The measurement of migration risks for OTC derivatives
The coming into force of CRD IV and CRR means that additional capital requirements for credit valuation adjustment (CVA) risks are necessary. They are supposed to reflect the risk of negative changes in OTC derivative markets in response to a deterioration in the credit quality of a counterparty. The capital requirement has to be determined on the basis of a so-called CVA charge. Banks that have no authorisation for their internal models, which measure derivative counterparty credit risk positions, have to calculate the CVA charge according to the standardised method. The most important input factors here are the exposure at default (EAD) values of each netting set that usually have to be calculated according to the Current Exposure Method - from 01.01.2017 probably according to the "Standardised Approach for Measuring Counterparty Credit Risk“ (SA-CCR). Other factors in the form of risk weights have to be assigned via the internal and external ratings of the counterparties. Hedges that use CDS and CDS indices can be reflected in the calculation of the CVA charge and will lower the capital requirement.
IMM-approved banks, which have approval for internal models for the calculation of the specific risk of a change in bond interest rates, calculate the CVA charge, in accordance with the advanced method, as Value at Risk (VaR) on the basis of simulated / varying credit spreads of the individual counterparties. The VaR has to be calculated under current market circumstances and, additionally, under stressed market circumstances. In the course of this, a 10-day VaR with a confidence level of 99 per cent has to be determined. Hedges that use CDS and CDS indices, analogous to the Standardised Approach, can be reflected in the calculation of the CVA charge and will lower the capital requirement.
The market value of the credit risk exposures of individual institutions vis à vis a counterparty (Debit Valuation Adjustment) may not be taken into account to reduce the capital requirement. From a regulatory point of view, the risk of a change in an institution's credit quality is not relevant. On the contrary, a DVA that is recognised in the balance sheet (e.g. in the case of mark-market liabilities) has to be deducted from capital as a prudential filter.
According to IFRS 13 Credit and Debit Valuation Adjustments are Fair Value Adjustments
In contrast to the regulatory treatment of CVA, fair value adjustments have to be made for both CVA as well as for DVA. The methodology is applicable to both components equally. For calculations in accordance with IFRS 13, parameters that are as relevant as possible to the market (can be observed in the market) should be used. This is because, in contrast to the CVA charge, which as the VaR takes into account both the volatility of credit spreads as well as of stressed parameters, the adjustment that is calculated serves as a snapshot at a specific time. It reflects the market value of a counterparty's credit risk exposure vis à vis the institution (CVA), or that of the institution vis à vis the counterparty (DVA).
The important input factors here, the same as for the CVA charge, are the future exposure values for each netting set. These can be determined on the basis of a so-called Monte Carlo simulation, or by using a model with parameter add-ons. At this point, regulatory EAD values tend not to be a suitable market valuation method.
CVA and DVA, as a rule, are determined on the basis of netting sets. If the valuation adjustment relates to instruments that, for example, represent different levels in the fair value hierarchy, then the valuation adjustment has to be allocated to the specific instruments. Likewise, under the COREP and FINREP reporting frameworks, it is necessary to make an allocation to the specific positions.
We can provide support for both the calculation of regulatory values as well as for valuation adjustments in accordance with IFRS 13 in the following ways
- Tool creation for the automatic calculation of the CVA charge according to the Standardised Approach
- Technical support and implementation for the calculation of the CVA charge according to the advanced approach. In particular, the implementation of the standards specified in the EBA document: "FINAL draft Regulatory Technical Standards on credit valuation adjustment risk for the determination of a proxy spread and the specification of a limited number of smaller portfolios under Article 383(7) of Regulation (EU) No 575/2013 (Capital Requirements Regulation CRR)”
- Selection of software solution for the calculation of the exposure (EE, PFE) as well as expert reviews of the models of software providers
- Determination of EAD for counterparty risks according to the Current Exposure Method, the Standardised Approach, or according to the new SA-CCR, which is expected to replace the other two current methods in 2017
- Technical support and implementation for determining valuation adjustments in accordance with IFRS 13
- Allocation of valuation adjustments and the CVA charge on specific business levels
Apply experience to the future
The SKS Group has already been able to successfully carry out the most diverse and most complex projects in the sphere of the CVA charge as well as in the determination of CVA and DVA for valuation adjustments within the scope of IFRS 13. You, too, can benefit from the high-quality yet also pragmatic solutions that SKS can provide.
Within the scope of the CVA charge according to the Standardised Approach, in future, the exposure values will have to be calculated on the basis of the so-called "SA-CCR". The SKS Group took the NIMM (non-internal model method, the precursor to the SA-CCR) regulations and, at that time, successfully transferred them to an Excel tool and, as part of a QIS on the NIMM, was able to apply it in several banks. This tool has already been adapted to the new Standardised Approach and can provide you with support in all aspects of the implementation of SA-CCR.
We can provide you with forward-looking, detailed and expert professional advice. Upon request, we would be very pleased to go to your offices for a personal meeting to discuss your requirements.