Banks Hone Credit Risk Systems

Terry Flanagan

Regulatory pressures demand real-time analytics.

With increased regulatory pressure on financial institutions to manage counterparty credit risk, robust real-time risk analytics for credit valuation adjustment, or CVA, are now a necessity.

Although real-time risk analytics for CVA is not required under current regulations, Basel III will require that banks calculate CVA and hold capital against this measure.

CVA is typically defined as the difference between the value of a derivative, assuming the counterparty is default-risk free, and the value reflecting default risk of the counterparty.

“While CVA for regulatory capital charges will typically be calculated less frequently than daily, active CVA hedging by the front office will necessitate this calculation on a daily, near real-time basis,” Denny Yu, product manager for risk solutions at Numerix, told Markets Media. “As the market environment continues to evolve and new technology innovations are introduced, banks looking to actively hedge CVA will look to adopt real-time CVA pricing as a tool to help in dynamic hedging of counterparty credit risk.”

“For example, a firm that had exposure to Lehman Brothers as a derivatives trading counterparty prior to its default would have benefited from a real-time CVA solution that would have allowed the firm to more dynamically hedge against Lehman’s increased counterparty credit [evidenced by higher Lehman credit spreads] and better quantify the credit risk of all the firm’s other trading counterparties,” said Yu.

pbb Deutsche Pfandbriefbank, a European specialist bank for real estate finance and public investment finance, has chosen Numerix for its firm-wide CVA calculations to assist with regulatory compliance.

With the Numerix CVA Monte Carlo engine, real-time calculation of CVA per counterparty for the entire firm will be possible, according to Dr. Roland Stamm, head of risk methods and valuation at pbb.

Regulations will also require banks will have to adjust the value of their derivatives holdings to account for fluctuations in the bank’s credit risk, known as debit valuation adjustment (DVA).

A DVA is typically defined as the difference between the value of the derivative assuming the bank is default-risk free and the value reflecting default risk of the bank.

“DVA is the credit adjustment made on a negative derivative exposure,” Yu said. “There is industry debate on the use of DVA to manage earnings, as DVA is essentially a downwards adjustment of the firm’s liabilities.”

As an example, noted Yu, Citigroup reported net income increase of over $1.9 billion [Q3 2011] by reducing its liabilities to counterparties as a result of its own credit spread widening (DVA adjustment).

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