Wednesday, March 17, 2010

CVAs, regulation by stealth?

Original posted on FT Alphaville by Paul Murphy:

Our previous encounters with the concept of Credit Valuation Adjustments were at the height of the crisis, when banks started to book “profits” arising from the fact that their own debt had blown out (i.e. their spreads had widened).

But under Basel III it seems that the concept of CVAs has been repurposed – in a stealthy and ominous way.

Under the Basel proposals, a CVA would be viewed as the new capital charge held against the risk of a counterparty having its rating downgraded or its CDS spread widening, as opposed to straightforward counterpart default risk.

This has provoked some consternation among the analysts at Credit Suisse. Here’s Daniel Davies in the bank’s regular European Wholesale Banks review on Wednesday:

In particular, detailed analysis of the Credit Valuation Adjustment…suggests that it may deliver a much more draconian capital charge than we had previously expected. Although this is not driving equity valuations at present, it is well worth being aware of to avoid a potentially unpleasant surprise in the future.

Davies notes that during the crisis a large portion of counterparty-related losses were down to mark-to-market losses on the deteriorating credit quality of entities like the monolines.

Meanwhile, the CS man is also aware that the regulators are pushing to get as much trading as possible onto exchanges or through central clearing arrangements. Consequently, regulators are likely to look favourably on anything that lands a large capital charge on OTC derivatives exposures:

We can see from this that the business lines at risk from this issue are those that carry out large volumes of balance sheet business with counterparties who have very low frequency of default, but who often see substantial volatility in their credit ratings or CDS spreads. This describes the OTC forex and rates derivatives business pretty accurately, in our opinion.

In fact, he thinks that for some banks the marginal capital requirement under Basel III could be twice as large as Credit Suisse had previously anticipated.

Davies sees all sorts of unintended consequences here, such as making low-risk plain vanilla rates of forex derivatives business uneconomic for many regulated institutions. He actually thinks the impact of implementing Basel III would be so great and so misguided that the rules will have to be changed.

Davis concludes:

We do not believe that the Basel Committee’s intention is to make OTC derivatives business uneconomic, and for this reason we believe that there is a good chance that the rules will be changed or reinterpreted when the Quantitative Impact Study (the results of which are due in H2; the deadline for submissions is the end of April) delivers the information about the effect of the proposed rules. The impact studies are always an important part of the overall process of introducing new regulations, and it is not uncommon to see several changes to the calibration when it turns out that a proposal delivers a capital charge significantly different from that anticipated. However, the regulators’ intention to provide a material capital requirement against credit valuation risk and to provide a material incentive to move OTC business onto exchanges needs to be taken seriously .

For the moment, regulatory risk and the Basel 3 impact appear to have moved off the top of investors’ priorities, in our opinion. However, it is likely that regulatory risk will come back at some point, and when it does, the CVA rules may get much more prominence than they have so far. It is worth being aware of this risk to avoid a potentially nasty surprise in H2.

More in the Long Room.

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