What’s all the fuss about CVA?
by Kevin Hoff, Senior Manager, KPMG Inc.
Over the past two to three years, an increasing focus has been placed on incorporating credit risk in the fair value of financial instruments. The emphasis can be traced to the global financial crisis and European sovereign debt crisis experienced between 2008 and 2011. These events highlighted the need for more accurate pricing of credit at inception of transactions and the dynamic quantification of credit exposures throughout the life of a trade, to more accurately reflect the inherent underlying credit risk. The crises brought to light weaknesses in the way that financial institutions and corporates across the globe were incorporating credit risk into financial instrument valuation, accounting, disclosure and risk management processes.
Credit risk relates to the risk that a counterparty will default before the maturity/expiration of a transaction and will consequently be unable to meet all contractual payments, thereby resulting in a loss for the other party to the transaction. A valuation adjustment for credit reflects the amount at which such risk is measured by a market participant.
What is CVA / DVA?
The valuation adjustments that have become prevalent across global markets are those that reflect the two-way risk of loss for the reporting entity (the corporate in this case) and the counterparty. These are commonly referred to as a credit valuation adjustment (CVA) – i.e., an adjustment reflecting the credit risk exposure to the counterparty – and a debt valuation adjustment (DVA) – i.e., an adjustment reflecting the corporate’s own credit risk to which the counterparty is exposed.
Although each may be relevant for both derivative assets and liabilities, CVA tends to be most significant for derivative assets and DVA for derivative liabilities.
Why consider CVA / DVA?
The progression of IFRS requirements and changing regulations for banks are encouraging corporates and banks, respectively, to apply CVA/DVA as best practice.
The implementation of CVA by a corporate increases transparency to be able to attribute the risk components of the financial instrument’s pricing, by allowing the credit risk component to be separated out from the pricing relating to other market risks. This in turn allows the corporate to better interrogate the pricing offered by its bankers, in particular relating to the premium charged for counterparty credit risk (CVA at inception).
The calculation of CVA from the corporate’s perspective (i.e., representing the bank’s own credit risk – DVA) allows the corporate to quantify the potential credit risk exposure that it has to the bank over the life of the instrument. This enables the corporate to negotiate the incorporation of the bank’s DVA (corporate’s CVA) in the inception pricing, reducing the overall cost to the corporate. Banks have historically been considered to be risk-free and therefore have not been required to pass on any pricing benefit associated with their own credit risk to corporates. With the introduction of CVA/DVA concepts, this opinion is being challenged across the local and global financial markets.
The requirements of IFRS 13: Fair Value Measurement, effective for periods beginning on or after 1 January 2013, have amplified the focus on incorporating credit/non-performance risk in asset and liability fair valuations. Even though IFRS 13 and IAS 39 don’t provide specific guidance on how this can be achieved or calculated, CVA and DVA have become the generally accepted methods for estimating the valuation adjustment to financial asset and liability prices for credit risk.
With the introduction of Basel III CVA calculation and capital requirements, banks are required to hold capital against CVA volatility. This capital charge is in addition to the existing counterparty credit risk capital charges and represents a further cost to banks for taking on client credit exposures. As with other capital charges, a portion of the cost is likely to be passed onto the corporate customer through the inception pricing, increasing the cost to the corporate for entering into financial instrument trades with a bank.
The impact of the these capital requirements is reduced in South Africa as a result of a directive issued by the South African Reserve Bank, which permits banks to hold zero percent capital for CVA risk attributable to over-the-counter (OTC) derivatives that are denominated and transacted solely in Rand or entered into bilaterally between local counterparties. However this directive is only applicable from 1 January 2014 to 31 December 2014, where after the full Basel III requirements are expected to be adopted.