Credit Valuation Adjustment (CVA) under Basel III

1. The Global and Indian Market for Financial Derivatives

Over-the-Counter (OTC) financial derivatives are off-balance sheet bilateral contracts between
two parties, the value of which is driven primarily by one or more market prices (interest rates,
exchange rates and equity prices). These include all interest rate derivatives (e.g. forward rate
agreements and interest rate swaps), currency derivatives (e.g. FX Forward, Currency Swaps,
Currency Futures, and Currency Options), and credit derivatives (e.g. credit default swaps) in the
trading book and banking book and also derivatives contracts entered into for hedging trading book
exposures.

As per the BIS data, the total notional amounts outstanding in the global OTC derivatives market
was $ 630 trillion, and the gross market value of the outstanding derivatives contracts was $21
trillion at end-December 2014. The interest rate segment accounted for the majority of OTC
derivatives activity, covering 80% of the global OTC derivatives market. The gross market value
of interest rate derivatives saw a significant rise in the second half of 2014, from $13 trillion to
$16 trillion. Declines in long-term yields, in many instances, contributed to a significant increase
in market values of all interest rate derivatives products, denominated almost in all of the major
currencies.

Foreign exchange derivatives made up the second largest segment of the global OTC derivatives
market, covering a total notional amount outstanding to the tune of $76 trillion, 12% of OTC
derivatives activity. The gross market value of foreign exchange derivatives had also increased to
$2.9 trillion at end-December 2014 from $1.7 trillion at end-June 2014, mostly due to the marked
appreciation of the US dollar against most other currencies. The increase the gross market value
of the interest rate and FX derivatives indicated a significant amount of risk of incurring huge
losses by the market participants if the counterparties failed to meet their contractual obligations
and the contracts had to be replaced at current market prices.

During 2007, credit derivatives, more specifically credit default swaps, had come close to
surpassing foreign exchange derivatives as the second largest segment in the global OTC
derivatives market. Subsequently however, the notional amounts have steadily declined from the
peak of $58 trillion at end-2007 to $16 trillion at end-December 2014, also with a steady decline
in the market value to $593 billion at end-December 2014.

As far as Indian derivatives market is concerned, the quarterly trading volume, as published by
Clearing Corporation of India Limited (CCIL), in OTC interest rate derivatives products (MIBOR-
OIS and MIFOR taking together) during the 4th Quarter of 2014-15 stood at USD 118.14 billion
(INR 748010 Crore @ 63.58), which was almost double of the same volume in the second quarter
of 2014-15 (USD 58.67 billion). The quarterly trading volume of exchange traded interest rate
derivatives products (Interest Rate Futures) in India, as published by the National Stock Exchange
(NSE), is relatively very small, and stood at USD 1.75 billion in Q4 2014-15, in comparison with
USD 0.90 billion in Q2 2014-15. At the same time, the total trading volume in OTC FX derivatives
(FX Forwards) in India, as published by CCIL, increased from USD 207 billion to USD 257 billion
between the second and last quarters of 2014-15, while the trading volumes of exchange traded
FX derivatives (currency futures and options) had increased from USD 220 billion to USD 299
billion (INR 1902639 crore @ 63.58) during the same period.

2. Capital Requirements for Derivative Transactions under Basel II

Positions in OTC derivatives are subject to two major risks – market risk and credit risk. Market
risk arises when the underlying market prices move in such a way as to make the value of the
derivative position negative and thus imply a market-related loss to one of the parties. Credit risk
(more specifically known as counterparty credit risk or CCR) is the risk that the counterparty to
the derivative transaction defaults on or before the final settlement of the transaction's cash flows,
thereby causing loss to the first party. Such a loss would occur only when the derivative transaction
has a positive economic value to the first party at the time of counterparty default. According to
the Basel regulations, banks are required to hold market risk capital and counterparty credit risk
capital for OTC derivative positions.

As per the Basel II guidelines, market risk capital charge for financial derivatives can be estimated
using the Standard Measurement Method (SMM) or the Internal Model Approach (IMA) to capture
interest rate risk, exchange rate risk or equity price risk. Overall Market Risk Capital Charge
(MRCC) can again be broadly divided as General Market Risk Capital Charge (GMRCC),
capturing the risk of loss in trading book derivative positions due to change in common market
prices, and Specific Risk Capital Charge (SRCC), protecting against adverse price movements of
derivative positions (Long and Short) owing to factors related to the underlying entity (example
issuer of corporate bond, specific risk of the equity issuer etc) in the derivative transaction.

Even prior to the global financial crisis, banks and financial institutions had, for more than a
decade, measured counterparty credit risk using the concept of potential future exposure (PFE)
and set limits to counterparties based on the same after accounting for the risk mitigating effects
of netting and collateral. Under Basel II, banks are also required to maintain credit risk capital on
the counterparty credit exposures associated with derivative portfolios.

The estimation of the Basel II credit risk capital charge for CCR in OTC derivatives positions is
based on one of the following three methods:

a. Current Exposure Method (CEM)

b. Standardized Method
c. Internal Model Method

3. Credit Valuation Adjustment for OTC Derivatives

Credit Valuation Adjustment (CVA) “is an adjustment to the fair value (or price) of over-the-
counter (OTC) derivative instruments to account for counterparty credit risk (CCR). Thus, CVA
is commonly viewed as the price of CCR. This price depends on counterparty credit spreads as
well as on the market risk factors that drive derivatives’ values and, therefore, exposure.” (BIS,
2015)

Some of the international banks and financial institutions which were subject to the “fair value”
requirements of IFRS accounting standards, had been estimating the CVA as part of the value of
OTC derivative positions by considering the counterparty risk and recognizing its impact on P&L.

3.1.Illustration of CVA

To demonstrate the effect of credit risk on the market price of an OTC derivative, we take a simple
example. Let us assume that Bank “B” holds an Interest Rate Swap (IRS) with the Counterparty
“A”. The IRS has a notional amount INR 30 crores with an original maturity of 5 years and an
effective maturity today of 2.5 years. The positive mark-to-market (MTM) value of the IRS today
is INR 1.5 crores for Bank B. Let us presume that some bad news about Counterparty A is
announced which suggests that there is now a higher likelihood that it will not be able to honour
its cash flow obligations still outstanding under the IRS contract. Thus, the IRS value after the bad
news is published will fall (to say INR 13 crores). The fall in the value of the IRS suggests that
Bank B is now facing a credit loss (13 – 15 = -INR 2 crores), even though an actual default has
not occurred. For historical and practical purpose, Bank B’s trading desk continues to price the
IRS off the risk-free curve. So, to account for the credit loss, the CVA is defined as the difference
between the value of the IRS under credit risk-free assumption and the true (fair) value of the IRS
which has accounted for the increased possibility of default by the Counterparty A.

CVA = Credit risk free value of the OTC derivative – Fair value of the OTC derivative (i)

Fair value of the OTC derivative = Credit risk free value of the OTC derivative – CVA (ii)

Observations:

1. The above equation provides a “unilateral” CVA which has accounted for only the change
in the default risk of Counterparty A.
2. In actual fair valuation, Bank B must also account for a change in the value of the OTC
derivative as a consequence of the change in its own credit rating (and associated default
risk), which is known as the Debt Value Adjustment (DVA). Thus, the more generic fair
value of an OTC Derivative would be given by
Fair value of an OTC Derivative = Credit risk free value – CVA + DVA (iii)
3. While inclusion of DVA is important for fair valuation under IFRS and symmetric pricing,
it is not relevant for the consideration of capital charge.
4. CVA is based on the potential for credit default losses by the Bank B if the Counterparty
A defaults and vice versa. However, a credit loss will occur for Bank B only if the
outstanding contractual cash flows of the derivative have a positive value at the time of
future default. Thus, the CVA risk is primarily driven by a positive exposure to the
counterparty, which in itself is driven by the volatility of the underlying market data.
5. While market risk can be diversified across the entire bank’s portfolios, a potential credit
loss affects primarily those transactions with the defaulting counterparty. The use of credit
derivatives, netting and collateral agreements can mitigate some of these potential credit
losses by reducing the net exposure to the counterparty.
 6. At the level of a portfolio of derivative counterparties, there may be some diversification
of the CVA risk.

4. CVA Capital Charge under Basel III

Prior to the global financial crisis, capital requirement for CVA had been ignored, largely due to
the relatively small size of derivatives exposures, the high credit rating of the counterparties
involved and the belief that large derivative counterparties were “too big to fail” or highly unlikely
to default on their derivative obligations. Therefore, the majority of the market participants, while
holding regulatory capital for default risk of derivative counterparties under Basel II, neglected to
consider the impact of the same on the value of their OTC derivative positions.

The aftermath of the global financial crisis changed the way in which financial institutions and
regulators look at counterparty credit risk in derivative positions. As the size of derivatives
exposure increased and the credit quality of the counterparties fell in the wake of the 2008 crisis,
the valuation of counterparty credit risk could no longer be assumed to be negligible and had to be
either priced in or hedged at a cost. The potential cost of doing business with certain counterparties
became a significant concern for anyone trading in the financial markets. On the one hand, the
belief of immunity from default was negated as banks incurred large losses associated with the
high profile failures of investment banks and monoline insurers who defaulted on their derivative
obligations. More importantly, majority of counterparty credit losses in the financial crisis were
suffered not as a result of actual defaults of the counterparty, but because of the adverse impact of
the volatility of credit quality of counterparties (and related credit spreads) on the value of the OTC
derivative positions. This was the risk of Credit Valuation Adjustment (CVA) for derivatives.

The financial crisis demonstrated that CVA-related losses can be large and larger than counterparty
default losses under stressed market conditions. “Under Basel II, the risk of counterparty default
and credit migration risk were addressed but mark-to-market losses due to credit valuation
adjustments (CVA) were not. During the financial crisis, however, roughly two-thirds of losses
attributed to counterparty credit risk were due to CVA losses and only about one-third were due
to actual defaults.” (BCBS, June 2011). Thus, while IRFS CVA is the cost of counterparty credit
risk, equivalent to the cost of CDS hedging under normal market conditions, a severe “spike” in
CVA can lead to large losses and banks must hold capital to protect against such scenarios (Figure
1).

Figure 1: Impact of CVA on Profit and Loss under Normal and Severe Market Conditions

Thus, under Basel III it became imperative to incorporate the requirement of capital as a buffer for
large losses due to CVA risk of OTC derivative positions arising due to the migration in the credit
quality of counterparties and accordingly, the volatility in the credit spread. CVA is thus a a core
component of Counterparty Credit Risk under Basel III. Banks are required to measure CVA risk
and hold additional capital for the same over and above the capital for counterparty credit risk
measured under Basel II.

All OTC derivatives, both from the banking and the trading book, need to be taken into
consideration while computing the CVA capital charge. However, derivatives cleared by Central
Counterparties (CCP) are excluded from CVA’s scope of application, because CCR between the
seller and the buyer is neutralized by the CCP through margin calls and collateral deposits.
Nevertheless, Basel III still recognizes a CCR risk with CCPs, where such transactions have a 2%
risk weight, ensuring a provision for an extra cushion of capital to be constituted in order to cover
any losses due to the default of the CCPs. Even if the IFRS rules (accounting rules) recognize both
CVA risk and DVA risk, Basel III recognizes CVA risk but doesn’t take DVA risk into
consideration for capital requirement.
5. Methods for Estimating CVA Capital Charge under Basel III

Banks must estimate the capital charge for CVA, using one of the following two methods:

a. Standardized Approach
b. Advanced Approach

If a bank has hedged its CVA risk using credit derivatives like CDS or positions in the credit index,
the hedge effect is accounted for by reduction in the capital charge for CVA. The Advanced
Approach is permitted only for those banks which have regulatory approval to 1) estimate the
exposure at default of OTC derivatives using the Internal Model Method (IMM) Approach and 2)
estimate specific risk of bonds using the internal market risk model. All other banks are subject to
the Standardized CVA capital charge based on a prescribed formula.

Thus the total counterparty credit risk capital under Basel III is estimated as shown in Figure 2.

Figure 2: Total Counterparty Credit Risk Capital Requirement under Basel III

5.1.Advanced Approach for CVA Capital

In the Advanced Approach, CVA for a counterparty is estimated using discrete time intervals as

Where,
  ti is the time of the i-th revaluation time bucket, starting from t0=0
 tT is the longest contractual maturity across the netting sets with the counterparty
 si is the credit spread of the counterparty at tenor ti, used to calculated the CVA of the
counterparty. It is either the CDS spread if available or a proxy bond market spread using
the rating of the counterparty
 LGDmkt is the loss given default of the counterparty and should be based on bond market
information about recovery rates. It is different from the LGD estimates used in the IRB
Approach for credit risk capital charge under Basel II.
 The first factor within the sum represents an approximation of the market implied (risk-
neutral) marginal probability of default of the counterparty between time ti and ti-1
 EEi is the expected exposure to the counterparty at revaluation time ti, measured using the
regulatory definition of expected exposure
 Di is the default risk-free discount factor (price of a zero coupon bond) at time ti, where
D0 = 1
 The second factor within the sum is the expected exposure for the counterparty for the i-
th revaluation period.

The CVA formula as per the Advanced Approach thus captures the risk-neutral expected value of
all the future cash flows arising from OTC derivative exposures to a counterparty. In order for a
bank to use the Advanced Approach formula for estimating CVA risk, it must have access to
market data on credit spreads and LGD based on counterparty ratings. It must have also built
modelling capabilities to measure potential future exposures as per the Internal Model Method.

The regulatory CVA formula must then be the basis for all inputs into the bank’s approved Value
at Risk Model for bonds when calculating the CVA risk capital charge for a counterparty or for a
portfolio of counterparties. Eligible hedges for CVA risk can be incorporated into the calculation
of the standalone CVA risk capital charge for a counterparty. The VaR based CVA risk capital
charge must consist of both the non-stressed VaR and stressed VaR component.

5.2.The Standardized Approach for CVA Capital

The Standardized Approach, as the name suggests, is a simple regulatory prescription for
estimating CVA capital for a portfolio of counterparties, as given below.
Where,

 h is the one-year risk horizon : h = 1.

 wi is the weight applicable to counterparty i, based on regulatory prescription linked to the
external rating of the counterparty (Table 1).
 EADiTotal is the exposure at default of counterparty i (summed across its netting sets and
including the effect of collateral as per the existing regulatory rules on collateral applicable
for calculation of counterparty risk capital charge). The exposure at default needs to be
discounted by applying the factor (1-exp(-0.05Mi))/(0.05Mi).
 Bi is the notional of purchased single name CDS hedges referencing counterparty i and
used to hedge CVA risk (also discounted by applying the appropriate discount factor
associated with the maturity of the hedge).
 Bind is the full notional of one or more index CDS of purchased protection, used to hedge
CVA risk (discounted by applying the appropriate discount factor associated with the
maturity of the hedge).
 wind is the weight applicable to the index hedges as mapped to the regulatory weights based
on the average spread of index.
 Mi is the effective maturity of the transactions with counterparty i, measured as the notional
weighted average maturity for each derivative transaction. Mihedge is the maturity of the
hedge instrument with notional Bi and Mind is the maturity of the index hedge.

Table 1: External Rating Based CVA Risk Weight (Standardized Approach)

 As can be seen from the formula above, CVA under the Standardized Approach of Basel III is
computed at a portfolio level. In fact, exposures are aggregated by counterparty, after applying
collateral and netting agreements, and CVA is computed on counterparties of the entire
derivatives portfolio. After that, the contribution of each counterparty to the portfolio CVA is
determined via reallocation methods. Moreover, the portfolio CVA capital under the
Standardized Approach is a Value-At-Risk model with 99% confidence level on a 1 year
horizon, and is applied to the entire portfolio.

While the Standardized Approach formula may appear complicated, if we remove the CDS
and index hedge effects, the simplified formula is as follows:

Where,

i is the i-th Counterparty

Ci = wi * EADiTotal * Mi

Ci represents the regulatory prescribed capital charge required for the i-th Counterparty and
EADiTotal, wi and Mi are as defined above.

If we further simplify the above formula to a two counterparty (1 and 2) portfolio, it is

1
𝐾 = 2.33 ∗ √𝐶12 + 𝐶22 + 2 ( ) 𝐶1 𝐶2
4

From the above equation we see that at a portfolio level, the CVA risk is calculated as a portfolio
standard deviation of CVA risk (with a prescribed correlation of 0.25 across counterparties). The
portfolio standard deviation of CVA risk is multiplied by 2.33 (the standard normal multiplier for
99% confidence level) to obtain the standardized capital charge.

5.3.CVA Capital Charge as per Basel III in India

The Reserve Bank of India has prescribed only the Current Exposure Method for Counterparty
Credit Risk for OTC derivative exposures under Basel II. Under Basel III, it has included the CVA
capital charge and prescribed the Standardized Approach for its estimation. The primary reasons
for curtailing the use of the Advanced Approach would be 1) absence of a liquid bond / CDS
market to derive the market spreads, 2) absence of market based LGD estimates for counterparties.
3) All banks in India are currently using the SMM approach for Market Risk and CEM for CCR
under Basel II.

5.4.Illustration of Total Counterparty Credit Risk Capital, Including CVA Capital under
Basel III

In the following table (Table 2), we demonstrate the calculation of Total Counterparty Credit Risk
Capital for a Bank’s portfolio of two derivative counterparties as per RBI’s guidelines of Basel III.
The external credit ratings of the two counterparties are assumed as A and AAA and the associated
Standardized Approach credit risk weights are 50% and 20% respectively. The cash margin
provided by the first counterparty is an eligible financial risk mitigant and will reducing the
counterparty exposure to that extent.

The bank has done two OTC FX forward deals with Counterparty 1 and one Interest Rate Swap
with Counterparty 2. The Credit Equivalent Exposure to both the counterparties is estimated using
the Current Exposure Method of Basel II. Thus, the Current Exposure of each deal is the positive
mark-to-market value of the deal and the Potential Future Exposure (PFE) of each deal is based on
a standardized PFE add on factor under the CEM method multiplied by the notional amount of
each deal. It is interesting to note here that as per RBI guidelines, netting of positive and negative
deal values to the same counterparty are not permitted. If it were permitted, the current exposure
to Counterparty 1 would be the sum of -1755727 and +1418863, which is -336865. The negative
net value of the deals with counterparty 1 would indicate a current exposure to counterparty 1 as
zero. The counterparty exposures are then adjusted for the available margin. The credit risk capital
for each counterparty under Basel II is derived by multiplying the counterparty exposures by the
respective credit risk weight times 9% (minimum regulatory capital adequacy).

In the second part of the table, the CVA capital for the portfolio of two counterparties is estimated
using the Standardized Approach for CVA described above. Thus, the total counterparty credit
risk capital under Basel III is the counterparty credit risk capital under Basel II plus the CVA
capital under Basel III.
Table 2: Illustration of Counterparty Credit Risk and CVA Capital Requirements

Basel II Counterparty Credit Risk

Counterparty (CP) Counterparty 1 Counterparty 2
External Credit Rating A AAA
CP Risk Weight (Standardized Approach
for Credit Risk) 50% 20%
Cash Margin (INR) 500,000 0
Deal Deal 1 Deal 2 Deal 1
Pay Fixed
Long USDINR Short GBPINR Receive Floating
Bank’s Deal Position Forward Forward IRS
Notional Amount (INR) 63,530,000 199,440,000 3,000,000,000
Remaining Time to Maturity (Years) 0.75 0.25 2.5
Mark to Market Value (INR) -1,755,727 1,418,863 15,000,000
Current Exposure (INR) 0 1,418,863 15,000,000
Potential Future Exposure Add On Factor
(as per Current Exposure Method) 2% 2% 1%
PFE Add On Exposure (INR) 1,270,600 3,988,800 30,000,000
CEM Deal Exposure (INR) 1,270,600 5,407,663 45,000,000
CP Exposure (INR) (Current Exposure
Method) 6,678,263 45,000,000
CP Exposure adj for Margin (INR) 6,178,263 45,000,000
CP RWA 3,089,131 9,000,000
Basel II CP Credit Risk Capital (INR) 278,022 810,000
Basel II Total CP Credit Risk Capital (INR) 1,088,022

Basel III CVA

Counterparty (CP) Counterparty 1 Counterparty 2
h ( = 1 year) 1 1
wi (Standardized Approach for CVA risk
weight) 0.80% 0.70%
Mi (in years) (Weighted Average Maturity
of all deals with Counterparty) 0.37 2.5
Discount Factor (as per Standardized
Approach for CVA) 0.99 0.94
EADi (INR) 6,121,816 42,301,115
Basel III CP CVA Capital 41,958 1,724,828
Basel III CVA Capital for CP Portfolio (INR) 1,735,793
Basel III Total CP Credit Risk Capital (INR) 2,823,815
6. Implications for Regulations and Bank Management

Banks will have to optimize correctly their portfolio by measuring and identifying accurately
counterparties that contribute the most to the CVA of the portfolio. This requires analyzing
concentration risk, as well as analyzing the maturities of each deal and counterparty ratings.
Accordingly, long maturity deals or deals with risky counterparties will increase the capital charge
significantly. Banks will have to diversify their portfolios in terms of number of counterparties
they are dealing with as well as focusing on a homogenous EAD distribution.

The dynamic nature of CVA risk suggests that banks should look beyond regulatory methodologies
and develop internal models to measure counterparty exposures based on simulation of market risk
factors and spread based CVA. These measures should then be actively incorporated into setting
counterparty exposure limits.

While maintaining CVA risk capital is already mandatory for Indian banks under Basel III, the
impending migration to the IFRS accounting standards will increase the volatility in banks’ P&L
due to CVA adjustments to the value of derivative positions. Thus, both for the purpose of capital
relief and to stabilize the P&L, banks must start actively hedging CVA risk. Credit derivatives in
general and credit default swaps (CDS) specifically are the most widely used instruments for
hedging CVA risk. Unfortunately, for the single-name CDS instruments permitted in Indian
markets, derivative exposures to a counterparty cannot be treated as underlying in the CDS.
Similarly, since CVA risk is diversified across counterparties, the portfolio CVA risk should be
permitted to be hedged using index based or multi-name CDS instruments, neither of which are
available in Indian markets.
References:

BIS Statistical release “OTC derivatives statistics” at end-December 2014; Monetary and
Economic Department, BIS, April 2015.

Quarterly Market Analytics; CCIL Economic Research; 2015-16:Q1

Basel III Framework: The Credit Valuation Adjustment (CVA) Charge for OTC Derivative
Trades; Client Publication, Shearman & Sterling LLP, November 2013

Basics of Credit Value Adjustments and Implications for the Assessment of Hedge Effectiveness;
Working Paper, KPMG

CVA capital charge under Basel III standardized approach; Ziad Fares & Benoit Genest

Global Research & Analytics; CHAPPUIS HALDER & CIE; April 2013.

Master Circular – Basel III Capital Regulations; Reserve Bank of India; July 01 2015.

Basel III: A global regulatory framework for more resilient banks and banking systems; Basel
Committee on Banking Supervision; December 2010 (Revised June 2011).