against their international rivals in the local derivatives market was, perhaps, unhealthy from a risk management perspective.
For the Japanese banks, it creates what he described as “adverse selection”, where local banks end up with a high proportion of trades with riskier counterparties, as these generate the most CVA.
“In Japan, if we price things differently [to international practice] what happens is the poor transactions are concentrated here in Japan,” he said. “That could lead to major risks and major costs, so we have to avoid that.”