The new Standardised Approach for calculating counterparty credit risk (SA-CCR) is set to replace the two current standardised approaches formally known as the Current Exposure Method (CEM) and the Standardised Method (SM). The focus therefore shifts towards the effects of SA-CCR on banks’ over-the-counter (OTC) derivative trading and compares its associated burden with that of its only alternative, the Internal Model Method (IMM) which is the only internal method prescribed under Basel regulatory framework. Mandatory implementation of the SA-CRR is scheduled for the 1st January 2017 and given that the vast majority of banks globally use the standardised CEM approach, the impact will be considerable. Moreover, only a handful of banks have obtained IMM approval from their national regulators as the approach will be difficult to implement. This paper begins with a brief outline of terms, formulas and relevant past information on derivatives regulation and then delves into the SA-CCR and its impacts on derivative trading within banks.
Understanding the CVA
The Basel Committee on Banking Supervision (BCBS) defines the Credit Valuation Adjustment (CVA) as the difference between the value of a derivative assuming the counterparty is default risk-free and the value of a derivative reflecting the default risk of the counterparty. The CVA charge therefore reflects the market value of counterparty credit risk and market risk factors that influence the value of derivatives. The CVA effectively ensures that banks are compensated for the counterparty risk they take on by quantifying counterparty risk and including it in the price of all derivative contracts. The CVA reduces the mark-to-market value of an asset or liability and thus reduces the balance sheet risk banks face.
The Exposure at Default (EAD) is the main component of the CVA and past capital charge formulas. A higher EAD leads directly to a higher CVA which in turn leads to a reduction of banks’ derivative assets and liabilities. Historically there have been several methods to calculate the EAD component of the CVA capital charge under Basel regulations. The two relevant methods discussed refer to the non-internal SA-CCR and the internal IMM which are set to be the only two prescribed methods under the Basel framework by 2017.
Why the change?
Since inception, the BCBS has constantly updated existing regulations and introduced new standards in an attempt to remain relevant and effective in regulating a fast changing financial sector. This is challenging and many of the latest Basel accords in the wake of the Financial Crisis have been reactive and are aimed to prevent history repeating itself. The Basel framework has struggled to keep derivative regulations relevant as derivative trading has evolved aggressively- increasing in volume, products traded and the complexity inherent to these trades. Pertaining Basel I (1988), derivative regulations simply comprised of an add-on factor for interest rate derivatives. This was appropriate at the time as derivative trading only accounted for a small fraction of business in a select few banks. Derivative trading subsequently evolved into a larger, more important part of banks’ profit and global financial trading, henceforth derivative regulation increased in importance and complexity as the contagion risk to the financial sector become apparent.
During the financial crisis, banks suffered significant counterparty credit risk losses on their OTC derivative portfolios. According to the Basel Committee on Banking Supervision’s (BCBS) CVA amendment, the majority of these losses directly resulted from fair value adjustments on derivatives. Basel II simply required firms to hold capital against the variability of their derivatives in the trading book and did not require firms to capitalise counterparty credit risk. The first response of the BCBS was to formally introduce the CVA as part of the Basel III Accord. The CVA is aimed at increasing banks’ resilience to potential mark-to-market losses following the deterioration in creditworthiness of counterparties. Secondly, the BCBS addressed the possible drawbacks of the methods used by and prescribed by the Bank for International Settlements (BIS) to calculate the EAD component of the CVA. In March 2014 the BCBS published a final paper mandating the new standardised SA-CCR method in calculating EAD, a new more risk-sensitive measure of counterparty exposure.
As mentioned, banks currently have a choice between two standardised methods namely the CEM and the SM methods and one internal method, IMM, which requires supervisory approval. The SA-CCR intends to address some of the criticisms of the CEM and SM approaches and will replace these two standardised methods with effect of 1st January 2017. It should be noted that some regulatory derivative exposure reporting metrics, such as the Leverage Ratio, will be required under the Basel framework when implementing SA-CCR, regardless of CVA method used. Therefore the reality is that all banks worldwide will be affected to some extent and will need to implement at least part of the SA-CCR method in their systems. Calculating SA-CCR The SA-CCR methodology is similar to that of its standardised predecessor, the CEM, and the formula below aids in the explanation. The SA-CCR EAD calculation includes the variables used in the CEM and an additional factor (alpha) set equal to a multiple of 1.4. The formula has two regulatory components: the replacement cost denoted “RC” and the potential future exposure denoted “PFE”. The RC is the cost of replacing a position should the counterparty default today. The calculation under SA-CCR addresses previous drawbacks in that it accurately recognises the benefit of collateral given or received. It is also important to note that margining under a central clearing house is specified to be categorised as collateral under SA-CCR. The PFE has also been enhanced to include two new add-on factors that account for maturity and certain hedging positions. The maturity factor is a welcome addition and accounts for the fact that longer maturity derivative positions are inherently more risky, ceteris paribus. The hedging factor allows for the full or partial offsetting of long and short transactions that share common attributes within an asset class.
No reason for this alpha multiple is provided in the BCBS’s SA-CCR document, indicating only that it is consistent with the 1.4 set by the Basel Committee for the IMM. Thus the only explanation for its inclusion lies in the BCBS’s IMM document which suggests that the alpha multiple of 1.4 is set too conservatively and practically accounts for a “bad state” economy. The alpha multiple factor has taken the brunt of SA-CCR’s public scrutiny and large banks such as UBS have publicly criticised the BCBS, requesting it be removed from the EAD formula.
Operational Impact on Banks
The introduction of the CVA caused many firms to reconsider their current risk systems’ design which led to the implementation of new sophisticated CVA models. Firms incurred high costs developing complex CVA models based on the CEM or SM methods. Post implementation, CVA models are an ongoing drain on time and resources. The implementation of SA-CCR will inevitably require banks to improve their data infrastructure and invest more resources into either developing new or updating their existing CVA models.
Banks’ risk management and information technology departments will need to understand the new calculation and the impact of the new variables on the EAD amount. For instance, the PFE component in the calculation includes two new add-on variables mentioned previously and requires different asset classes to be considered individually. These teams will need to be aware of the SA-CCR requirements such as the inclusion of sub-classes under the various existing asset-classes, supervisory deltas, correlation and volatility measurements. Banks will need to understand the SA-CCR improvements on the CEM in order for them to fully benefit from the compulsory regulatory change. For example, if the RC differs among margined and un-margined transactions, a bank can reduce their EAD on their margined transactions if they recognise margins as collateral as permitted under SA-CCR. All of the above translates to additional data input requirements and additional variables to consider when adjusting from CEM to SA-CCR.
It is therefore necessary for banks to consider the full implementation effects of this new standard in order to ensure successful transition takes place. Banks will also need to make judgment on whether their current IMM is fundamentally better than the proposed SA-CCR or not, given the cost implications and resource constraints. Specific attention should be given to data availability and sufficiency, data architecture and management information systems.
The Way forward
SA-CCR is still viewed as a crude, conservative methodology that will continue to significantly overstate the true counterparty exposure in well diversified portfolios. It is still unclear whether any capital benefits will accrue when banks transition from CEM to SA-CCR. Indeed, some banks may even be penalised when using SA-CCR compared to the CEM, especially on unsecured, non-diversified counterparty portfolios. In terms of regulatory capital, the use of IMM might therefore be a better alternative to many banks. The mandatory move from CEM to SA-CCR will force banks to redesign and re-implement their current counterparty exposure measurement systems. The additional complexities of SA-CCR will result in significant implementation and running costs. Subsequently some banks may decide to request IMM approval from regulatory authorities if they are going to have to change their systems anyway. It should be noted, however, that the IMM approval process can be quite onerous and time consuming to banks. Moreover, some national regulators have become reluctant to even consider granting this approval in order to avoid any dubious methodologies, especially following the financial crisis.
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