Art and Science: Credit Valuation Challenge II

More so, the rise in capital adequacy requirements and the instruments eligible for counting against CVA charges can push institutions into inadvisable procedures, a potential unintended source of systemic risk. “I’d say the fact that to achieve capital relief incentivizes banks to stop hedging certain risks, which are easily hedge-able, and attempt to hedge even illiquid credit risks, is the biggest worry,” says Gregory.

Onerous Costs
As the credit market for counterparties that may be small or mid-sized is illiquid at best, systemic risk is therefore engendered from those who choose not to hedge the CVA due to onerous costs and keep the risk on their books.

A briefing note from the Association for Financial Markets in Europe, issued following the Basel recommendations, reads: “A consequence of this approach is that institutions that use effective hedges for exposure to reduce exposure volatility but that are not considered eligible for CVA risk capital are subject to higher capital requirements compared to institutions that choose not to hedge their CVA risk. This may result in institutions choosing to carry higher risk in order to avoid penal capital requirements.”

Also important for the computing of regulatory CVA is the inclusion of “wrong-way” risk, defined by the International Swaps and Derivatives Association (ISDA) as risk that occurs when default risk and credit exposure increase together. As well as the computational loads associated with risk calculation, stress-testing and scenario analysis are integral parts of satisfying wrong-way risk mandates. Various stochastic equations, those that measure seemingly random behaviors, have been developed by academics to integrate wrong-way risk with CVA calculations, with standardized stress-tests quantifying CVA changes for areas such as credit, stressed market data, volatility, mean reversion, and other areas.

Salient Points

• While credit valuation adjustment (CVA) in itself is a demanding technical operation at the best of times, hedging CVA requires further investment both in multi-asset trading software, and advanced computational methods to factor in wider volatility data.
• Basel III expands on its previous iteration's requirements for counterparty credit risk management, increasing costs and changing the equation with the addition of Value-at-Risk (VaR) to CVA calculations. While the standard prescription is relatively simple, technical challenges occur with the use of internal models and the advanced calculation.
• For larger banks, centralized CVA desks are the practical solution for managing the problem, as well as for hedging it, although further advanced quantitative groups will also be required for simulating proxies when dealing with counterparties for which credit spread information isn't readily available, or which don't have their own CDS for default protection.