Basel’s CVA upgrade: persuasive in the US, less so in Europe

Ban on credit risk models could encourage US banks to adopt more sophisticated CVA method

Key points Summary Q&A

• Bank capital rules in the European Union and the US are diverging, with CVA treatment a clear example of growing differences.
• After the new rules took effect in January, many EU banks chose the simpler BA‑CVA, because the SA‑CVA sometimes raised capital needs, and the inclusion of IMM for counterparty credit risk could make BA‑CVA cheaper.
• The EU kept exemptions for corporates, sovereigns and pension funds, which limited SA‑CVA’s ability to recognise CVA hedges and reduce capital charges.
• US dealers are expected to favour SA‑CVA as regulators move to curb IMM and remove the Collins Floor, making CVA capital more binding and BA‑CVA less attractive.

These summaries are generated by an LLM, but edited by humans.

Bank capital rules in the European Union and the US are growing apart. As the pile of deviations grows, diverging outcomes also multiply. The latest example is the capital charge for risks posed by the deteriorating health of derivatives counterparties, known as credit valuation adjustments.

Before it was abolished by the Basel Committee on Banking Supervision in 2017, many EU banks adopted the more sophisticated CVA approach involving internal models, while US banks preferred a simpler method resting on regulator-set standardised risk weights. Calculating CVA involves measuring changes in both the risk of the counterparty, and the level of market risk exposure to them.

When EU banks became subject to the new rules from January last year, many chose the BA-CVA

After the 2017 reforms – known as Basel III – the standardised approach (SA-CVA) became the most sophisticated option available. It requires banks to use quantitative analysis to determine changes in their exposures under a set of prescribed shocks. Meanwhile, the fallback is a more basic approach (BA-CVA) that also relies on prescribed shocks but with less quantitative analysis.

In principle, the SA-CVA is supposed to reward banks’ investments in risk measurement with smaller capital requirements, while BA-CVA should lead to the opposite outcome. Moreover, the SA-CVA is supposed to be a tempting prospect due to the convenience of recognising the offsetting effects of market risk hedges for CVA exposures. The previous CVA framework did not allow this, forcing EU banks to capitalise market risk hedges related to their CVA risk as open exposures in trading book capital metrics. The new method is also intended to promote better risk management, since de-risking CVA leads to a capital reward.

Despite these theoretical advantages, some EU banks found the SA-CVA may propel capital requirements higher. Consequently, when EU banks became subject to the new rules from January last year, many chose the BA-CVA instead.

 

Some found their peers’ choices surprising, since a few of the BA-CVA users relied on the internal models method (IMM) for calculating counterparty credit risk, which is closely related to CVA. Given the IMM involves modelling techniques relevant for SA-CVA, there was an expectation those banks would adopt the new machine.

EU banks, however, realised the IMM could unlock smaller capital requirements on the BA-CVA than the SA-CVA. Banks can use IMM to calculate their exposures at default within BA-CVA. If BA-CVA costs less in both capital and operational expenses, SA-CVA becomes less desirable. These banks saw a fall in their capital requirements, or at worst a slight increase, coupled with lower operating costs.

A further factor is the EU’s decision to retain existing exemptions for CVA capital charges related to exposures to corporates, sovereigns and pension funds, which denied SA-CVA its capital superpower. These counterparty groups usually leave their trades uncollateralised, which produces larger market risk CVA exposures. But if the EU regulatory capital regime overlooks this risk, banks cannot transfer the related market risk hedges over to their CVA book for regulatory purposes, and they would be classified on the balance sheet as unhedged market risk instead.

Atlantic rift

Expectations differ in the US. Sources anticipate dealers will predominantly take up the more sophisticated option, namely the new version of SA-CVA, even though few banks used internal models for CVA in the past. Risk.net spoke to one bank using the simple approach wanting to apply the SA-CVA to most of their exposures. This appetite doesn’t seem to be dimmed by the fact US banks benefit from a capital offset for market risk CVA hedges, which will continue under the new framework.

US banks are turning to the more sophisticated CVA approach

Differences in rules can explain the differences in expectations. US regulators want to take the IMM away as part of a broader cull of credit risk internal models, which leaves banks capitalising counterparty credit risk with the more punitive standardised approach (SA-CCR). US banks would have to use SA-CCR within BA-CVA, which makes it less appealing for them.

US banks’ investment in SA-CVA will also become more worthwhile under the proposed rules. Currently, the binding capital requirement for these banks is the higher of their internally modelled approaches for several risk types – including CVA – or an old, standardised approach for only credit and market risks. Seven out of nine banks find the standardised stack is higher, which undermines the case for investing in advanced approaches since they don’t determine binding capital requirements.

Since US regulators propose to scrap the so-called Collins Floor under their draft plans published in March, CVA would always play a role in determining banks’ capital requirements. Together with the fact the switch means CVA capital requirements will prove additive for most, US banks are incentivised to invest in capital-efficient approaches.

There is an irony to all of this. A good chunk of large EU banks rely on the cruder method for CVA precisely because the more sophisticated IMM is available, while US banks are turning to the more sophisticated CVA approach because regulators are forcing them to use the cruder SA-CCR.

US regulators still have plenty of work to do before they finalise their version of Basel III, which sources don’t expect they will need to comply with until 2028 at the earliest. In the meantime, it shouldn’t come as a surprise if more contradictions emerge between the US and EU implementations of the rules.

Editing by Philip Alexander