Credit value adjustment needed to incentivise pricing of risk and optimal hedging
Colin Lawrence, director, prudential risk division, Financial Services Authority, UK, discusses the credit valuation adjustments necessary to save banking as we know it. April 19, 2011 | Colin LawrenceRecent proposed changes to the capital charges on credit value adjustment (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? CVAs are a necessity to value derivatives correctly and transparently and thereby manage the risks properly. They are also necessary to recognise losses progressively without waiting for default blow-ups. Currently, many banks in Asia are not calculating CVA at all, which means they actually fail any fundamental compliance test. Increases in counterparty risk during the crisis led to huge CVA losses, in particular for businesses that concentrate one specific business area. This risk was completely missing from the rules, so CVA capital charge in Basel III has become indispensible. The Basel III CVA charge is not just about higher capital, but also incentivising proper counterparty risk management, for example; hedging especially using collateral, netting and master agreements. 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. Use of uniform, consistent CVA capital charge across banks makes the capital cost of derivatives uniform across banks, and hence improves consistency. The actual hedge is often not appropriately hedged. In the fast-paced trading world, illiquidity is ignored; capital requirements must be placed on overall positions, not on narrow delta hedging, and CVAs needs to undergo stringent product control and scrutinise valuation uncertainty. Regulations will continue to look at the entire exposure, which includes all aspects of the trade, the counterparty, the booking of the trade and the balance sheet. Slide 1: CVA definition<... Please login to read the complete article. If you already have an account, you can login now or subscribe/register.
Categories: Asian Banker Summit 2011, Risk and Regulationsummit 2011,Risk and Regulation, Asian Banker Summit 2011,Risk and Regulation, Keywords:CVA CVA
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