FRTB may bite harder for Europe’s CVA modellers

Farther reach of advanced approach and lighter load on total requirements mean limited takeaways from Canada and Japan’s implementation

Five years on from its finalisation, Basel’s new framework for capitalising credit valuation adjustment (CVA) risk – the potential for a derivative contract to drop in value following changes in market or counterparty risk – is becoming populated by more and more dealers as countries gradually adopt the Fundamental Review of the Trading Book.

While the market risk pillar of FRTB has received the bulk of the industry’s attention – due to how radically it upset dealers’ modelling-costs-versus-capital-savings calculus – it is CVA capitalisation that may have seen the most sweeping overhaul, due to the complete removal of a modelling option. As rulemakers put it in 2017, CVA risk is fiendishly complex, more so than most trading book risks, and as such, “cannot be modelled by banks in a robust and prudent manner”.

Dealers in Canada, Japan and now Switzerland have provided the petri dishes to gauge how capital charges may be reshaped at banks in other jurisdictions – primarily the European Union and the UK.

Among the main takeaways so far: counterparty credit spreads weigh more heavily than market risk; the impact of hedges can vary widely; and going for the bare-bones basic approach over the authorisation-only standardised approach does not necessarily make for exploding risk-weighted assets (RWAs).

Generally, banks in Japan and Canada did not see CVA gobble up a larger share of their capital on switching to FRTB, with the component’s proportion of total RWAs mostly flat or down. Royal Bank of Canada and Mitsubishi UFJ Financial Group provided the exceptions, but still saw relatively contained rises of 28 basis points and 50bp, respectively.

 

This may bode well for dealers next in line to adopt FRTB, as it would imply little to no RWA inflation relative to the rest of the capital requirement stack. Nevertheless, the devil is in the detail.

Outside of the EU and the UK, only two of the banks that already switched to FRTB used to employ the advanced approach for modelling their own CVA charges: Scotiabank and UBS, rising to three when including Nomura, which only became subject to the new framework last week. Of the 37 EU and UK dealers tracked by Risk Quantum, however, 14 are advanced approach users.

Additionally, the fact that CVA charges weigh far less on EU and UK banks’ RWA load – with the most recent available data showing only three banks surpassed, barely, the 1% mark – could be read as being anomalously low, in which case the FRTB switch could herald a major increase, bringing some single-bank proportions of CVA capital in line with those experience by Canadian or Japanese dealers.

 

For major dealers, UBS provides perhaps the best litmus test. CVA RWAs – which it used to model – were 1.8% of the total as of December 31, a level the bank had last seen in the fourth quarter of 2016.

The next day, as FRTB came into effect, CVA RWAs rose by $2.6 billion, and their capture of total requirements to 2.3%. Assuming the underlying exposures were unchanged, the CVA risk density rose from 10.9% as of December 31 – with density of 4.9% on modelled charges offsetting the 23.9% on standardised one – to an implied figure of 14.1% on January 1.

The more burdensome CVA requirement is hardly impossible to manage for UBS. The bank’s book may also contain idiosyncrasies that made it more susceptible to RWA inflation, courtesy of the baggage it carries over from the legacy Credit Suisse balance sheet.

Still, its example fuels the idea that, under the new regime, certain EU and UK banks may have to live with a larger CVA load than they had been used to.

Correction, April 29, 2025: An earlier version of this article wrongly stated that the CVA component of FRTB had been delayed to 2026 in the European Union, as with the market risk component. The error has been corrected.