Managing XVA risk is crucial for ensuring the stability and profitability of financial institutions in the dynamic banking world. XVA, or valuation adjustments, refers to a set of adjustments made to the fair value of derivative contracts to account for various risks, including credit, funding, and counterparty credit risks.These adjustments are becoming increasingly important, as banks face stricter regulatory requirements imposed by Basel IV, the fourth instalment of the Basel Accords. In this study, we explore the various XVA and CVA risks in particular. In addition, we discuss Basel IV changes and their implications.
The concept of XVA risk emerged in the early 2000s as banks recognized the need to incorporate non-credit risks into the valuation of derivative portfolios. Traditionally, fair value was determined using models that assumed perfect creditworthiness and zero default risk, also known as the law of one price described by John Hull in his famous book Options, Futures, and Other Derivatives. However, as credit markets become more volatile, these assumptions become increasingly unrealistic.
The potential violation of the law of one price by XVA risk has implications for both pricing and risk management. In terms of pricing, this suggests that the fair value of a derivative contract may not be sufficient to capture all risks associated with the contract. Consequently, it may be necessary to incorporate XVA adjustments into pricing models to ensure that prices are accurate and reflect the true risks involved.
In terms of risk management, the XVA risk needs to be considered separately from the market risk of the underlying derivatives. This is because XVA risk can arise from factors that are not directly related to the market price of derivatives, such as the creditworthiness of counterparties and the liquidity of funding markets.
The 2008 financial crisis highlighted the importance of XVA risk management. The collapse of Lehman Brothers and the subsequent market turmoil exposed banks to significant losses due to counterparty defaults and funding/liquidity issues. Regulators and industry bodies have begun to develop standards for measuring and managing the XVA risk.
XVA is a comprehensive framework that encompasses a set of derivative valuation adjustments designed to account for the various risks associated with over-the-counter (OTC) derivative transactions. The 'X' in XVA represents a collection of adjustments:
CVA is a measure of the additional loss that a bank may incur in an OTC derivative transaction if its counterparty defaults. This loss can arise from a variety of factors such as the unwinding of the derivative position at a loss, the potential for legal action, and the costs associated with bankruptcy proceedings.
The CVA is calculated based on several factors, including
Several possibilities exist in practice to determine CVA. Unilateral and bilateral CVA are differentiated. In the first case, the bank considers only the counterparty’s creditworthiness. However, in the bilateral approach, banks’ default risk is included. Only a unilateral approach can be used for regulatory purposes. CVA can be determined at the portfolio, counterparty, netting-set, or individual transaction levels.
The current CVA framework according to the CRR allows for two methods to determine the CVA risk capital charge: the advanced method with supervisory approval and standardized approval. Both methods are designed such that only the credit spread risk of the counterparty is considered as the sole driver of CVA risk.
The revised framework pursuant to CRR 3 consists of two subframeworks (SA-CVA and BA CVA) and a simplified approach. The Standard Approach (SA-CVA) is designed for banks to calculate CVA sensitivities to various risk factors and requires supervisory approval. The Basic Approach (BA-CVA) builds further upon the current standard model, and the simplified model can only be applied if the off-balance sheet derivatives business is below 5% of the total assets and is not deemed material.
The Basel Committee pursues the following goals within the new CVA framework:
In addition to OTC derivatives also SFT (Securities Financing Transactions (SFTs) are to be included in the calculation of the own fund’s requirement if the CVA risk is determined material.
Regarding the existing exemptions for the CVA calculation, Article 382(4) CRR 3 does not provide any changes. The following transactions are still not considered in the CVA risk calculation:
Nevertheless, articles 382 (4a and 4b) in CRR 3 introduce a new provision requiring institutions to report the results of the calculation of their own funds requirement for CVA risk for exempted transactions.
In response to the Basel IV changes, banks have adopted a range of strategies to manage CVA risk effectively:
By more accurately calculating CVA, banks can better manage their counterparty credit risk, improving their overall risk profile and enhance their risk management.
As BASEL IV reshapes the regulatory landscape for banks, the calculation and management of XVA for OTC derivatives will undergo significant changes. Financial institutions must adapt to new requirements, invest in technology and data infrastructure, and enhance risk management practices.
The future of XVA under BASEL IV holds both challenges and opportunities. While compliance with new requirements may increase costs and complexity, it also provides an opportunity for financial institutions to strengthen their risk management frameworks and improve the accuracy of XVA calculations.
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