Art and Science: Credit Valuation Challenge II

Marking Your Own Homework
For banks, selling insurance on their own institution for counterparties in the case of default is problematic for obvious reasons. For this, a closer look at the data is required, and debt valuation adjustment (DVA) needs to be considered.

Put simply, DVA is a form of inverse CVA—if the latter is an assessment of a firm’s counterparty’s creditworthiness and probability of default, then DVA is an assessment of its own risk of default. It has proved controversial as an accounting practice, particularly with its use during the financial crisis, with one industry practitioner describing it as “perverse.” This stems from the idea that as the value of a company’s debt decreased, the company in question would often then book that as a profit, although the amount of money owed remains largely unchanged. Therefore, the declining credit quality of a bank, for instance, proved to be a positive development.

“There’s been a lot of discussion around CVA reporting, and if you look at a lot of banks’ reports, the DVA is one of the big impacts that hit the earnings bottom line,” says Denny Yu, product manager for risk at Numerix. “Banks like Citigroup last year reported nearly $2 billion in earnings, and that was just from a paper gain in DVA. Citigroup’s spreads widened and their liabilities reduced, so DVA came in as a gain. A lot of banks are now trying to evolve to either hedge that volatility by hedging the CVA component, and DVA, but we’re seeing that as more and more try to do this, there’s crowding in the kinds of trades and securities that are used for this. For the counterparty piece, these are CDS, and the CDS Main and CDX indexes. With crowding in these markets, there might be the introduction of systemic risk, because everyone is using the same types of trades. Liquidity will be constrained, and as we move into a new paradigm of centralized clearing, we’ll see squeezes on initial and variation margin.”

The Basel Question
Much has also been made of the latest rules on counterparty credit management in Basel III. Whereas Basel II dealt with counterparty default risk in broad strokes, the latest iteration of the accord introduces an additional capital charge for mark-to-market (MTM) losses on the expected CVA. Institutions now have to calculate the additional capital requirements using a Value-at-Risk (VaR) model that assesses the impact of changes in the counterparty’s credit spread, to satisfy compliance.

Common criticism, such as that from Capco Institute director Damiano Brigo in the previous part of this feature, holds that the Basel Committee is attempting to enforce a standardized solution onto a non-standard problem. Heightened charges, such as Basel’s CVA provisions and subsequent capital adequacy requirements, are certainly having real effects. At a recent Risk conference in the US, for instance, Oliver Jakobs, head of investment banking market risk at UBS, cited CVA charges as one of the reasons it set about closing its fixed-income division. UBS declined to comment on its CVA operation in time for publication.

“What Basel III has done is add an extra cost of capital that factors in the CVA swing, and this adds another calculation that you have to do,” explains Quantifi’s Pugachevksy. “You can do this either in standardized form, or in advanced form. Standardized isn’t that hard—it doesn’t add much burden, and you can do this using more additive quantitative calculations. It’s more punitive in most cases, so most banks will try to use advanced methods, although they may not have a choice if they have internal models for CVA, as they then have to use it. The advanced formula requires the calculation of CVA VaR. Calculating it, again, isn’t that hard, but you have to repeat it using stress-tests, and change your spreads and exposures. Basel III isn’t clear on how to do this, but it is a burden because you have to store the historical data and recalculate with VaR.”

In addition, disallowing the use of internal models for all but the most advanced banks creates an ill-informed picture of exposure and adequate risk provision. As the Basel CVA VaR calculation only takes into account the risk associated with credit spreads, it ignores the other sensitivities that typically have an effect on derivatives trades, such as changes in foreign exchange (FX) rates and anomalous market events.