The global financial crisis brought Counterparty Credit Risk and credit value adjustment (CVA) very much into the spotlight. The Basel III proposals first published in December 2009 introduced changes to the Basel II rules including a new capital charge against the volatility of CVA. As the Basel committee noted, two thirds of the counterparty risk related losses during the credit crisis were actually from CVA volatility rather than defaults. Not surprisingly then, the new CVA ‘VaR capital charge is quite punitive and worthy of focus.
There are two ways for a bank to compute CVA VaR--what are commonly called the standardized and the advanced methods. The alternatives available to a bank depend on its current regulatory approval within related aspects of Basel III. Under both methods there is also the potential to reduce the capital charges via eligible hedges. In this article, Dmitry Pugachevsky, Director of Research, Quantifi and Rohan Douglas, CEO, Quantifi explore the capital charges under the two regimes and the capital relief that can be achieved using hedging.
These new capital charges can be calculated using either a simplified standardized formula or an advanced method that requires calculating the CVA VaR of the full portfolio using a Monte Carlo model approved by regulators.
We show there that in risk management terms, the standardized formula has the interpretation as being the 1-year 99% CVA VaR under normal distribution assumptions for the portfolio of netting sets (with individual hedges included) with additional index hedges applied to the whole portfolio. For the advanced method, Basel requires calculating two 10-day 99% VaR’s of CVA changes: for the current one-year period and for one-year stressed period defined as increasing credit spreads.