A Critical Analysis of Counterparty Credit Risk and CVA in a Basel III World. Jon Gregory, Partner

Transcription

1 A Critical Analysis f Cunterparty Credit Risk and CVA in a Basel III Wrld Jn Gregry, Partner

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3 Regulatin and the difference guises f CVA Credit spread mapping Cmparisn f default risk capital charges Impact f Basel III CVA VaR Examples 3

4 CVA and Accunting Rules IFRS 13 (1st January 2013) The entity shall include the effect f the entity s net expsure t the credit risk f that cunterparty r the cunterparty s net expsure t the credit risk f the entity in the fair value measurement when market participants wuld take int accunt any existing arrangements that mitigate credit risk expsure in the event f default (CVA) Nn-perfrmance risk includes, but may nt be limited t, an entity s wn credit risk (DVA) Exit price cncept Explicit that wn credit must be incrprated int the fair value measurement based n the cncept f exit price Exit price implies the use f risk-neutral default prbabilities 4

5 CVA and Basel III capital requirements BCBS Cnsultative dcument (December 2009) Rughly tw-thirds f CCR lsses were due t CVA lsses and nly abut ne-third were due t actual defaults. The current framewrk addresses CCR as a default and credit migratin risk, but des nt fully accunt fr market value lsses shrt f default. BCBS Basel III text Banks will be subject t a capital charge fr ptential mark-t-market lsses (i.e. CVA) assciated with a deteriratin in the credit wrthiness f a cunterparty. Cunterparty Spread CVA = LGD max 0; exp s t LGD exp s t LGD EE B + EE B 2 BCBS Applicatin f wn credit risk adjustments t derivatives the Basel Cmmittee is f the view that all DVAs fr derivatives shuld be fully deducted.. 5

6 Overview f cunterparty risk related capital charges Banks with IMM apprval and with specific risk VAR apprval fr bnds Banks with IMM apprval nly Other banks Default Risk Capital Charge Higher f IMM capital charge based n EAD calculated with a) standard calibratin b) stressed calibratin Nte : IMM apprval will typically nt cver 100% f trades Sum f EAD s frm: current expsure methd standardised methd shrtcut methd (cllateralised) Advanced methd: CVA Risk Capital Charge uses banks VAR mdel fr bnds t mdel spreads eligible hedges (CDS, CCDS, indices) can be included sum f nrmal and stressed VAR CVA frmula belw must be used Standardised methd: Variance type frmula assuming 50/50 split between idisyncratic and systematic spread cmpnents Hedges included but index hedges gives nly mderate capital relief 6

7 The Different Guises f CVA Default Prbability Expsure DVA Accunting Frnt-ffice (fr pricing) Regulatry (CVA VAR) If CVA is seen as a reserve then real wrld parameters are used Histrical (r blended) default prbabilities Histrical vlatilities and crrelatins If CVA is seen as a market price then risk-neutral parameters are used Credit spread implied default prbabilities Market implied vlatilities and crrelatins (where available) Current accunting rules (IAS 39 / FAS 157) d nt give clear directin IFRS 13 requirements ver exit price imply a risk-neutral apprach (particularly relevant fr the calculatin f default prbabilities) Typically risk-neutral (spread based) even if bank s accunting CVA is defined histrically May charge based n histrical (r blended) but then ignre DVA Risk-neutral (Basel III clearly defines CVA with respect t credit spreads) Mapping methds are imprtant Typically risk-neutral expsure Real wrld simulatin if used will prbably be a facet f using lder PFE type systems fr CVA calculatins Real wrld parameters fr simulatin (IMM), r implicitly in ther methds (e.g. CEM) Risk-neutral apprach cnsideratin fr IMM banks t get better alignment Additinal f stressed VAR cmpnent creates misalignment Currently mandatry (FAS 157) r ptinal (IAS39) Future IFRS 13 requirements make DVA mandatry fr all banks Typical price will include sme (but nt all) f the DVA (nt with real wrld default prbs) Nt allwed (n DVA ffset in calculatin f CVA VAR) 7

8 Regulatin and the difference guises f CVA Credit spread mapping Cmparisn f default risk capital charges Impact f Basel III CVA VaR Examples 8

9 Impact f curve shape n CVA 1 exp % % = 34.08% 5Y Spread = 500 bps, Recvery = 40% CVA 5-year trade 10-year trade Upwards 2.3% 13.5% Flat 2.6% 12.4% Dwnwards 3.0% 11.1% Range 30% 22% 9

10 Mapping Apprach Eurpean Names Example categrisatin fr Eurpean cunterparties CDS Cunterparty Rating Index CDS Index Prxy Crprates Financials BBB & better BBB and belw itraxx EUR Nn-Financials itraxx EUR crssver itraxx EUR Financials Svereigns Itraxx SvX Single name CDS prxy Single name CDS 10

11 Regulatin and the difference guises f CVA Credit spread mapping Cmparisn f default risk capital charges Impact f Basel III CVA VaR Examples 11

12 Definitin f Expsure at Default (EAD) Simple appraches t define EAD directly Current expsure methd (CEM), standardised methd, shrtcut methd Limitatins is ptentially vercapitalisatin due t inherent simplicity and misalignment f capital requirements with actual ecnmic risk Under IMM, expsure can be calculated mre directly and EAD is defined as: Alpha factr Effective EPE Sme cnservativeness and misalignment ptentially intrduced via alpha factr and definitin f Effective EPE 12

13 Capital Charges CEM vs. IMM Fr Single Swaps Single interest rate swap Zer mark-t-market Psitive mark-t-market 13

14 Capital Charges Impact f Netting Prtfli f tw swaps Weak netting Strng netting 14

15 Regulatin and the difference guises f CVA Credit spread mapping appraches Cmparisn f default risk capital charges Impact f Basel III CVA VaR Examples 15

16 Requirement t use Stressed Data Similar t market risk VAR rules under Basel 2.5 Calibratins using histrical data - quiet perid tend t precede crises, creating prcyclicality Basel 3 defines that a stressed calibratin must be used in additin t standard calculatin Data must be 3-years with 1-year perid f stress (increasingly spreads) EEPE is defined by the max f the nrmal and stressed calculatins Nte that this is in additin t the stress perid fr CVA VAR (see later) Des switching t a risk neutral calibratin slve the prblem? N - must use a stressed risk-neutral calibratin als 16

17 Mdelling Cllateralised Expsures Shrtcut methd can be rather cnservative IMM methd requires mdelling Threshld / minimum transfer amunt Time t receive cllateral Vlatility f cllateral Need t pst cllateral E t max( V t C t k,0) Psitive expsure at time t Future value at time t Ttal cllateral accunt k days ag t k t 17

18 Basel III Changes in Cllateral Mdelling Assumptins The imprtant parameter, the margin perid f risk was previusly required t be (at least) 10 business days fr OTC derivatives prtflis Margin perid f risk increased in the fllwing cases Netting sets with mre than 5,000 trades at any time during a quarter (20 days) Illiquid cllateral r OTC derivatives that are hard t replace (20 days) Tw r mre cllateral disputes in last tw quarters (at least dubled) Disallw rating triggers Under IMM, cannt mdel any benefit frm taking (mre) cllateral linked t a deteriratin in credit quality These tend nt t wrk and create cliff edge effects 18

19 Margin Perid f Risk IMM impact f margin perid f risk f 20-days (zer threshld) Imperfect receipt f cllateral Need t pst cllateral 19

20 Impact f Cllateral n Expsure 20

21 Mtivatin fr CVA VaR Capitalise mark-t-market lsses fr cunterparty risk (CVA vlatility) Tw thirds f the actual cunterparty risk lsses in the crisis Criticism Sme smaller banks see CVA as a reserve r prvisin and nt a market value Challenges CVA is very hard t define with n market standard (mdels, parameters) Clearly a cmputatinal challenge (CVA is cmplex, VAR is cmplex) Hw t give capital relief (single name hedging, index hedging, securitisatin) Exemptins CVA VAR t CCPs (Basel III) Eurpean svereigns (CRD IV) CVA VAR t nn-financials? 21

22 CVA VaR Standardised Apprach (I) Nrmal distributin VAR apprach based n the standard deviatin f CVA 99% cnfidence level, 1-year time hrizn Including single-name and index hedges Start with expsure t each cunterparty (hedged with single name CDS) N i M EAD i ttal i M hedge i B i Single name hedged ntinal Effective maturities Ntinal f singlename hedge EAD may be defined by Current expsure methd (MtM + add-n) Standardised methd Shrtcut methd (cllateralised trades) IMM methd (EEPE alpha) maximum f nrmal and stressed scenaris 22

23 CVA VaR Standardised Apprach (II) Index hedges (systematic risk) driven by a standard nrmal variable and cunterparties driven by anther nrmal variable: V = ρv + 1 ρ ε The standard deviatin f the prtfli wuld then lead t: V Nte: this implies cunterparty cunterparty spread crrelatin f 2 Systematic term Idisyncratic term K i h wi Ni wind M ind Bind i i i ind i Crrelatin parameter (50%) Cunterparty weight by rating Index hedges w N Single name hedged ntinal =50%, 99% cnfidence level (2.33 factr) and 1-year time hrizn (h = 1) Vlatility represented by weights (w) accrding t rating (r average rating fr index hedges) Weights : AAA = 0.7%, AA = 0.7%, A = 0.8%, BBB = 1%, BB = 2%, B = 3%, CCC = 10% 23

24 CVA VaR Advanced Apprach (I) Bank can mdel the VAR with their wn mdels with CVA defined by: Fixed CVA = LGD max 0; exp s t LGD exp s t LGD EE B + EE B 2 Lss given default Spread fr time pint EE (frm IMM mdel) Discunt factr Expsure prfile is held fixed fr simplicity Only credit spreads are simulated Ignres ther market factrs (interest rates, FX, equity, cmmdity,.) Other pints t nte Separate t nrmal VAR calculatins Capital defined as sum f nrmal and stressed (wrt credit spreads) calculatins 10-day perid, 99% cnfidence level, usual multiplier f

25 CVA VaR Advanced Apprach (II) 10-day perid Recalculated CVA values Simulate credit spreads (and hedges) CVA VAR LGD max 0; exp s t LGD exp s t LGD EE B + EE B 2 Fixed 25

26 CVA VaR Capital Relief Single name CDS Standardised apprach - ffset accrding t EAD and maturity adjustment Advanced apprach - ffset calculated within VAR simulatin (delta neutral?) Index CDS Standardised apprach as abve but accrding t assumed 50% crrelatin Advanced apprach crrelatin can be mdelled althugh If the basis is nt reflected t the satisfactin f the supervisr, then the bank must reflect nly 50% f the ntinal amunt f index hedges in the VaR Structured credit N benefit frm ther credit derivatives (tranches, nth t default structures) Securitisatins? Market risk hedges Split hedge issue - must be included in standard VAR calculatin (unlike eligible hedges) and therefre will increase capital 26

27 Regulatin and the difference guises f CVA Credit spread mapping appraches Cmparisn f default risk capital charges Impact f Basel III CVA VaR Examples 27

28 Cmparisn f Standardised and Advanced Appraches Time hrizn, cnfidence level, ther multipliers Distributinal assumptins Expsure at default definitin Credit spread vlatility Spread crrelatin / prtfli effect Delta hedging capital relief Standardised Advanced Change 1-year, 99%, n ther multiplier = days, 99% and standard VaR multiplier /250 3 = 1.40 Gaussian Empirical / Nn-Gaussian Impact f crude appraches (e.g. CEM) and alpha factr in IMM Intrduced via the weights per rating categry Cunterparty spread implicitly assumed 50% idisyncratic. Intra spread crrelatin implicitly 25% Likely underhedge due t cnservative definitin f EAD Use f EE directly shuld be smaller and give better alignment with CVA Actual empirical data including stressed spreads may prduce higher vlatility Higher crrelatin likely leading t a wrse prtfli effect due t undiversifiable systematic risk Regulatry definitins better aligned with CVA prducing better capital relief Index hedging capital relief Crrelatin is assumed t be 50% Higher crrelatins can be used if they can be justified Prcyclicality Spread parameters fixed thrugh time Spread parameters will change thrugh the ecnmic cycle 28

29 Examples Standardised vs. Advanced Capital Charges CEM / Standardised 5-year swap. CEM apprach gives relatively small expsure and much lwer capital charge. Single cunterparty examples IMM / Advanced 5-year + 7-year swap. Off market and strng netting benefit. CEM apprach gives relatively small expsure and much lwer capital charge. 29

30 Return n Capital Analysis (single swap) Pricing required t cver CVA and achieve a return n capital (RC) fr swaps as a functin f maturity (DVA ignred) RC = (Price CVA) 0.5 Regulatry Capital Maturity Apprximately the same fr 6-year swap. Advanced apprach gives higher csts fr lnger maturities 30

31 Impact f Single Name Hedges 6-year swap (CVA VAR fr standardised and advanced apprximately the same) Standardised apprach Delta hedge t small as EAD is relatively large under CEM apprach. Capital relief very misaligned with CVA hedging. Advanced apprach Delta hedge slightly t small due t need t use stressed data in EEPE calculatin (assume all ther cmpnents are aligned) 31

32 Impact f Index Hedges 6-year swap (CVA VAR fr standardised and advanced apprximately the same) Standardised apprach Capital relief pr due t misaligned delta and 50% crrelatin assumptin. Advanced apprach Delta hedge quite gd giving almst 50% capital relief (80% crrelatin assumed). 32

33 Impact f Prtfli Effect Impact f increasing number f cunterparties Standardised apprach Significant prtfli effect. Hedging imprves with size f prtfli. Idisyncratic risk diversifies and systemic risk can be hedged. Advanced apprach Prtfli effect pr with high crrelatin f 80% assumed (mre systemic risk). Nt clear if high crrelatin is beneficial r nt fr large prtflis. 33

34 Advanced Apprach - Prtfli Effect with Index Hedging High index-cunterparty crrelatin likely t be assumed This allws better hedging efficiency and capital relief Hwever, it als implies less diversifiable idisyncratic risk as cunterparty cunterparty spread crrelatin must als be high Lwer crrelatin implies mre diversifiable idisyncratic risk Higher crrelatin gives better capital relief (index hedge mre efficient) 34

35 Cnclusins CVA charges and charges fr CVA capital are cmparable Advanced methd generally gives higher capital charges than standardised Mst bvius driving frce culd be seen as need t add nrmal and stressed CVA VaRs Single-name hedging is misaligned with delta hedging Much better in advanced apprach where nly stressed EEPE creates a prblem Index hedging seemingly better in advanced apprach Since index cunterparty crrelatins can be argued t be much higher than the 50% in the standardised case Hwever, this is nt cmpletely clear as this limits diversifiable idisyncratic risk Imprtant questins fr the future Will Basel III incentive the right kind f hedging? Is CVA VaR unraveling already with the issues with the advanced apprach tgether with the need fr exemptins? 35