Regulatory capital and CVA for banks

Francisco Roque A. Lumbres and Viktor Xenon O. Lequin

(Second of two parts)

First Published in Business World (8/19/2013)

In the first part of this article, we discussed the circumstances leading to the growing importance of credit valuation adjustment (CVA) and counterparty credit risk, as well as the financial reporting requirements relating to CVA and debit valuation adjustment (DVA) and an overview of its calculation.

Aside from the financial reporting requirements of Philippine Financial Reporting Standards (PFRS) 13 which apply to all entities, banks are subject to the additional supervisory capital requirements of the Bangko Sentral ng Pilipinas (BSP). Counterparty credit risk is already incorporated in current capital standards of the BSP based on Basel II. However, this year the BSP has issued an exposure draft (ED), drawn up based on Basel III, proposing an expanded counterparty credit risk capital framework for Philippine universal and commercial banks including their thrift bank and rural bank subsidiaries and affiliates. The BSP plans to adopt the proposed implementing guidelines beginning January 1, 2014.

This framework is consistent and aligned with the Basel III reforms by introducing an additional capital charge to cover the risk on expected counterparty risk, referred to in the ED as CVA risk capital charge.
The key proposals in the ED are summarized as follows:

• In addition to the credit default risk-weighted assets (RWA) for both on- and off-balance sheet items, including OTC derivative transactions under Basel II, banks will be required to calculate CVA RWA for OTC derivatives under Basel III;

• Risk capital charge for CVA shall be computed for OTC derivatives, and will exclude derivative transactions with qualifying central counterparties (CCP) and securities financing transactions (SFT), except when CVA loss exposures from SFTs are deemed material by the BSP;

• A Standardized Approach in computing CVA capital charge for banks which adopt the Standardized Approach for counterparty credit default risk capital charge. The Internal Model Method can only be used if the BSP has given the bank approval to use the Internal Ratings-Based (IRB) approach under the Basel II guidelines;

• Hedging for purposes of mitigating CVA shall be allowed, subject to compliance with the provisions of PFRS/Philippine Accounting Standards on hedge accounting;

• Banks must assign risk weights (depending on the credit rating between 0.7% for AAA credit rating to 10% for below B- and 3% for Unrated) for CVA for a counterparty/credit index;

• Banks shall allocate sufficient resources to monitor and manage collaterals received for its risk exposures. A collateral management policy shall be maintained and kept up-to-date for control, monitoring and reporting purposes;

• Additional capital requirements for banks with exposures to regulated financial institutions with assets equal or exceed US$100 billion and unregulated entities regardless of size, in the form of a correlation factor of 1.25 on credit risk exposures including CVA RWA.

These foregoing proposals highlight the differences between regulatory and financial reporting calculations, as discussed in the first part of this article, and introduce divergence in the treatment of CVA. A potential for cost savings can be realized here where banks may use shared resources to support the regulatory capital processes and the CVA adjustments for financial reporting process.

Business impact, implementation issues and challenges ahead
Introduction of CVA is expected to significantly, if not fundamentally, impact the way banks manage their derivatives exposures. The BSP proposal represents, on the whole, expanded capital requirements for banks which are likely to result in higher capital charges than the previous capital regime. The above requirements also presuppose that banks have adequate processes in place for calculating and reporting CVA and for assessing capital adequacy in relation to counterparty credit risk. The incremental capital and implementation cost provides incentives for banks to allocate their capital more prudently and efficiently, and to manage and monitor their counterparty credit risk more effectively.

Banks should consider the following when adopting processes to comply with CVA requirements of the BSP proposal, as well as PFRS 13:

• Design or, if already existing, assess and enhance the bank’s CVA calculation process and infrastructure, commensurate with the nature and extent of the derivatives activities of the bank, with the assistance of internal or external specialists or consultants;

• Set up or implement a CVA management function, and incorporate it into the business’ internal management reporting and performance measurement framework;

• Form a core team of personnel from different groups with varying competencies (quantitative, financial and regulatory reporting, compliance, risk and IT) in the bank to assess, implement and enhance processes for calculating and reporting CVA;

• Increase awareness and training for different stakeholders, including those charged with governance, on CVA;

• Compliance support for the CVA process and assessment of regulatory aspects of counterparty credit risk for banks, including accounting support around the implementation of PFRS 13 and related principles of credit adjustments.

CVA is here to stay, as the importance of managing counterparty credit risk has already been highlighted during the global financial crisis. It is only a matter of time before CVA and counterparty credit risk management will become incorporated into the business-as-usual practices of banks, as these are already included in financial and capital reporting requirements.

Francisco Roque A. Lumbres, CFA, PRM is a Partner of SGV & Co.
Viktor Xenon O. Lequin is a Senior Associate of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.