Japanese banks eye phased CVA introduction

A Japanese industry group believes there is a “growing need” to introduce credit valuation adjustment (CVA) into the fair values of local banks’ derivatives portfolios, but says the accounting measure, which would generate losses in earnings, should be phased in across different portfolios over time – a practice some accountants disagree with.

The Japanese Bankers Association (JBA) formed a working group in February to discuss the implementation of CVA into accounting for the first time, based on probability-of-default data derived from the credit default swap (CDS) market. The group, which consists of local so-called megabanks and small regional firms, released a report on June 29 detailing its discussions.

The report listed a number of pros and cons to implementing CVA, but concluded that introducing the adjustment would be prudent. “Given that we see growing needs to introduce CVA in Japan, Japanese banks with significant exposures on derivatives are expected to consider applying CVA in their practices,” says the report.

This is a key development, according to one Tokyo-based derivatives valuation adjustments manager. “The important thing is that, based on the report, the Japanese megabanks – but also the smaller regional banks – will try to do their best to introduce the CVA framework,” he says. 

The implementation could be done in stages across the derivatives book, the report says. One suggested approach would see banks starting with plain vanilla instruments and then moving to more exotic trades. Other suggested approaches include phasing in by region or by type of counterparty.  

Implementing CVA would result in losses in the earnings report, so a phased approach would smooth the impact of the adjustment compared with doing it all at once. Recent CVA methodology adjustments at Standard Chartered and ANZ saw the banks take losses of $712 million and $122 million, respectively, when applied across their whole books.

The important thing is that, based on the report, the Japanese megabanks – but also the smaller regional banks – will try to do their best to introduce the CVA framework

Tokyo-based derivatives valuation adjustments manager

Not all accounting experts agree that this is the right approach, however. “From an accounting point of view there should be no cherry-picking of accounting treatment,” says one Tokyo-based accounting source.

The JBA working group includes three of the big four local megabanks – Mitsubishi UFJ Financial Group, Mizuho, Sumitomo Mitsui Banking Corporation – as well as Resona Bank, The Iyo Bank and North Pacific Bank. Nomura did not attend as it has already implemented accounting CVA and is not a JBA member. The Bank of Japan, the International Swaps and Derivatives Association and the Japanese Financial Services Agency (JFSA) attended as advisers.

Japanese banks have traditionally not priced CVA into derivatives trades, instead relying on the qualitative credit risk information they obtain on counterparties from their broader loans businesses. The Basel rules require them to hold regulatory capital against CVA exposures but they do not have to account for it under local Japanese accounting rules, meaning they do not have to pass these costs on to clients. As such, the banks generally lack the ability to calculate a price for CVA.

The report lists a number of reasons to adopt CVA. For instance, as Japanese banks don’t price CVA, the prices they charge for trades with high-counterparty-credit-risk clients are generally lower than international banks. The report notes that this can lead to such trades being concentrated on local banks that don’t charge CVA.

Given most Japanese banks do not have a dedicated CVA hedging desk, the report raises concerns about firms’ ability to cope with a financial crisis if they have not properly mitigated the counterparty credit risk on their uncollateralised exposures.

It also raises the forthcoming introduction of a new regulatory CVA approach that is being implemented as part of the Fundamental Review of the Trading Book as another reason to introduce the accounting adjustment in Japan.

Timing unclear

The CVA implementation timeline is unclear, however. “We are collaborating with member banks and relevant authorities in Japan,” says JBA spokesman Masaaki Misawa. “The timeline is not yet fixed, but we are trying to develop it as soon as possible.”

The JFSA tells Risk.net it expects to monitor the progress of each bank’s CVA implementation, although it has not yet decided how it will carry this out. Tokyo-based consultant Michael Reeves says that unless CVA implementation is required by the JFSA, it might not be adopted in full.

It has got to be tempting to go for the low-hanging fruit that only has a negligible effect on your competitiveness

Michael Reeves, consultant

“If you don’t have to, as you move through the bank the view might be ‘actually there is a real risk and we need to account for it, but we got away without accounting for it for an awfully long time, so why today, why not tomorrow?’,” says Reeves.

Alternatively, he says, banks may implement the adjustment only on instruments that would not attract much CVA, such as collateralised swaps: “If you’re going to phase it in, it can be [done] in different ways by different organisations. It has got to be tempting to go for the low-hanging fruit that only has a negligible effect on your competitiveness.”

Others are more optimistic about the likelihood of Japan’s megabanks introducing CVA without intervention from the prudential regulator. “Depending on each bank’s situation, they will try to introduce the best CVA model possible,” says the Tokyo-based derivatives valuation adjustments manager.

The JBA report also identifies barriers to adopting CVA, such as the low levels of liquidity in the CDSs that are used to hedge instruments in the market. This complicates the hedging of names that have CDS contracts and makes the construction of proxy curves for counterparties without a CDS contract more difficult.