Risk of a credit valuation adjustment (CVA)
Introduction and background
The credit valuation adjustment (CVA) framework is designed for OTC derivatives. These harbour not only market risk, but also credit risk. A deterioration in the credit quality of the derivative counterparty has a negative effect on the value of the derivative. The resulting absolute loss in the value of the derivative is greater, the higher the price of the derivative is. The described relationship between market risk and credit risk can be measured by looking at the difference in value between a credit-risk-free portfolio and an identical portfolio that takes into account a potential change in creditworthiness. This difference in value is termed the credit valuation adjustment (CVA). Credit institutions are required to measure the risk of a change in CVA values (CVA risk). As described, a change in CVA values may be caused by a change in the credit quality of the counterparty (credit risk), by a change in the absolute price of the derivative (market risk), or by a combination of the two.
During the financial crisis, banks incurred significant CVA losses, and it was therefore decided to introduce a capital requirement for CVA in the Basel III framework and the CRR. Therefore, with some exceptions, capital has to be held against CVA risk for all OTC derivatives.
At present, two methods are available for calculating the capital requirements. Institutions generally have to use the standard CVA approach. The calculation is performed using a predefined formula based on certain components of OTC derivatives trades (eg maturity, amount, and the risk weight of the counterparty). Under certain conditions, institutions have to calculate the capital requirements using an internal CVA model – these conditions are fulfilled at present by only a few, large institutions with an extensive OTC derivatives portfolio.
The current CVA framework, too, has been under revision in Basel. The internal CVA model approach is being discontinued, which means that only the Standardised Approach for CVA will be available in future. In keeping with the principle of proportionality, this contains a range of methodologically and conceptually different calculation options. It is thus ensured that the institutions will have available to them a suitable standardised CVA approach for calculating the capital requirements that is consistent with the complexity and scale of their OTC derivatives portfolios.