FRTB-CVA and Basic Approach - CeFPro

Implementing the Revised CVA Capital Framework:FRTB-CVA and Basic Approach

Andrew Green

20th April 2016

Andrew Green (c) FRTB-CVA 2016-04-20 1 / 34

Disclaimer

The views expressed in this presentation are the personal views of thespeaker and do not necessarily reflect the views or policies of current orprevious employers.

Chatham House Rules apply to the reporting on this presentation and thecomments of the speakers.


Outline of the Presentation

1 Introducing FRTB

2 Introducing BCBS-325 / FRTB-CVA

3 Revised CVA Capital Proposal

4 Consultation Exercise

5 Aside: EBA and CVA Corporate Exemption

6 Implications for CVA Trading Desks and CVA Management

7 Impact on Capital Requirements and KVA

8 Bibliography


Introducing FRTB


Introducing FRTB: Basel IV

Fundamental Review of the Trading Book

Final rules outlined in [3]Key changes:

Trading book - Banking book boundaryNew sensitivity-based standardised methodology that all banks mustimplement and reportInternal Model Approach:

Stressed Expected Shortfall“Desk” level approval processFallback to SBANo securitisations

Impact [2]:Non-securisation:

IMM: Up 28%Standardised: Up 80%

SecuritisationSecuritisation (excluding CTP) : Up 22%Correlation trading portfolio : Up 70 %


Introducing BCBS-325 / FRTB-CVA


Introducing BCBS-325 / FRTB-CVA

BCBS-325 [1] provides a consultative document on changing theapproach to CVA Capital

Aims to bring CVA Capital closer in line with FRTB / Market RiskCapital Framework

Issued in July 2015 for response Oct 2015

QIS combining FRTB and FRTB-CVA conducted in Q3 2015

Revisions and further QIS expected in 2016


Key Driving Factors

Stated factorsCapturing all CVA risk and better recognition of CVA hedges

Basel III CVA Capital ignores market risk of CVA and market riskhedges

Alignment with industry practices for accounting purposes

IFRS13Market-implied calibration

Alignment with proposed revisions to the market risk framework

Align with FRTB methodologyRecognition of CVA as fair-value adjustment implies CVA should betreated as market risk for capital

Other FactorsAlignment with US Implementation of Basel III?

US Basel III allows CVA market risk hedges to be taken out of marketrisk capital framework

Trading book / banking book boundary impact?


Revised CVA Capital Proposal


Scope and Hierarchy

Scope

All derivatives subject to counterparty credit risk - i.e. all derivativesthat are not cleared through qualifying CCPIncludes margined trades, banking book trades irrespective ofaccounting treatmentSecurities Financing Transactions that are fair-valued

Heirarchy of MethodologyFRTB-CVA

Internal Models Approach: IMA-CVA [4]Standardized Approach: SA-CVA

Basic CVA Framework


FRTB-CVA


FRTB-CVA: Eligibility

3 Main Eligibility Criteria

Must be able to calculate CVA sensitivities to the level required bySA-CVAMust have proxy spread methodology for illiquid counterpartiesMust have dedicated CVA Risk Management function

Eligible Hedges

Proxy (credit) hedges now allowedMarket risk hedges for CVA Risk - managed by CVA desk and formpart of CVA bookCVA book is distinct from Trading book and Banking book

Regulatory CVA

Now based on best practice accounting CVADVA is not recognised (nor are any other XVAs)Margin is recognized but MPOR is important consideration2 Options considered for exposures:

A Accounting CVA - i.e. Q-measureB IMM models - typically P-measure


Standardized: SA-CVA I

Cut-down version of FRTB-SBA

Reduced granularityNo default risk or gammaMore conservative aggregationmCVA for wrong-way risk

Report monthly

Sensitivities must meed FRTB sensitivity validation standards

Defined as finite differenceHowever - on good authority AAD will be allowed

CalculationsDelta

counterparty credit spreadsinterest ratesFXreference credit spreadsequity


Standardized: SA-CVA II

commodity

Vega - both exposure and options

interest rates

FX

reference credit spreads

equity

commodity

Procedure

1 Calculate CVA sensitivity sCVAk

2 Calculate hedge sensitivity sHdgk

3 Obtain weighted sensitivities:WSCVA

k = RWksCVAk

WSHdgk = RWks

Hdgk

4 Sum to give net weighted sensitivity WSk = WSCVAk + WSHdg

k


Standardized: SA-CVA III

5 Aggregate capital charge per bucket

Kb =

√√√√√(1− R)

∑k∈b

WS2k+∑k∈b

∑l∈b;l 6=k

ρklWSkWSl

+ R∑k∈b

[(WSCVA

k)2 + (WS

Hdgk

)2]

where R = 0.016 Aggregate across buckets

K = mCVA

√∑b

K 2b +

∑b

∑c 6=b

γbcKbKc

7 Parameters are specified separately for each asset class8 Total CVA capital given by sum of all the K ’s across each risk factor


Basic CVA I

General Issues

If a bank does not have approval for FRTB-CVA must use Basic CVAOnly credit spread hedges are eligible - single-name CDS, single-namecontingent CDS, index CDSLimited single-name proxies allowed (same sector and region)

Calculations

Basic CVA Capital: K = Kspread + KEE

For banks with no CVA hedging

K unhedgedspread =

√√√√(ρ∑c

Sc

)2

+ (1− ρ2)∑c

S2c

where

Sc =RWb(c)

α

∑NS∈c MNSEADNS

b(c) is the supervisory risk bucket of counterparty cRWb is the risk weight for bucket b


Basic CVA II

EADNS is the EAD of the netting setMNS is the effective maturity of the netting setα is the multiplier used to convert EEPE to EAD = 1.4ρ supervisory correlation between credit spread and systemic factor

For banks that hedge

Kspread =

{ρ∑c

Sc −∑h∈c

rhcSSNh

−∑i

S indi

2

+ (1− ρ2)∑c

Sc −∑h∈c

rhcSSNh

2

+∑c

∑h∈c

(1− r2hc )(SSNh )2

} 12

where

SSNn = RWb(h)M

SNh BhSN

S indi = RWb(i)M

indh Bhind

b(e) is the supervisory risk bucket of eBhSN is the discounted notional of single-name hedge hMSN

h remaining maturity of single-name hedge hBi ind is the discounted notional of index hedge iM ind

i remaining maturity of index hedge i


Basic CVA III

rhc is the correlation credit spread of c and the single-name hedge h ofc.

KEE = βK unhedgedspread where β = 0.5


Consultation Exercise


Questions posed by the Basel Committee

1 To what extend do large netting sets, potentially illiquid transactions,recent disputes affect internal assessment of MPoR

2 MPoR: Supervisory floor of N+9 or as per Annex 4 of Basel

3 Should IMM approval be included as an additional eligibilityrequirement under option A: accounting CVA

4 To what extent is there synergy between accounting CVA and EADcalculation

5 Is option A (accounting) or option B (IMM-based) preferred forexposure calculation

6 Simulation time horizon:Option 1: FRTB liquidity horizon for credit spreads of liquidcounterparties and systemic components of illiquid spreads. One yearfor illiquid components of illiquid spreadsOption 2: 60 day horizon for credit spreads of liquid counterparties andsystemic components of illiquid spreads. One year for illiquidcomponents of illiquid spreads


Issues raised by the Industry in Response I

Desire to see use of internal models (IMA-CVA) for CVA Capital,although IMA may be removed from the final document

Desire to see regulatory CVA aligned with accounting practice

Concern that the “use test” might lead to unintended consequences(lack of DVA in regulatory CVA)SFTs - not in accounting CVA - hence should be excluded fromregulatory CVAConcern about standards required on legal netting enforceabilityDesire to see different recovery rates allowed for secured exposures etc.

Focus on Material Risks

For example under bilateral margin rules - CVA will likely not bematerial but rules force these names to be calculated at considerablecomputational cost

Align Definition of CVA desk with FRTB allow allow multiple CVAdesks


Issues raised by the Industry in Response II

Avoid double counting downgrade risk in CVA and CCR

Recognize economic risk - i.e. DVA and / or FVA

Basic CVA

Risk Weights imply up 7 x increase in RWA versus BIIILack of risk sensitivity in risk weights as granularity is lowerMaturity is double counted - costly for long dated derivativesKEE is just a multiplier - does not reflect risks of EE

SA-CVA

Finite difference sensitivities specified - would like AAD etc to beallowed

IMA-CVA

Clarification on P&L Attribution - does it apply top regulatory oraccounting CVA etc.Specific back-testing multiplier for CVAReview purpose and calibration of mCVA

Potential computational cost of IMA-CVA


QIS 1.0 vs QIS 2.0 I

General

Terminology changes: derivative → covered

FRTB-CVA (SA)Change of formula in paragraph 45 - bucketed capital charge:

Kb =

√√√√√(1− R)

∑k∈b

WS2k+∑k∈b

∑l∈b;l 6=k

ρklWSkWS l

+ R∑k∈b

[(WSCVA

k

)2+(WS

Hdgk

)2]

Becomes

Kb =

√√√√√∑k∈b

WS2k+∑k∈b

∑l∈b;l 6=k

ρklWSkWS l

+ R∑k∈b

[(WS

Hdgk

)2]

Changes of multiple risk weights - some increase but majority are down.Counterparty credit spreads:

Local government, public backed etc - now in separate risk bucket andhighly correlated with Sovereign entitiesOption 1 Liquidity Horizons: risk weights down


QIS 1.0 vs QIS 2.0 II

Option 2 Liquidity Horizons: IG down, HY / NR - mixed

FRTB-CVA (IMA)

Provision for banks with multiple CVA desks

Expected Shortfall average now 60 business days

Based CVA

Changes for IMM banks to netting set maturity and exposurediscountingRisk weights down by varying amounts - approx 50%

Sovereigns down from 8.8% to 0.5% (option 1) and 0.9% (option 2)


Aside: EBA and CVA Corporate Exemption


Aside: EBA and CVA Corporate Exemption

Potential loss of corporate exemption for CVA capital [5]

Consultation Paper issued by EBA 12th November 2015


Implications for CVA Trading Desks and CVAManagement


Implications for CVA Trading Desks and CVA Management

FRTB-CVA will give CVA capital more closely aligned withaccounting CVA, although differences remain - DVA / FVA

Implementation effort will be considerable

CVA engines will see much greater regulatory scrutiny

IMA-CVA is potentially very computationally intensive: ≈ 1000 fullCVA revaluations of the entire portfolio daily


Impact on Capital Requirements and KVA


Impact on Capital Requirements

Loss of corporate exemption - factor ?

Basic-CVA

BCBS-325 - up to x7 (Consultation Response)Revised QIS - up to x 3.5?

SA-CVA

Much lower capital required than BasicRevised QIS?


Impact on KVA I

KVA = −∫ T

tγK (s)e−

∫ st λB(u)+λC (u)duE

[e−

∫ st r(u)duK (s)− rB(u)φ

]ds

Basic CVA

Formula based - straightforward to implementNo P in Q problem

SA-CVA

Risk basedNeed accounting CVA sensitivities inside Monte CarloOnce sensitivities are obtained - simple formula to get capitalrequirementAccounting CVA inside Monte Carlo ⇒ Longstaff-SchwartzCan differentiate the LS to give sensitviities + AADNo P in Q problem


Bibliography


Bibliography I

[1] BCBS.Review of the Credit Valuation Adjustment (CVA) risk framework -consultative document.Bank for International Settlements, 2015.

[2] BCBS.Explanatory note on the rivised minimum capital requirement formarket risk.Bank for International Settlements, 2016.

[3] BCBS.Minimum capital requirements for market risk.Bank for International Settlements, 2016.


Bibliography II

[4] BCBS.Reducing variation in credit risk-weighted assets - constraints on theuse of internal model approaches.Bank for International Settlements, 2016.

[5] EBA.Consultation paper guidelines on the treatment of cva risk under thesupervisory review and evaluation process (srep).European Banking Authority, 2015.


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