The global financial crisis brought counterparty credit risk and CVA very much into the spotlight. The Basel III proposals first published in December 2009 introduced changes to the Basel II rules and the need for a new capital charge against the volatility of CVA. This ‘CVA VaR’ capital charge was always likely to be punitive since the Basel committee considered that it referenced two thirds of counterparty risk related losses. However, there are two ways for banks to compute CVA VaR, so-called standardised and advanced methods, which depend on their current regulatory approval with respect to other aspects. Furthermore, there is the potential to reduce the capital charges via eligible hedges.
There are two ways for banks to compute CVA VaR, standardised and advanced methods, depending on their current regulatory approval. Furthermore, firms can potentially reduce the capital charges via eligible hedges. This paper reviews the two regimes by:
- Describing and comparing the various methodologies for calculating counterparty credit risk capital under Basel regulations
- Analysing these methods in detail and demonstrating that both standardised and advanced formulas can be interpreted as 99% VaR of losses due to CVA volatilities; thus simple comparative analysis can be done based on CVA volatilities and correlations implied by the methods
- Running simple tests for three methods: standardised (CEM), standardised (IMM) and advanced to investigate which one performs better for various maturities and different types of counterparties
- Analysing results for a real portfolio and highlighting that the difference in capital between the simple and more advanced approaches when considering hedging can be significant
