Methodology for Credit Value Adjusted (CVA) Capital Charge calculation

Background:

This article is a part of the series of articles pertaining to regulatory capital charge for banks that I had published a couple of months back which spoke about the technique for computation of Capital charge for fixed income products And also the methodology to calculate the Capital Charge from Market Related Off-balance sheet exposures.

The links to abovementioned earlier articles are: FI capital charge, Off-balance sheet exposures . In this article we understand the third component that is required by a bank to arrive at its total capital charge from market risk perspective. Further, as this is a regulatory requirement, this computation is done by the bank daily. Banks have their risk infrastructure designed to calculate these numbers daily by their enterprise risk systems for the consumption by Risk Management teams as well as for Regulatory / MIS reporting.

We know that the total capital charge from market risk perspective for a bank, is a combination of three items namely:

1. Market Risk capital charge for the trading portfolio (i.e., capital charge coming from securities classified as HFT/AFS which is further drilled down product wise. This component involves calculating various items like general risk, specific risk, horizontal and vertical disallowance etc.)

2. Credit Value Adjustment (CVA) capital charge

3. Capital Charge from Market Related Off-balance sheet exposures

In this article we will understand the approach to arrive at item no. 2 listed above.

The treatment for item 1 and item 3 has been discussed in the earlier articles of this series as mentioned above.

Idea behind calculating the CVA charge:

For any bank/lending institution, exposure to credit risk happens to be a major area of concern. Due to the very nature of the banking business, banks are expected take on a certain amount of credit risk depending on their risk tolerance and risk appetite. Both of these items are decided by the top management and approved by the Board. The level of risk tolerance broadly classifies banks/lending institutions either as conservative Or aggressive. However, in any case a bank is expected to make capital provisions to counter the risk from exposure to counterparty credit risk as per the Basel guidelines.

The CVA capital charge is calculated with the idea of capturing the potential credit risk that the bank is exposed to owing to the changes to the credit standing of their counterparties. Technically, this is also called as the credit transition risk of counterparties. Most of the counterparties that banks trade with are private institutions — be it other banks or non-banking companies. Therefore, there is always a potential risk of default that the bank would need to provision for in case the counterparties with whom the bank is holding traded positions default at any time during the tenor of the traded contract. It is for this reason, that banks calculate their CVA capital charge daily to manage the counterparty credit transition risk on their books.

Our Approach:

Just like my previous article, we will study the approach for CVA charge calculation through a sample calculation. Following will be the approach followed:

a. We will consider a hypothetical portfolio representing derivative assets in the Trading Book of the bank. Popular varieties of derivatives include forwards, swaps, options etc.

b. We will follow a bottom-up approach: beginning with trade-wise data on credit exposures and gradually stepping up to the enterprise level (i.e., bank level)

c. Once the CVA charge is calculated, we can relate it with the RWA item by adjusting the CVA number by the capital adequacy ratio required by the regulatory guideline.

RWA i.e., Risk Weighted Assets happens to be a key metric that is examined by risk managers and top management when they monitor the capital adequacy framework for the bank.

CVA Capital Charge Methodology demonstration:

1. The table below shows the trade-wise report for a hypothetical portfolio of derivatives trades of the bank. Counterparties (Cpty) may be banks/non-banks both domestic and foreign.

· We assume that we have a pricing engine that calculates the MTM of trades and for PFE calculation, we use the same methodology as described in the previous article on off-balance sheet capital charge.

2. In the above table we observe that bank has multiple trades with counterparty A. In the next step we will collate the trades across the respective counterparties and also adjust them for collateral that is received from the respective counterparties. Note that collateral which is received from counterparties reduces the counterparty exposure by that much amount.

This is the next step in the direction of calculation of CVA charge on a bank-wide level i.e., enterprise-wide level.

Using the table above, we get the CVA capital charge as:

3. The corresponding RWA number is given by: 199641121/8% = $2496 mio

$199.6 mio computed above is the CVA capital charge for the bank today. When we add the capital charge from the other two components as mentioned above in the Background section, we can get to the total market risk capital charge for the bank on that day.

Exclusion from CVA capital charge:

A few items in the trading portfolio are excluded from CVA capital charge requirements because they do not carry credit risk. A few examples of excluded items include:

a. Futures contracts guaranteed by Exchanges

b. Derivatives backed by CCPs

c. Sold option positions etc.

The above approach for CVA capital charge computation is generally automated and runs as a batch process daily in Enterprise Risk Systems of banks. The bank needs to ensure that they have this data ready at all times for both internal MIS reporting or for regulatory reporting.

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