Dealers eye model change to cure CVA capital headache

With hopes of EU regulatory carve-out fading, some banks are taking matters into their own hands

When the coronavirus hit, banks blamed the huge surge in market risk capital charges on the hedging of counterparty credit risk from uncollateralised derivatives.

They’ve lobbied since for a regulatory carve-out for hedges of the interest rate and foreign exchange elements of credit valuation adjustment (CVA) from market risk capital requirements, which they argue unfairly penalise prudent risk management. But with European regulators yet to budge, some dealers have started overhauling their models to mitigate the problem themselves.

“In lieu of regulatory relief designed to exclude interest rate and FX hedges from risk-weighted asset [RWA] calculations, the only solution you are left with is integrating the CVA sensitivities into your market risk value-at-risk models. That’s what we have developed internally and believe is probably the way forward for the market,” says the head of CVA at one European bank. 

Under current Basel III regulations, banks are required to hold capital against future variations in counterparty credit risk, known as the CVA value-at-risk charge. This charge can be mitigated through the use of credit derivatives, which are exempt from market risk VAR, on which the RWA figure is based.

But accounting CVA, which measures the current value of counterparty credit risk, is based not only on credit spread movements but also other aspects such as changes in interest rate and foreign exchange levels. Hedges of these non-credit elements are exempted from market risk RWAs in some countries, such as the US and Canada. But in Europe, they sit in the book as naked, directional positions.

This created problems in March, when big rates and FX movements saw the value of these CVA hedges soar, making them extremely RWA heavy. One bank claimed it was responsible for half its market risk capital requirement in the first quarter.

While this issue will ultimately be solved by the upcoming Fundamental Review of the Trading Book (FRTB) – which better aligns with accounting rules by including the effect of interest rate and FX changes in the CVA capital charge and exempts associated hedges from market risk RWAs – its implementation has been delayed by a year due to Covid-19.

In the meantime, banks have been pushing for temporary regulatory relief to be put in place so they don’t have to continue holding what they view as excessive capital on their books.

The only solution you are left with is integrating the CVA sensitivities into your market risk value-at-risk models

Head of CVA at a European bank

“It’s a very important topic since everyone wants to count their CVA hedges against their RWAs. We hope that there is some development in this sphere, since holding capital for CVA hedges contributes to a material amount of RWAs,” says a derivatives valuation adjustment head at a second European bank.

Dealers had hoped something could be achieved through changes to the European Central Bank’s guide to internal models, which describes how Europe’s Capital Requirements Regulation (CRR) should be applied.

But while discussions are ongoing between the industry and regulators, sources say no decision is in sight, and many banks remain doubtful that any regulatory relief would become available before FRTB goes live.

“Both the ECB and European Banking Authority have implied that regulatory relief would be difficult to achieve given the way that CRR is written,” says the CVA head at the first European bank.

The ECB declined to comment. The EBA did not respond to a request for comment before going to press.

Rather than being achievable through new interpretations of the existing CRR rules, regulatory relief might only be possible by amending the underlying CRR rules themselves. Given the typical lengthy process associated with amending financial regulations, market participants believe there simply isn’t enough time for regulatory relief to become available.

“Unfortunately, asking for a change in law is obviously something that would take a very long time – we’d need to explain to them what the issue is, European Parliament would need to start working on it, and the EBA and ECB would need us to provide estimates of how effective a rule change would be in solving the issue. It’s a process that would be incredibly long and would probably bring us up to FRTB anyway, so it’s clearly not an option,” says the CVA head at the first European bank.

It’s difficult to understand why regulators are promoting counterparty risk hedging but at the same time don’t allow most of the CVA deltas to be included in VAR calculations

Derivatives valuation head at a European bank

A derivatives valuation head at a third European bank expresses frustration at the lack of progress on the issue.

“It’s difficult to understand why regulators are promoting counterparty risk hedging but at the same time don’t allow most of the CVA deltas to be included in VAR calculations,” he says.

Some banks are instead preparing to include those interest rate and FX-related CVA exposures in their market risk VAR calculation. This would provide something for their related hedges to offset during big market moves, meaning they no longer sit naked and directional in the book, generating unnecessary RWAs.

However, including these exposures in VAR calculations is no small task for banks. According to the CVA head at the first European bank, many banks fully reprice their portfolios 250 times a day to calculate their daily market risk VAR. But repricing interest rate and FX-related CVA exposures in that way would be computationally difficult.

“That’s extraordinarily challenging from an IT and infrastructure perspective, to the point where it’s even questionable whether it’s feasible. It’s not a method that we favour, and I suspect isn’t the road the industry is considering,” says the CVA head.

Off-the-shelf sensitivities

Instead, the industry is leaning toward using pre-calculated CVA sensitivities and applying shocks, to avoid having to reprice the whole CVA portfolio.

For example, if a bank’s CVA has an estimated sensitivity of €100,000 ($115,000) per basis point of interest rate moves, if interest rates increase by 1 basis point it would result in a hypothetical loss of €100,000 for the bank. Banks can then integrate that sensitivity into their market risk VAR calculations to give them a rough estimate of the impact interest rate moves would have on their overall CVA.

The difficulty is working out how many sensitivities to include. Sensitivities could include an upwards move in the curve, or changes in a certain tenor, across various benchmarks. The key is including enough to ensure the gap between this sensitivity-based model and the full repricing model is minimised, but not so many that the calculation becomes too complicated.

“That’s where compromise is necessary, as to have a comprehensive set of sensitivities covering all the risk factors of your CVA portfolio, computed on a daily basis, means you almost end up facing the exact same issue that you’d face with the full repricing method,” says the CVA head at the first European bank.

Any such model changes also face a wall of regulatory red tape. According to Gregg Jones, director of risk and capital at the International Swaps and Derivatives Association, some firms already have permission to include CVA-related exposures in market risk VAR, some are allowed to include valuation adjustments, but others are allowed none at all.

If a bank without the requisite permissions wants to change its model, Jones says, it may well trigger a lengthy model change approval process.

Clearly in times of stress and crisis – which we find ourselves in now – more timely decision-making is necessary on behalf of competent authorities

Gregg Jones, International Swaps and Derivatives Association

“Getting model change approval is quite a drawn out process, and clearly in times of stress and crisis – which we find ourselves in now – more timely decision-making is necessary on behalf of competent authorities,” he says.

The first European bank’s CVA head is currently working on securing approval from the ECB to obtain the required permissions.

“We are working actively on a file to submit to the ECB for incorporating our CVA exposures into the market risk VAR calculations. While we’d obviously like to be given the green light as soon as possible, it’s not an easy file that we’re submitting for approval. The ECB has to gain confidence that the model change we propose is legitimate and robust enough to be used,” he says.

Despite the hurdles, some market participants believe that including FX and interest rate-related CVA sensitivities in market risk VAR is the most likely solution to their capital problem.

“Quite a few banks are currently working on achieving this. It definitely seems like the majority of major dealers are at least looking at it, so I suspect that over the next 18 months we will see a significant number of banks submitting a similar file to regulators and hopefully getting validation to include sensitivities within their market risk VAR,” the CVA head at the first European bank says.

However, Isda’s Jones stresses that no regulatory decision has yet been made on the issue, so it may be too soon for banks to start changing their RWA models – especially given the associated costs.

“One of the things firms are trying to ensure is that when they’re in a period of stress and are writing a cheque to overcome an issue for today, the solution they pick is also appropriate over the longer term,” he says.