Basel Committee on Banking Supervision

Can the Basel Committee clarify whether the 1.06 scaling factor applied to RWA for credit risk CRE30.4 will apply to the CVA RWA category? Our expectation is that the calculation of CVA RWA is a market risk calculation and the 1.06 scaling factor should not be applied.

The 1.06 scaling factor does not apply. The CVA volatility formula multiplied with the factor 3 (under the quantitative standards described in MAR30.16) produces a capital number directly, rather than an RWA. Multiplying the CVA volatility charge by 12.5 to get an RWA equivalent would then not involve the 1.06 scalar.

How should purchased credit derivative protection against a banking book exposure that is subject to the double-default framework CRE32.27 or the substitution approach CRE22.32 to CRE22.34 be treated in the context of the CVA capital requirement?

Purchased credit derivative protection against a banking book exposure that is subject to the double default framework (CRE32.27) or the substitution approach (CRE22.32 to CRE22.34) and where the banking book exposure itself is not subject to the CVA capital requirement, will also not enter the CVA capital requirement. This purchased credit derivative protection may not be recognised as hedge for any other exposure. (This is consistent with CRE51.16 that says that the exposure at default, or EAD, for counterparty credit risk from such instruments is zero. It is also consistent in the sense that hedging should not increase the capital requirement.)

Is a bank required to calculate the CVA capital requirement daily?

Banks should discuss the frequency with which the CVA capital requirement needs to be computed with their national supervisor. To receive regulatory approval to use the advanced CVA approach, banks are generally expected to have the systems’ capability to calculate the CVA capital requirement on a daily basis, but would not be expected or required to calculate it on a daily basis. Instead, banks are required to calculate the CVA capital requirement at least on a monthly basis in which expected exposure is also required to be calculated. In this case, banks are to calculate VaR and stressed VaR by taking the average over a quarter.

Could the treatment of defaulted exposures in terms of CVA capital requirement and incurred CVA be clarified?

Banks are not required to calculate the CVA capital requirement for defaulted counterparties, where the loss due to default has been recognised for accounting and reporting purposes and provided that, as a result of the default, the derivative contracts have been transformed into a simple claim and no longer have the characteristics of a derivative.

MAR50.3 permits the use of proxy CDS spreads. As the majority of banks have portfolios that extend well beyond the scope of bond issuers, proxying a CDS spread will be the norm rather than the exception. We consider this approach to be acceptable given an appropriate model. Is this correct?

Yes, that is correct. To the extent that single-name CDS spread data is not available, banks should use a proxy spread, the methodology for determining the proxy being part of the approved internal model for specific interest rate risk.

MAR50.3 states: “Whenever such a CDS spread is not available, the bank must use a proxy spread that is appropriate based on the rating, industry and region of the counterparty.” For counterparties (eg small or medium-sized entities) where no market data is available, neither CDS spreads nor traded debt, VaR modelling based on proxy index spreads is hard to validate. Is it left to the national supervisor to decide whether these may be modelled in advanced CVA or should standardised CVA be compulsory? The recognition of index hedges is very different in advanced CVA and standardised CVA, so this could lead to material differences in implementation.

Yes, it is left to national supervisors to decide.

MAR50.10 requires a period of stress for credit spread parameters to be used in determining future counterparty EE profiles under the stressed VaR capital component of the advanced CVA risk capital requirement. We seek confirmation that the credit spread of the counterparty input into the CVA and regulatory CS01 formulae (ie si) is not impacted by this. That is, the si inputs remain the same for both the VaR and stressed VaR capital calculations of the CVA risk capital requirement.

It depends on the specific risk VaR model. If the VaR model uses a sensitivity (or Greek) based approach, the credit spread values in the 1st and 2nd-order sensitivities (as in MAR50.7) are the current levels (“as of valuation date”) for both unstressed VaR and stressed VaR. In contrast, if the VaR model uses a full-revaluation approach using the CVA formula as in MAR50.3, the credit spread inputs should be based on the relevant stress scenarios.

From MAR50.10, our understanding is that the periods involved in the calculation of stressed Effective expected positive exposure (EPE) and the CVA capital requirement, according to MAR50.10(2), are as follows:

Please confirm our understanding of the above.

Yes, this is correct. The one-year period of stress used for the stressed CVA VaR calculation is the most severe year within the three-year period used for the stressed Effective EPE calculation. This one-year period may, and will probably, be different to the one-year period used for market risk calculations.

A strict interpretation of MAR50.12 and MAR50.13 suggests that market LGDs (based on bond recovery rates) should be used instead of LGDs that reflect internal experience, potential security packages or other credit enhancement that could be available in the Credit Support Annex or the trade confirmation. Is this strict interpretation intended by the Committee?

Yes, market LGDs (LGDMKT) based on market recovery rates are used as inputs into the CVA risk capital requirement calculation. LGDMKT is a market assessment of LGD that is used for pricing the CVA, which might be different from the LGD that is internally determined for the IRB and CCR default risk charge. In other words, LGDMKT needs to be consistent with the derivation of the hazard rates – and therefore must reflect market expectations of recovery rather than mitigants or experience specific to the bank.

We seek clarity on the treatment of internal trades and CVA VaR. There is a concern that if a CVA desk buys protection from another desk (within the bank) which faces ”the street” it would not get CVA credit although the CVA VAR would be flat (MAR50.12).

Only hedges that are with external counterparties are eligible to reduce CVA. A hedge that is only with an internal desk cannot be used to reduce CVA.

With regard to MAR50.3: we seek confirmation as to whether the risk mitigation available for EE profiles remains unchanged. Specifically, please confirm our understanding that the post risk mitigated exposure values are used in the CVA capital requirement, whilst the additional mitigation is also allowed for the CVA capital requirement itself, via eligible CVA hedges, which is undertaken post any EE mitigation available.

The EEs or the EADs used as inputs in the advanced and standardised CVA risk capital requirement must not have been subject to any adjustments arising from credit protection that a firm intends to include as an eligible hedge in the CVA risk capital requirement (see MAR50.12 to MAR50.14). However, the use of other types of credit risk mitigation (eg collateral and/or netting) reducing the EE or the EAD amounts in the CCR framework can be maintained when these EE or EAD feed the CVA risk capital requirement.

Industry seeks further clarifications as to how the following two cases of different risk characteristics associated with CVA hedge providers should be treated for CVA capital requirement purposes. Is a single name CDS (or a basket of CDS that is not tranched) an eligible CVA hedge if the entity that provides protection is any kind of special purpose entity (SPE), private equity fund, pension fund, or any other non-bank financial entity? Does the answer change if the bank is providing a liquidity facility or another kind of credit enhancement to the protection provider, whereby the bank is effectively exposed to a certain tranche of the underlying default risk? (That is, a bank buys CDS protection, while an additional transaction or facility is transferring a tranche of the default risk back to the bank.) The liquidity facility or credit enhancement would be on accrual accounting so that no CVA risk is transferred back to the bank via that facility.

There are no specific restrictions on the protection provider for the purposes of the CVA hedges. Eligible CVA hedges can be bought from SPEs, private equity funds, pension funds, or other non-bank financial entities as long as the general eligibility criteria set by the Basel framework (see in particular CRE22.90) are met. If the bank remains effectively exposed to a tranche of the underlying default risk by providing any form of credit enhancement to the protection provider, then the CDS is not an eligible CVA hedge because, in economic substance, the transaction becomes a tranched CDS protection, regardless of whether the credit enhancement is on accrual accounting. All kinds of engagement between the bank and the protection provider need to be taken into account in order to determine whether the protection is effectively tranched.

When hedging CVA, given the underlying derivatives portfolio (netting sets) is changing over time, excess CDS hedges bought cannot always be unwound and are sometimes “cancelled” by selling protection (ie the CVA desk is selling protection). The eligible CVA over-hedge is the hedge to this protection sold. How is this to be recognised under Basel III?

Since the dedication of CDS-bought protection for the purpose of CVA hedging needs to be done explicitly, the same process, documentation and controls can be and are expected to be applied for bought protection as well by partial unwinding the excess CDS hedges by making use of the same instrument via the opposite position; this being based on approval of the national supervisor.

If the national supervisor does not agree to recognise the inclusion of sold protection in the framework (standalone portfolio) of CVA calculation and CVA hedging, respective trades are treated as any other derivative or any CDS that is not part of CVA hedging.

Industry seeks further clarification as to whether a single-name CDS for which the bank uses proxies can also be considered as eligible hedges. The answer to MAR50.13(FAQ6) states: “Any instrument of which the associated payment depends on cross default (such as a related entity hedged with a reference entity CDS and CDS triggers) is not considered as an eligible hedge.” A question has arisen whether this means that a single-name CDS cannot be recognised against an exposure to a related counterparty (for example a sovereign CDS against a province in the same country) even if the VaR model captures the basis risk between the exposure and the hedge, or was this clause aimed at instruments other than single-name CDS, that pay out only if there is more than one default event.

Single -ame proxy hedges cannot be recognised in the advanced CVA capital requirement, irrespective of whether the basis risk between the exposure and the hedge is appropriately captured in the model. In fact, MAR50.13 admits as eligible hedges only instruments (such as CDSs and contingent CDSs) referencing the counterparty directly or index CDSs. As an example, consider an exposure to counterparty B with no CDS traded on its name (eg a province within a country) whose spread is approximated by that of counterparty A (eg the central government of that country). The only eligible hedge of the exposure to counterparty B would be an index C containing counterparty A, provided the bank can incorporate the basis between C and A into its VaR model to the satisfaction of its supervisor.

Further, to the extent that single-name proxy hedges are not to be recognised in the advanced CVA capital requirement on one hand, but a proxy spread is required to be used whenever the relevant CDS spread is not available on the other hand, banks should be further noted that they are prohibited from, or should derecognise, over hedging on a single-name level.

To illustrate this, in the above example, whenever the bank over hedges its exposure to A, these hedges on A will effectively act as a proxy hedge for the exposure to B; this is true irrespective of whether B is mapped to the CDS spread of A or not. Therefore, the firm should set a cap on the recognition of all single-name hedges.

With respect to identifying eligible hedges to the CVA risk capital requirement, the Basel III provisions state that “tranched or nth-to-default CDSs are not eligible CVA hedges” (MAR50.14). Can the Basel Committee confirm that this does not refer to tranched CDS referencing a bank’s actual counterparty exposures and refers only to tranched index CDS hedges? Also, can the Committee clarify that Risk Protection Agreements, credit-linked notes, short bond positions as CVA hedges, and First Loss on single or baskets of entities can be included as eligible hedges?

All tranched or nth-to-default CDS are not eligible. In particular, credit-linked notes and first loss are also not eligible. Single name short bond positions may be eligible hedges if the basis risk is captured. When further clarifications are needed, banks should consult with supervisors.

MAR50.15 states that, in the case of index CDSs, the following restrictions apply: “Mi is the effective maturity of the transactions with counterparty i. For IMM banks, Mi is to be calculated as per CRE53.20. For non-IMM banks, Mi is the notional weighted average maturity as referred to in CRE32.44”. CRE32.41 includes in it a cap which means that M will not be greater than 5 years. Can the Basel Committee provide clarity on whether this cap still applies for the purpose of calculating Mi above?

For CVA purposes, the 5-year cap of the effective maturity will not be applied. This applies to all transactions with the counterparty, not only to index CDSs. Maturity will be capped at the longest contractual remaining maturity in the netting set.

If a bank has more than one CDS contract on the same counterparty, the instructions for the standardised CVA capital requirement demand a different discounting than in the case of several index CDS. For single-name CDS, each contract gets discounted using its individual maturity and the quantities M x B are to be summed. In contrast, for index-CDS, the full notional (summed over all index contracts) must be discounted using the average maturity. Is there a reason for this difference in the treatment of single-name vs index hedges?

For index CDS, the same treatment should be applied as described for single-name CDS. That is, each index contract gets discounted using its individual maturity and the quantities M x B are to be added.