US sidetracks bid to end European CVA exemption

Fed’s change to SA-CCR capital renews EU industry calls to preserve carve-out

  • European banks are exempt from capital charges for credit valuation adjustments on trades with corporate counterparties – something the European Banking Authority is keen to change.
  • A recent Basel consultation proposes to ease rules on capital held against CVA, which could set the stage for removal of the exemption.
  • But US regulators have now watered down the standardised approach for counterparty credit risk (SA-CCR), specifically for trades with corporates.
  • This is likely to strengthen European Union objections to ending the CVA exemption and industry lobbyists want any change to be preceded by a detailed impact study once the Basel amendments have been completed.
  • The industry also wants the EU to copy the US changes to SA-CCR, preferably before the existing version comes into force in mid-2021.

Like a child at the centre of a custody battle, European banks have become wearily familiar with the squabble among higher powers over a controversial carve-out for capital charges on derivatives trades.

The battleground is credit valuation adjustment. On one side is the European Union, which passed an exemption for CVA capital on trades with non-financial corporations, pension funds and sovereigns in 2013. On the other side is the European Banking Authority, which hopes to sweep away the exemption on the basis that it deviates from globally agreed standards.

In November 2019, the Basel Committee on Banking Supervision released a consultation paper seeking to amend its rules on CVA; a move that would appear to add weight to the EBA’s efforts to eliminate the exemption. The proposed changes are designed to align regulatory CVA calculations more closely with accounting CVA, to provide more regulatory recognition of hedges for CVA risk and possibly to soften the overall calibration of the capital charge.

Lars Overby, head of risk-based metrics at the EBA, welcomes the Basel proposals: “What we see in the revised CVA framework is quite a significant increase in capital requirements for CVA risk. It is fair to ask whether this is reflective of an actual increase in CVA risk or whether this is a calibration issue which has perhaps not been fully tackled by the Basel Committee. If it is the latter, then it is clear that the Basel Committee is doing the right thing by trying to bring the numbers down a bit.”

But another potential gust threatens to blow the EBA’s plan off course, from an unexpected direction – the US regulatory agencies. In November, they completed rules to implement Basel’s standardised approach to counterparty credit risk (SA-CCR). The US version largely followed the Basel standards, but with one significant twist: a multiplier of 1.4x, known as an alpha factor, was removed for trades with commercial end-users, cutting the capital that banks will need to hold when facing those clients.

In addition to directly affecting the capital charges – and therefore the pricing – of derivatives trades, SA-CCR is also widely used in other parts of the Basel framework as a way to measure derivatives exposures. Those secondary applications include the leverage ratio, the large exposures rule and the basic approach to CVA (BA-CVA).

“Having a lower level of CVA capital and a more appropriate treatment of CVA hedges may make removal of the EU exemption more reasonable,” says Jon Gregory, an independent CVA consultant who previously worked as a credit trader at Barclays Capital. “The US has recently removed the 1.4 alpha factor in the SA-CCR for the same type of counterparty – non-financial – which has a knock-on effect on BA-CVA as well, so there is lots of calibration going on here.”

European lobbyists are already pushing EU lawmakers to take a lead from their US counterparts and soften the SA-CCR by reducing the alpha factor (see box: SA-CCR fast track). But the US move will potentially add impetus to European industry efforts to save the CVA exemption because banks fear losing a chunk of corporate derivatives business to transatlantic competitors who can offer keener pricing on trades.

War of attrition

Despite a long-standing objection to the CVA exemption, the EBA’s efforts to remove it have been unsuccessful – for now. The authority sought to introduce a Pillar 2 supervisory add-on to replace the exempted Pillar 1 capital charge, but struggled to overcome legal difficulties. So the EBA tried to remove those legal obstacles by building more supervisory flexibility into the second Capital Requirements Regulation (CRR II).

Even after the release of Basel’s consultation paper, the EBA provided advice in December to the European Commission on adopting wider revisions to the Basel capital framework, which included a call to scrap the peevish CVA exemptions, although with a transition period to cushion the impact.

The fundamental problem is the widespread perception among market participants that the CVA capital charge is much too conservative compared with the economic risk that banks face. That risk centres on accounting revaluations of derivatives triggered by changes in the creditworthiness of a counterparty.

The concern about calibration intensified further when the Basel Committee decided to remove the option of using internal models for calculating CVA in its final December 2017 Basel III package. That will potentially drive up capital requirements and cause them to diverge from actual accounting CVA risk. Bank lobbyists have consistently sought – and retained – the support of EU lawmakers on what might seem an arcane topic by warning that overzealous CVA capital charges will push up the cost of hedging for corporate clients.

“We are concerned about the removal of exemptions without a material recalibration of the framework, and what that means for the provision of derivatives and related products to end-users who, fundamentally, don’t have the ability to margin or the access to collateral that is required to have a reasonable treatment for CVA,” says Sahir Akbar, a director on the prudential regulation team at the Association for Financial Markets in Europe (Afme).

Bowing to pressure to recalibrate the capital requirements, the Basel Committee proposed one important change to the CVA framework in its consultation and asked for views on whether it should consider a second. The first change involves the way risk is aggregated across a portfolio, designed to make it easier for banks to hedge whole CVA portfolios using credit default swap indexes such as iTraxx or CDX, even if the index and the portfolio do not match exactly.

“We are seeing quite a lot of banks who were happy, certainly looking at the hedging relief they will get,” says Gregory. “[In the current framework] there is a misalignment problem with most bank portfolios, and the representation of sectors in iTraxx and CDX, which means they don’t always get as much capital relief as they would expect.”

Multiplier effect

The second – at this stage more exploratory – idea from the Basel Committee involves lowering the 1.25x multiplier on the CVA capital charge or even removing it altogether. The EBA believes this change would be the most substantial in terms of its impact, potentially shaving as much as 20% off overall final CVA capital requirements if the multiplier is dropped altogether. For its advice to the European Commission, the EBA undertook a sensitivity analysis showing the effect of a 10% reduction in CVA capital requirements.

“With the Basel consultation paper out, it is difficult for us to provide an end-figure of the capital impact of the revised CVA framework. We can provide the current impact on headline numbers and supplement that with a sensitivity analysis that allows us to proxy the capital impact of potential changes,” says Overby. “It is clear, however, that the numbers are still subject to change, depending on the ultimate revisions chosen by the Basel Committee.”

Nonetheless, the EBA’s own data clearly shows the removal of the CVA exemptions has a much larger effect on overall CVA capital requirements than cutting the multiplier (see figure 1). And the increase in risk-weighted assets (RWAs) resulting from the loss of the exemption is vast – 558%, according to the EBA’s own numbers, shaved down only slightly to 479% if all the proposed Basel amendments are adopted.


While CVA only accounts for a small proportion of total RWAs, the impact on the pricing of affected trades could be substantial. But Overby says this is not the whole story if banks look at capital consumption holistically rather than at individual products in isolation.

The CVA framework forms part of a Basel III package that will include an output floor on internal models. According to the Basel standards, total bank capital requirements must not fall below 72.5% of what they would be if calculated using the standardised approaches. Since internal models for CVA were abolished under Basel III, CVA capital will effectively be 100% of the standardised approach – well above the floor.

That hypothetical “surplus” on CVA capital can then be used to offset requirements for other business units, which are on internal models that return outputs below the 72.5% floor.

“Some firms may be bound by the output floor, others may not. That’s where it becomes more complex, but many of the large firms that are internationally active in the derivatives markets currently appear to be bound by the output floor,” says Overby.

Wait and see

For the industry, this argument involves too many untested assumptions about the Basel consultation and the eventual impact of the final framework. The Basel Committee has given parties until February 25 to respond to its consultation, and Afme’s Akbar anticipates the final Basel standards are likely to be unveiled by the end of 2020.

That would be too late to include in the European Commission’s first draft of the revisions to the CRR, already dubbed CRR III by the industry, which is due by mid-2020. But that won’t be a problem, because there will be a process of negotiation with the European Parliament and Council of the EU that could take around 18 months, according to Akbar’s expectations. The Basel amendments could be slotted in during that time.

We think a full impact study should be done once Basel has recalibrated this standard

Sahir Akbar, Afme

However, Afme wants any decision on removing the CVA exemptions to wait until after the EBA has been able to collect data on the actual impact of the amended framework, which is likely to take the timeline beyond the completion of CRR III.

“We think a full impact study should be done once Basel has recalibrated this standard, which looks at the impact of the revised framework – taking into account the impact on end-users – before a decision is made as to the removal of the exemptions,” says Akbar. “Whenever the industry requests any changes or seeks any amendments, the regulatory community asks the industry for quantitative data to support its views… so we are just asking for a consistent approach in that regard.”

Hence the Basel amendments could be just the next battle in a long war for the EBA. But Gregory says bankers already anticipate the regulatory agency will win in the end. He adds that the “slight sweetening of the capital rules” at Basel will help the EBA get its way.

“In terms of banks’ pricing behaviour, you definitely see that a bank looking at a long-dated trade isn’t just ignoring CVA capital entirely. For example, they might price it in beyond the five-year point, suggesting a removal of the exemption at this point,” says Gregory.

And the EBA is ready to deploy existing industry pricing practices as evidence for its own case. In the regulator’s view, the fact that CVA capital charges are already priced into some corporate trades undermines the argument that removing the exemptions would harm end-users.

“It is our understanding that banks currently reflect some CVA risk in the pricing of their derivatives transactions to their clients – including their exempted clients. So the question is who those CVA exemptions are currently serving?” says Stephane Boivin, a senior policy expert at the EBA. “The target for us has always been to to have a regulatory CVA framework which is accurate, rather than conservative, in order to get closer to banks’ CVA practices.”

SA-CCR fast track

The EU has already implemented SA-CCR in line with the Basel standards, as part of the CRR II package agreed in April 2019. The industry had lobbied for a softer calibration than Basel, but to no avail.

As a result, the US decision to remove the 1.4x alpha factor has come as a very unwelcome surprise to European bankers. Afme will now urge the European Commission to amend SA-CCR in the forthcoming Basel III implementation package, for which the first draft is due by mid-2020.

“The existing 1.4 alpha factor is based on historic analysis done by the industry. We have rerun those tests and we see that due to changed dynamics in the market, [such as] increased central clearing, the alpha factor is no longer 1.4 and closer to one,” says Akbar.

Although revisions to SA-CCR are not currently in the commission’s plans, Akbar points out that it will have a bearing on CRR III in any case. As a standardised approach methodology, SA-CCR will form part of the 72.5% output floor, which is essentially the most important item to be included in CRR III. The EBA advice estimated the output floor will add 8.6% to capital requirements (compared with 3.9% for the CVA framework if exemptions are removed).

“It will have an impact on the calibration of the output floor, so the calibration of SA-CCR is key. We are advocating for… regulators and policy-makers to have a look at the calibration of the alpha factor, and in line with the policy in the US to set that to one for commercial end-users,” says Akbar.

But there’s a problem with timing, given that Akbar does not expect CRR III to be completed until the end of 2021 at the earliest. There is also due to be an EBA review of CRR II, but that could be even later, in 2023.

In the meantime, CRR II enters into force in mid-2021, and with it, the current version of SA-CCR, which will now be significantly tougher for corporate derivatives trades than the US implementation.

“That means the impact of SA-CCR will be felt either before the EBA has completed its review or the CRR revisions have gone through. So we would need to see some sort of fast-track proposal to recalibrate SA-CCR ahead of its go-live in mid-2021,” says Akbar.

Editing by Alex Krohn

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