Credit Valuation Adjustments Some Risk Management and Measurement Issues from a Regulatory Perspective Dr. Colin Lawrence and Dr. Nat Benjamin Prudential Risk Division, Financial Services Authority, UK ASIAN BANKER RISK SUMMIT, 8 th APRIL, 2011.

The CVA Session “Recent proposed changes to the capital charges on CVA have stirred up a storm in the banking community. Is this sufficient for banks to reduce counterparty risks in Asia? To what extent will the changes improve consistency across the banks in Asia?”

Why CVAs are necessary? Take a step back: CVA is necessary: To value derivatives correctly and transparently and therefore risk-manage them properly To recognise losses progressively without waiting for default blow-up and spooking the market with huge bullet loss To note: many banks in the Far East are not calculating CVA at all. This is bad. It means they actually fail any fundamental compliance test. Objective is not to punish banks but Fair Value Counterparty “Credit Risk ”

The Justification of a CVA Approach to Capital Charges  Increase in counterparty risk during the crisis led to huge CVA losses, in particular for monolines. This risk was completely missing from the rules, so CVA capital charge in Basel 3 was indispensible  Basel 3 CVA charge is not just about higher capital, but also incentivising proper counterparty risk management, e.g. Hedging especially using collateral, netting and master agreements.  Basel 3 CVA charge is VaR-based: consistent with the MtM nature of CVA volatility risk  The CVA charge correctly penalises potentially inappropriate CVA hedging, whereby CVA desks increase positions in underlying derivatives to offset CVA volatility: this just increases the underlying economic risk in the balance sheet and can destabilise markets (more on this in the slides).  Use of uniform, consistent CVA capital charge across banks makes the capital cost of derivatives uniform across banks, and hence improves consistency

Definition: CVA Downward adjustment to the valuation of OTC derivatives to reflect counterparty risk into their fair value. Calculated as price of counterparty risk, and hence the present value of expected future counterparty losses on the netting sets concerned:

Definition: CVA Based on term structure of the expected exposure to the counterparty, reflecting netting rules and projected values of instruments in the netting sets.

Materiality During the last crisis, counterparty losses were mostly incurred through CVA rather than actual defaults. The creditworthiness of counterparties deteriorated, their spreads increased and this impacted negatively the fair value of derivative transactions passed with them despite the fact that few defaulted. Very substantial losses were incurred during the crisis due to CVA, in particular in situations of wrong-way risk as in the case of exposures to financial guarantors (monolines). For some firms this constituted a major portion of overall trading losses. Materiality: up to several billions of losses, sometimes in short timeframes, especially for banks with monoline exposures CVA losses by themselves constituted 24% of losses aggregated across the 10 largest UK regulated banks between January 2007 and March 2009.

CVA Risk Management Practices Many large firms have set up CVA desk, with mandate to hedge CVA volatility. Counterparty risk transferred from derivatives desks to CVA desk. The CVA desk is often managed like any other trading desk, with its trading VaR and limits. CVA DeskTrading DeskCounterparty Change in fair value Change in CVA Change in CVA hedge value CVA Hedge provider Bank Natural CVA hedging instruments: CDSs to offset CVA volatility due to a changes in the creditworthiness of the counterparty. IR swaps, FX forwards, etc. to offset CVA volatility due to changes in counterparty exposure.

Treating CVA as a standalone complex instrument: undesirable consequences. Huge basis risks linked to time horizon, pricing, basis risk and measurment. Building up hedge positions with same sensitivities as underlying derivatives offsets CVA volatility, but increases the overall economic risk on the balance sheet. Can destabilize markets: 2010 Euro crisis, volatility higher at long end of IR swap curve, exacerbated artificially by CVA hedging activities. Self-exciting process. CVA Risk Management Practices

Conclusions Partial equilibrium delta type hedging can lead to even overall greater exposure. Doubling up of same position! DE FACTO YOU ARE HEDGING A STRIP OF CONTINGENT RISK FACTOR DIGITALS. MASSIVE CONVEXITY EXPOSURE. AND ADDING MORE COUNTERPARTY RISK The actual hedge is often not appropriately hedged. In fast paced trading world illiquidity is ignored and convexity shifts in Pds not accounted for; Capital requirements must be placed on overall positions not on narrow delta hedging; CVAs needs to undergo stringent product control and valuation uncertainty scrutinise; Regulation will continue looking at the entire exposure which includes all aspects of the trade, the counterparty, the booking of the trade and he balance sheet. CVA is necessary to incentivise appropriate pricing of risk and optimal hedging of this risk especially with collateral managment. DONT GET RID OF IT!

CVA Risk Management Practices In addition, CVA hedging strategies often do not take account of the credit risk nature of CVA, and CVA desks can tend to take positions in any instrument whose sensitivity to a risk factor offsets that of CVA. Example: positions in interest rate swaps to offset CVA spread sensitivities. Risk management practice disconnected from the analysis of true economic risk. CVA risk measurement and hedging strategy should be based on the entire fair value of the derivatives, not just a portion of it. Need to articulate suitable sequencing order when looking to offset CVA sensitivities and lay out the types of instrument that provide a sound economic hedge to each sensitivity. Typical basis risk and hedge mismatches: Use of non-credit-related instruments (e.g. IR swaps) to hedge CVA spread sensitivity. Use of proxies (e.g. index CDSs) to hedge single-name spread sensitivity.