Basel III has ushered in new rules for calculating credit value adjustment (CVA). But rather than being an expensive challenge, if tackled correctly, the new regulation can offer banks a lot more than just compliance, says Quartet FS co-founder Georges Bory

The debate surrounding the new capital charge for CVA continues apace, with regular murmurs of how the risk management community is getting to grips with the new regulation due in 2013. A survey by Fitch Solutions in April this year, for example, revealed that among 200 credit and counterparty risk practitioners, only 32% believed the new regulation will assist them in managing risk more effectively, while 25% thought that it would have the opposite effect and 43% remained unsure.

Designed to introduce better management and understanding of banks' exposure to credit risk, the CVA capital charge was part of new measures on counterparty credit risk within the Basel III regulations declared last December. While other parts of the package - particularly the increase in minimum capital requirements, new counter-cyclical buffer and liquidity ratios - may have the broadest implications, the counterparty credit risk rules could end up having the biggest impact on OTC derivatives dealers. Even though the new regulations have been welcomed by many, the modification is also set to make the CVA calculation far more complex and costly for institutions to deliver.

Changes afoot
Regulations such as this are always a catalyst for change. But, in addition to meeting the new requirements, risk managers need to look beyond pure regulatory compliance. They need to grasp the opportunities presented by the new CVA approach, beyond a simple measuring and reporting tick-box exercise.

As it currently stands, the CVA methodology will make the CVA calculation far more complex than previously outlined and all firms are now subject to the new standardised capital charge, rather than just those that have an approved VAR model. In practical terms, conducting the calculation requires financial institutions to project thousands of scenarios and then aggregate them in a non-linear fashion. This means that banks will have to design scenarios that cover the broad range of trade types, build calculation capacity to run the scenarios and then be in a position to undertake dynamic analysis of these wide ranging data sets.

However, while this new methodology to CVA calculation is undoubtedly more scientific and will empower risk managers with a more robust view of their exposure, it has also raised the issue of the increased cost of calculating the CVA. What's more, because CVA is not static, the challenge lies in being able to aggregate high volumes of data from multiple streams, to produce both the CVA calculation and the ability to drill down into the data in real-time.

In addition, banks have come to recognise that the CVA charge can be linked to the trades that generated it. As such, banks are looking to find ways to enhance their existing technology frameworks to manage the costs associated with CVA by paying greater attention to its use in the front office.

The role of CVA in the front office
Typically, risk managers calculate CVA on a particular week day using 'after the fact' values and, as such, the data and sensitivities are old. Therefore a weekly calculation of CVA does not provide up-to-date information, even if risk managers use some of the sensitivities to approximate daily values.

In response to this, some banks have set up CVA desks. With these desks in place, there is a now a need for a front office tool to calculate the CVA capital charge, its updates and also be able to hedge it.

For example, Citibank has set up CVA desks to consolidate credit risk management within the company. Here traders are in charge of reducing and managing the overall CVA of the bank. Traders are tasked with looking at where the CVA is and then trying to hedge it by buying the appropriate instruments.

Goldman Sachs was reportedly saved by its CVA desk when Lehman Brothers defaulted in 2008.

Long-term benefits
Approached in the right way, the changes to CVA can be an opportunity for financial institutions to go beyond regulatory compliance and develop a valuable operational tool for use by both the front office and risk managers. Since CVA is dynamic, moving with the markets, it allows banks to better predict the future - especially when combined with analytics as outlined above. So, while initial roll-out costs may seem an issue to some, longer term banks that adopt this approach stand to benefit from their clearer picture of risk.

In conclusion, it is likely that over the coming year there may even be further changes to the CVA charge, as some banks are reported to be pressing for a review. But whatever happens, a more proactive stance to managing CVA has become an important consideration for all firms in the aftermath of the credit crisis. If implemented properly, not only will new systems deliver on the regulatory side of the CVA scales but balance this with greater confidence and understanding of risk for the benefit of the business overall.