16/04/2013

CVA Capital Charge under Basel III standardized approach (Avril 2013) by Benoît GENEST & Ziad FARES

Since the 2007 – 2009, Counterparty Credit Risk (CCR) has become one of the biggest issues and challenges for financial institutions.

As the crisis revealed shortcomings and loopholes in managing CCR, and more specifically CVA risk, new regulations have been issued in the sole intent of capturing this risk and building an extra cushion of capital to absorb losses and consequently to strengthen the resilience of the banking industry.

Basel III framework proposes two ways for measuring CVA Risk: a standardized approach and an advanced approach.

In this paper, the standardized approach will be analyzed and studied. At first, an analysis will be provided to better understand why CCR became so important, what are its characteristics, etc... Then a discussion around the CVA definition from the regulator’s perspective will be presented. Finally, a paragraph will be dedicated to better understand what the standardized formula refers to, what is being computed, and for what purpose.

Our decision to focus on the treatment of counterparty risk in Basel III - standard method only - can be explained by three major observations:

1) A lot of literature already exists, and a certain number of very good specialists refer to the subject. We do not pretend to add other new elements, in all cases not herein;

2) Few banks actually are able to assess their counter party risk under some advanced and internal methodologies. The application of the standard method is highly widespread among financial institutions subject to Basel III;

3) Few people, when they need to assess their risk using the standard approach, really take the time to analyze choices and specific assumptions according to this method.

 

Our main objective here is to help financial institutions better understand how their regulatory capital levels evolve under this approach and the impact on their day to day business.

 

 (Avril 2013) by Benoît Genest & Ziad Farès

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