Fluttering and falling: banks’ capital requirements for credit valuation adjustment (CVA) risk since 2014

Giulio Malberti and Thom Adcock

The financial crisis exposed banks’ vulnerability to a type of risk associated with derivatives: credit valuation adjustment (CVA) risk. Despite being a major driver of losses – around $43 billion across 10 banks according to one estimate – there had been no capital requirement to cushion banks against these losses. New rules in 2014 changed this.

This article uses data from banks’ disclosures to see how CVA capital requirements have evolved since their introduction. Interestingly, these trends in CVA capital requirements might be a reflection of broader changes in derivatives markets.

What is the credit valuation adjustment?

Derivatives create several types of risk:

  1. Market risk, ie the risk of losses from movements in market prices, such as interest rates, FX rates and commodity prices. For example, if you enter into a derivative contract to buy a barrel of oil at a given price on a given date, you will make a loss if the price of oil decreases below the agreed price.
  2. Counterparty credit risk, ie the risk of your counterparty defaulting on amounts they owe you. For example, if you enter into a derivative contract to buy oil at a given price, and the price of oil is now above that price, you are at risk that your counterparty defaults before the trade matures.

Many derivatives are cleared, which means a specialist organisation (a clearing house) acts as an intermediary and assumes the role of both buyer and seller in a transaction. Transactions subject to margin requirements typically create low or no CVA capital requirements. Cleared transactions usually take this form. Due to this and other mitigants, they often have very low counterparty credit risk. Other derivatives are not cleared, for example if counterparties trade bilaterally with no intermediary.

With non-cleared derivatives, each party faces the risk that the other’s credit quality deteriorates. Derivative prices as listed on financial platforms may not fully adjust for this risk. But accounting rules often require that the value of derivatives in accounting statements should include an adjustment to reflect counterparty credit risk. This accounting adjustment is the credit valuation adjustment (CVA), and is in some ways similar to an expected loss provision on a loan. Of course, the characteristics of most derivatives make the calculations more complex.

Recognising CVA means that changes in a counterparty’s credit quality over the life of a derivative can result in a profit or loss in banks’ accounts. This means a bank can record immediate losses related to counterparty risk even when there is no default and even if all cash flows associated with the derivative are subsequently paid – the increased likelihood of default is enough to generate losses for banks.

CVA became particularly relevant in the financial crisis. The Basel Committee estimated that roughly two-thirds of losses associated with counterparty creditworthiness were due to CVA losses and only one-third were due to actual defaults. A report by the UK Financial Services Authority (the predecessor of the Financial Conduct Authority and the Prudential Regulation Authority) estimated $43 billion of CVA losses across 10 banks from 2007 to 2009. 

The regulatory framework for CVA risk

The losses incurred by banks during the financial crisis showed that there was a big gap in the capital framework that left CVA risk uncaptured. New standards from the Basel Committee in 2010 (implemented in 2014) introduced a regulatory charge to capitalise for the possibility of increases in CVA. This capital requirement is typically more material for derivatives with long maturities and with poorly rated or unrated counterparties. Cleared derivatives typically do not generate large CVA capital charges.

There are two approaches for determining CVA capital. The first is a simple approach – ‘standardised CVA’ – that adjusts for the credit quality (eg AAA, BBB) of the counterparty and the residual maturity of the derivative. The second is a model-based approach – ‘advanced CVA’ – where the models are similar to the ones built for market risk. A recent study by the Basel Committee shows that CVA capital across both approaches is 1.4% of total minimum capital requirements for large banks.

Long-term trends in CVA risk-weighted assets (RWAs)

We used Pillar 3 disclosures (mandatory disclosures that banks make to promote market discipline and transparency) from 15 global systemically important banks (G-SIBs, of which 10 from Europe and 5 from the US) to see how CVA capital requirements have evolved since their introduction. We found two striking trends:

  • First, we found a long-term decline in capital requirements for CVA risk despite there being no change in the CVA capital rules: risk-weighted assets (RWAs, a regulatory measure that directly determine banks’ capital requirements) for CVA risk fell by more than 60% between December 2014 and December 2018 for more than half of the G-SIBs in our sample.
  • Second, we found high volatility in CVA RWAs over relatively short periods: yearly changes in RWAs of over 30% are common across our sample of globally systemic banks.

Chart 1 shows the declining trend in RWAs, where the median bank has seen a 62% decrease. The trend is more evident in Europe, where CVA RWAs went down by almost 70% for the median bank in the sample.

Chart 1: G-SIBs CVA RWAs (31 December 2014 = 100)

Yearly changes in RWAs of 30% or more are common across our sample of G-SIBs (Chart 2), despite there being no major changes in the regulatory rules for CVA capital over the period. Across the 15 banks in the sample, 12 of them show at some point in the last three years an annual change (up or down) of over 30%. Four showed an annual change of over 50% at some point in the last three years.

Chart 2: Yearly change in CVA RWAs

What could be driving these trends?

There are many plausible reasons for the long-term decline:

  • After the financial crisis regulators introduced a number of regulatory changes to incentivise clearing of derivatives and reduce counterparty credit risk. A recent report shows that clearing levels (as measured by notional amounts outstanding) for interest rate derivatives increased from 24% in 2009 to 62% in 2017. Since cleared derivatives do not generate large amounts of CVA capital, increased clearing tends to reduce CVA capital requirements.
  • New rules also make initial margin mandatory for many non-cleared derivatives. These are scheduled to be implemented by 2021 in six phases, with many important entities already subject to these rules.
  • Data from the Bank for International Settlements (BIS) suggest that derivatives volumes have declined in recent years, partially due to greater use of trade compression techniques (ways to reduce the number of derivative contracts but keep the same economic exposure). Globally, the notional amount of over-the-counter foreign exchange (FX), interest rate and equity-linked derivatives decreased from US$609 trillion in the first half of 2014 to US$534 trillion in the second half of 2018.
  • Banks themselves might now be willing to engage in different forms of transaction, for example with less counterparty credit risk, and might have developed the capabilities to make greater use of hedges to reduce their CVA capital requirements (mainly Credit Default Swaps, which provide insurance against counterparty risk).
  • And credit conditions might have improved over the period (following the European debt crisis and continuous recovery from the financial crisis).

The trend is likely to be explained by a combination of these reasons. And it may be expected to continue; as the scope of transactions subject to mandatory margining increases, CVA RWAs may fall further.

The volatility in CVA RWAs is more difficult to explain. Some could be explained by the factors mentioned above – since much of the volatility is caused by large negative changes. In other cases, large reductions or increases in CVA RWAs may be due to bank-specific factors (eg exiting certain markets, or large-scale restructuring of investment banking activities).

What is clear is that the nature of derivatives markets has changed quite significantly in recent years, and the risks associated with those markets have changed as a result.

Giulio Malberti and Thom Adcock work in the Bank’s Banking Policy Division.

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