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EBA Report on CVA Summary

Core Content

This document is the EBA Report on Credit Valuation Adjustment (CVA) and a Review on CVA charges to non-financial counterparties (NFCs) established in a third country, both issued in February 2015. It provides an analysis of the CVA framework under the Capital Requirements Regulation (CRR), including its scope, calculation methods, eligible hedges, and the impact on industry practices. The report also outlines policy recommendations to improve regulatory consistency and alignment with actual risk exposure.

Main Views and Key Information

1. CVA Risk Charge under CRR

• Article 456(2) of the CRR mandates the EBA to monitor CVA risk and report on the treatment of CVA as a stand-alone charge or an integrated component of market risk.
• The CVA risk charge includes:
  • Scope: Covers OTC derivatives and Securities Financing Transactions (SFTs), but excludes exchange-traded derivatives.
  • EU Exemptions: Some counterparties are exempt from the CVA risk charge based on Article 482 of the CRR.
• The Basel CVA framework was introduced to address CVA losses during the financial crisis. It defines two methods:
  • Advanced CVA (A-CVA): Uses internal models and market-implied data.
  • Standardised CVA (S-CVA): Relies on a regulatory formula and predefined parameters.
• DVA and FVA are also included in the CVA risk charge, but the Basel framework has faced criticism for its conservatism, inconsistency, and potential market distortions.

2. Industry Practices and Convergence

• Banks are increasingly using market-implied data (e.g., CDS spreads) to reflect CVA in the fair value of derivatives.
• Accounting practices vary, with some institutions using historical default probabilities rather than fair value adjustments.
• The IFRS 13 framework requires institutions to use observable inputs for fair value measurement, while national GAAPs may allow different approaches.
• Convergence in CVA practices has been observed due to IFRS 13 and Basel CVA implementation.

3. Impact of CVA Risk Charge

• Higher trading costs for clients due to the inclusion of CVA in capital requirements.
• Increased collateral usage to mitigate CVA risk.
• Changes in modeling practices and a greater reliance on credit derivatives as eligible hedges.
• Shift from hedging CVA P&L to hedging CVA risk charge rather than the underlying profit and loss.

4. Policy Recommendations

The EBA proposes the following recommendations to improve the CVA framework:

1. Clarify the scope of CVA risk charge to include exchange-traded derivatives.
2. Harmonise the treatment of SFTs in the EU.
3. Reconsider EU exemptions for NFCs, as they may lead to underestimation of CVA risk.
4. Implement a coordinated approach for yearly monitoring of exempted transactions and identifying excessive CVA risk situations.
5. Move the definition of 'clearing member' and 'client' to Article 4 of the CRR for clarity.
6. Reconsider the treatment of indirect clearing in light of international regulatory developments.
7. Allow alternative proxy spread methodologies for counterparties where credit spread data is not available.
8. Amend the Regulatory formula for the advanced method to reflect netting set seniority.
9. Clarify the computation of the standardised method, especially the term $M_i \times EAD_i^{Total}$.
10. Remove the Original Exposure Method (OEM) for CVA risk charge, as it is not sufficiently risk-sensitive.
11. Amend CRR Article 386 to clarify eligible hedges for both advanced and standardised methods.
12. Move CVA to the market risk framework and treat it as a fair value adjustment subject to prudent valuation.
13. Allow proxy hedging subject to specific conditions.
14. Enable advanced institutions to use internal CVA pricing models for capital calculations.
15. Align the CVA framework with internal practices to better reflect actual risk.

5. Review on NFCs in Third Countries

• The CRR Article 382(5) mandates the EBA to review the application of CVA charges to NFCs established in third countries.
• The current exemption for NFCs is based on EMIR clearing threshold, which may be inadequate.
• The EBA recommends a revised approach for excluding NFCs from CVA risk charge, ensuring international consistency and relevance.

Key Findings from Data Collection Exercise

• 32 European banks participated in the data collection exercise.
• There is a convergence in CVA practices, with most institutions using proxy spreads and CDS data.
• Accounting and prudential scopes are often misaligned, leading to discrepancies in CVA risk assessment.
• The impact of removing EU exemptions is significant, with potential increases in CET1 capital ratios.
• The proxy spread methodology is used for most institutions, but there are challenges in identifying and removing exempted transactions.

Conclusion

The EBA report highlights the need for a more aligned and consistent CVA framework across the EU and globally. It recommends revising EU exemptions, clarifying the scope, and integrating CVA into the market risk framework. These changes aim to ensure that regulatory capital requirements reflect actual CVA risk exposure, reduce market distortions, and promote prudent valuation and effective risk management.