Introduction and background

The CVA framework covers OTC derivatives and, if deemed material, securities financing transactions as well. These harbour not only market risk, but also credit risk: A deterioration in the credit quality of the counterparty in a transaction has a negative effect on the value of the transaction. The higher the potential exposure to the counterparty, the greater the resulting absolute loss in value. 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 creditworthiness, that could potentially change. 

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 value of the transaction (market risk), or by a combination of both.

Own Funds Requirements

During the financial crisis, banks incurred significant CVA losses, which led to the decision to include a capital requirement for CVA in the Basel III framework and the CRR. Institutions can generally use the CVA basic approach (BA-CVA) to determine own funds requirements. The calculation is performed using a predefined formula based on certain characteristics of the relevant transactions (e.g. maturity, exposure value, and the credit quality of the counterparty). There are two configurations of the basic approach available, one allowing to take hedge positions into account, and the other not. Under certain conditions, an institution may also use the easier to implement simplified approach instead of the basic approach. 

This approach is based on the own funds requirements for counterparty credit risk. Institutions also have the option of applying to the competent authority for authorisation to use the CVA standardised approach (SA-CVA). This approach is based on sensitivities and is more risk-sensitive but also more intricate to implement.