The CVA helter skelter: European supervisors could quash exemptions

Europe’s credit valuation adjustment exemption was the outcome of a protracted legislative debate, but it may prove to be the end of a chapter, rather than the end of the story. As US banks protest and supervisors review the issue, a number of problems are emerging. Matt Cameron reports

As Europe crawled towards an agreement on its version of Basel III during the first quarter of this year, some UK banks came to what seemed a reasonable conclusion – legislators had agreed on February 27 to protect corporates, sovereigns and pension funds from the new capital charge for derivatives counterparty risk, known as credit valuation adjustment (CVA), and although the text still had to be formally approved and adopted, it seemed safe to strip the charge out of annual reports.

So they did. Barclays, Lloyds Banking Group and Royal Bank of Scotland (RBS) slashed their risk-weighted asset (RWA) totals, with equity capital ratios jumping as a result – in the case of RBS, by half a percentage point.

That may have to be reversed. Although the fourth Capital Requirements Directive (CRD IV) – and the Capital Requirements Regulation (CRR) that contains the CVA exemptions – sailed through the rest of the legislative process, finally being adopted by the Council of the European Union (EU) on June 20, there are reports of growing unrest among Europe’s bank supervisors. Their response could be a capital add-on to compensate for the exemptions. This prospect is already alarming European Union (EU) banks, and the politicians who saw the carve-out as a way to safeguard corporate hedgers (Risk October 2011, pages 36–38).

“In a sense, if you’re in a bank, you feel regulators can do whatever they want – but it would be completely against the whole thinking of a common European capital framework, which at the end of the day has been implemented as a regulation, meaning it doesn’t require local transcription into law. It would go against that completely if local regulators essentially decide to ignore what the legislators have decided,” says one regulatory capital expert at a UK bank.

Politicians feel the same way: “What legislators have come up with is a set of good rules, and regulators and authorities should not rethink and re-establish them. They should accept the legislation that the council and the parliament in their wisdom have decided upon. They shouldn’t jeopardise the work we have done, as the only ones being disadvantaged will be European corporates,” says Markus Ferber, member of the European Parliament in Brussels.

A pragmatic approach would be to demand a capital charge for CVA risk on top of the Pillar I charges

Germany’s Bundesanstalt für Finanzdienstleistungsaufsicht (Bafin) confirms in an email to Risk that it is considering a capital add-on for the exempt trades, and the UK Prudential Regulation Authority (PRA) – one half of the old Financial Services Authority – is expected by a number of regulatory and capital experts to follow suit, a belief that gained credence when the PRA ignored the exemptions in its report on UK bank capital shortfalls, published on June 20.

The exercise gives RBS an RWA figure of £567.9 billion and equity of £37.2 billion – a ratio of 6.5%. But, in its annual report, RBS said it had RWAs of £495 billion – and its June 20 statement clarifies that £36 billion of the difference came from its assumption that it would benefit from the CVA exemptions. That was worth an additional 0.5% to the bank’s equity ratio.

There is nothing in the PRA exercise to say the regulator is planning to ignore the CVA exemptions when CRD IV comes into effect – in fact, both RBS and the regulator claim the exemptions were ruled out purely because they had not been finalised as of December 31 last year, which was the PRA’s cutoff point. But a capital specialist at one UK bank says he expects the PRA to impose a CVA overlay, a view shared by regulatory experts at three US institutions.

How would that be done? On the face of it, member states have no wiggle-room on the matter – the exemption will be implemented in the EU as regulation, meaning enabling legislation is not needed at the national level. But the CVA charge comes under Pillar I of the Basel framework, where individual banks calculate their own capital requirements using standardised or advanced models. Pillar II of the framework gives supervisors some latitude to apply a capital add-on where they believe a given exposure is not being appropriately captured. Bafin already does this for interest rate risk in the banking book, for example, which is not the subject of a specific Pillar I charge.

A CVA add-on would delight US banks and lance a growing boil of resentment – if European banks do not face a CVA capital requirement when trading with corporates, they would be able to offer better prices, but there is thought to be little chance of the US copying the European exemptions when it proposes its own version of the CVA charge (Risk June 2013, page 8).

Some US critics of the exemptions dress this competitive fear up as a systemic concern, warning it would not be a good thing for European banks to end up with a concentration of uncollateralised exposure to corporates in the US and elsewhere. Others present it simply as a level playing-field issue. “There has been of a lot of discussion about falling short of Basel standards, and if we’re trying to reach an international accord, it does feel like European regulators need to step up and use Pillar II to achieve that,” says one head of CVA trading at a US bank in New York.

Barclays’ annual report appears to anticipate this possibility. It warns the regulator may “alter its stated approach to the adoption of CRD IV in the UK. For example, the scope of application of the volatility charge for CVA may be different from that expected.”

Germany’s position is clearer. In its email to Risk, a spokesman for Bafin says the supervisor and the German central bank will decide whether the country’s banks are holding enough capital for their CVA exposures. The email raises the possibility of “formally ordering the banks to hold certain amounts of capital for CVA risk on top of the Pillar I capital requirements” because of the exemptions.

“A pragmatic approach would be to demand a capital charge for CVA risk on top of the Pillar I charges, when this appears necessary to ensure that the bank will hold enough regulatory capital to support the combined risks. Germany has already adopted this route for interest rate risk in the banking book... [But] there are no guidelines on how CVA risk should be measured by banks for derivatives that are exempted from the Pillar I charge. Against this background, no decision has been taken so far. A common approach of the EU’s competent authorities on this issue is desirable,” the email says.

The PRA says it intends to consult on its implementation of CRD IV and the CRR in due course. It declines to offer any further comment. National supervisors in the Netherlands, Spain and Sweden also say they have not come to a decision or refuse to comment.

But even if the CVA exemptions stick, EU banks see them as a mixed blessing. On the one hand, they offer a competitive advantage; on the other, they create some awkward pricing problems.

The first of these relates to trades with non-financial counterparties (NFCs), and arises from the fact that the CVA exemption is tied to a similar carve-out in the European Market Infrastructure Regulation (Emir). According to Emir, a non-financial counterparty does not have to clear over-the-counter trades as long as they are considered bona fide hedging instruments. For transactions that are not objectively measurable as reducing commercial or financing risks, the NFC must remain below a notional threshold, which varies by asset class – for interest rate, commodity and foreign exchange derivatives, it is set at €3 billion, while for credit and equity derivatives it is €1 billion.

If the entity breaches the thresholds, it becomes what is termed an NFC+, and is then subject to the clearing requirements. At the same point, the CVA exemption also no longer applies – forcing dealers to hold CVA capital against the client’s entire portfolio. That could be painful. If, for example, a dealer had entered into some hefty, long-dated, cross-currency swaps with an NFC assuming the trades would remain CVA-exempt, the customer’s migration to NFC+ could make the positions value-destroying at a stroke – which begs the question, should dealers price in the probability that a corporate will breach the clearing threshold?

“This is super-challenging. At this point, we don’t have a master plan, and we’re trying to work out how to deal with it. We think it will be very difficult to assign a probability that the corporate will breach the threshold, because it is not based on market-driven factors – it is based on the whim of the customer. And because we don’t have a great deal of insight into the sizes and composition of our counterparties’ portfolios – we don’t see what they’re executing with other banks – even trying to bluntly extrapolate or estimate the likelihood of them breaching the threshold is difficult,” says one CVA trader at a European bank.

The issue is complicated further in two ways. First, exposures that count towards the threshold have to be aggregated with the exposures of all non-financial entities within a corporate group. For example, if an entity had set up 10 special-purpose vehicles (SPVs) to conduct securitisations – which are likely to be considered NFCs under Emir – a bank trading with one SPV would have to recognise that nine other SPVs could all be doing non-hedging swaps, which will count towards the threshold.

The second issue is that the threshold is denominated in euros, but the trades themselves may be in other currencies. According to guidance provided by the European Securities and Markets Authority (Esma), the transactions all have to be added up afresh – using updated exchange rates – every time the aggregate position is calculated. It means an NFC that has transacted a portfolio of dollar swaps could be tipped into NFC+ status by virtue of the euro weakening against the dollar.

“It could get very complex trying to model this stuff, so we are probably not going to go down that route. Instead, our gut feeling is to slice the corporate swap portfolio into three categories. The first category is for firms you are confident will breach the threshold – or that are already above it; the second is for clients where you have reasonable insight into their portfolios and can get comfortable that they won’t do swaps that will count towards the threshold. The third is the tricky part. Here, you lump together all the clients where you are not sure, and you have to make a judgement call on how to price the swap,” says the European bank’s CVA trader.

A CVA trader at a second European bank says he expects the vast majority of NFCs to avoid swaps that do not count as bona fide hedging instruments. In those cases, the bank will price assuming the exemption applies for the life of a given trade. “There is minimal probability in most cases. But if a corporate trades in large notional sizes, and you think there is a risk the CVA charge could be applicable in the future, it might be worth taking a prudent approach and pricing for some capital at least, otherwise you are taking on a binary risk. We don’t have a strict rule right now – there is some latitude – and we are charging for capital on a case-by-case basis,” he says.

Other banks are toying with the idea of immunising themselves against the risk by inserting language into swap contracts that would allow the cost to be passed on to the corporate should it breach the clearing threshold. “I think this is something we will definitely look at seriously,” says one capital expert at a European bank.

The precise scope of the exemptions is also unclear – corporates, sovereigns and pension funds might sound straightforward enough, but dealers say it quickly becomes complicated when applied to actual clients. As a result, trading desks are being forced to make a call on whether some customers are exempt or not, with the risk that if they are wrong, the trade will have been mis-priced.

“There are some pretty large grey areas at the moment, and nobody is quite sure who is in and who is out of scope. And this makes pricing trades with counterparties that are within those grey areas difficult to say the least. You don’t want to make the wrong decision and mis-price trades. At the moment, we are having discussions internally, and we have our own legal and risk departments looking to reach some kind of conclusion. And then it would be for the regulator to review what we have done and decide whether it is appropriate treatment,” says the third European bank’s head of CVA trading.

There are three main areas of uncertainty. The first concerns transactions with clearing houses. According to the CRR text, transactions with a central counterparty (CCP) are excluded from the CVA charge, as are a client’s transactions with a clearing member, when the clearing member is acting as an intermediary between the client and a qualifying CCP (QCCP). A QCCP is a clearing house that adheres to – and is regulated in accord with – global principles published last year by the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions.

But while the text refers to QCCPs in the context of cleared client trades, it does not specify a QCCP when referring to other transactions with clearing houses – an apparent drafting error, lawyers say, which means banks would technically be able to clear their own swaps at a non-qualifying CCP without having to hold CVA capital – thus dampening the incentive for banks to clear with QCCPs only.

“The scope does not distinguish between transactions with QCCPs and CCPs, which indicates that institutions would not have to take a CVA charge in respect of transactions they enter into directly with a non-qualifying CCP,” says Charles Morris, senior associate at law firm Norton Rose Fulbright in London.

The text also fails to make a distinction between trades that banks clear at CCPs, and direct transactions between CCPs and dealers – to provide treasury hedges, for example, or inoculate the portfolio of a defaulted member firm.

“As far as we can tell, the text refers to transactions of all kinds, so our current take is that we won’t have to hold CVA capital against any of them,” says one CVA trader at a European bank in London.

The second grey area relates to non-financial counterparties. The CRR exemption takes its lead from the clearing carve-out in Emir, which defines an NFC as an undertaking established in the EU, other than a CCP or a financial counterparty. In general, this includes SPVs, but the waters are muddy for some SPVs – including those used to issue collateralised debt obligations (CDOs), asset-backed commercial paper and loan participation notes – because of Emir’s definition of financial counterparty.

One of the many types of entity listed in that definition is any fund authorised or registered in accordance with the Alternative Investment Fund Managers Directive (AIFMD), which enters into force this month. The AIFMD says it does not apply to securitisation vehicles – apparently confirming that SPVs are within the scope of the exemption – but it defines these entities by reference to yet another policy document, this time belonging to the European Central Bank (ECB). Lawyers say the ECB document appears to exclude CDOs and some other types of securitisation.

“It is very difficult to work out whether certain SPVs fall within the ECB definition. The whole Street is struggling with this, and the guidance received has not been clear either, so it’s a bit of a guessing game at the moment,” says Bob Penn, a partner at law firm Allen & Overy.

The third area of confusion relates to sovereigns – and banks believe it may enable them to draw a wider set of counterparties into the exemption, which is defined in two ways. As with the NFC exemption, it refers to the language used in Emir – which lists sovereign debt offices, central banks, and other entities such as the Bank of International Settlements and multilateral development banks – but it also mentions counterparties for which article 110 in CRR specifies a risk weight of 0%.

Article 110 states that exposures to regional governments or local authorities shall be treated as exposures to the central government of the jurisdiction in which they are established, as long as the local entity has its own revenue-raising powers.

Banks have tended to treat regional governments and local authorities, for the purposes of Basel II, as exposures with a 10% risk weight, but they believe article 110 could be used to justify lowering the risk weight of some of those exposures, thus bringing them into the scope of the CVA exemptions.

“Most of our exposures to regional governments are not risk-weighted zero, and a 10% risk weight is usually assigned – but we are now taking a closer look at whether we can define these exposures as quasi-sovereign. The reason we think this is possible is because of the revenue-raising powers referenced in article 110. The article seems to say that if those counterparties can raise revenue through tax, for example, they should be treated the same as a national government. So if you look at some US states or other regional governments that collect taxes, as a matter of legal interpretation we think they could qualify for a 0% risk weight,” says the head of CVA trading at a European bank.

Besides all of these uncertainties, dealers also claim the CVA exemptions could encourage banks not to hedge their counterparty risk. Because there will be no charge on the affected trades, any credit default swaps that are in place would no longer be serving to mitigate capital requirements – but the hedges themselves would still be viewed as trading positions and would attract capital, essentially mirroring the industry’s long-standing complaint that market risk hedges are not considered when calculating CVA exposure.

“Imagine you are a firm that actively hedges your CVA by buying credit protection against a sovereign or corporate counterparty that has been exempted from the CVA capital charge. These hedges are essentially naked in the trading book. So you have a situation where your hedges to your accounting CVA are generating a capital charge. For those firms that actively manage their CVA, there is a capital incentive not to hedge – how crazy is that?” said Henry Wayne, senior adviser on regulatory reform and risk at Citi, at the Risk Annual Summit in March.

European banks are aware of the issue, and say that to manage the exposures becomes a balancing act. “Yes, there is a disincentive. But the question is about your priorities. Do you want to hedge the economic and accounting CVA, avoiding profit-and-loss volatility, but creating unwanted RWAs in the trading book? Or do you want a long credit position and the resulting volatility, but without the hassle of extra RWAs?” says the first CVA trader at the European bank.

 

BOX: How to dodge the CVA charge
There is an easy way for European banks to extend the credit valuation adjustment (CVA) safe harbour, if corporates are exempt, according to a London-based regulatory capital expert at one US bank. All they would need to do is persuade one of the exempt firms to stand between the dealer and a non-exempt client. Because the bank is facing the corporate, it is not subject to a CVA charge, and can afford to pay the corporate a spread to take on the trades. “You could drive a bus through these rules. And I’ve warned regulators about that,” he says.

European banks, however, dismiss the idea. “If a salesperson came to me with this I’d send them away immediately – it’s the kind of trade that always ends in tears. I don’t believe corporates would want to engage in this type of business, and regulators would not view it in a good light. It is not in the spirit of the rules,” says a counterparty credit expert at one UK bank.

Dealers also point out that these types of trade would be restricted by the clearing threshold to which corporates are subject, and that both sides of the trade would have to be counted towards the threshold – both the trade facing the bank and the trade facing the bank’s client. This means large trades would not be possible. They also argue that the spread a corporate could earn would not be juicy enough to compensate for the risk of losing the clearing and CVA exemptions.

 

BOX: Letter from America
For the past three months, representatives of the world’s biggest banks have been trying to write a letter – or, rather, trying to agree on the wording of a letter. The subject is the European Union’s decision to protect its banks from the credit valuation adjustment (CVA) capital charge in Basel III, and it’s proving tricky because the letter would be signed by board members of the Global Financial Markets Association (GFMA) – which is more or less evenly split between EU and non-EU institutions.

The result, according to a source involved in discussions on the wording of the letter, has been a behind-the-scenes spat: “There is a lot of interbank friction. The US banks have tried to get the EU banks to say they don’t want the exemption,” he says.

That call is said to have been rebuffed. The exemption applies to trades with corporates, sovereigns and – for a limited period – pension funds, giving EU banks a potentially decisive advantage when competing for that business. While European banks did not campaign for the exemptions, they are also not desperate to give them up – they would prefer regulators in other jurisdictions to follow suit.

The existence of the draft letter was revealed in minutes of an International Swaps and Derivatives Association committee meeting in mid-April, but it is understood to have been in the works for some weeks prior to that. The Isda minutes say: “We understand that this letter is a result of concerns regarding the ‘favourable’ treatment EU banks might enjoy CVA-wise vs. US banks... It is unlikely this letter will be approved by the GFMA board and signed.”

That is disputed by one of the GFMA’s 31 board members. He insists the association will – eventually – reach a common position on the exemptions. It might, though, end up being a relatively anodyne call for regulatory consistency.

 

BOX: What UK bank annual reports say on the CVA exemptions

Barclays
The policy: It is assumed that European Union (EU) corporates, pension funds and sovereigns are exempt from the credit valuation adjustment (CVA) volatility charge.
The disclaimer: The Financial Services Authority may also alter its stated approach to the adoption of the fourth Capital Requirements Directive (CRD IV) in the UK. For example, the scope of application of the volatility charge for CVAs may be different from that expected... with the result that individually and/or in aggregate such changes may materially negatively affect Barclays’ CRD IV capital, leverage, liquidity and funding ratios.

HSBC
The policy: We have estimated our regulatory CVA risk capital charge based on the draft July 2011 CRD IV text, calculated on a full range of over-the-counter derivative counterparties without exemptions that may be available under the final CRD IV text.

Lloyds Banking Group
The policy: It is assumed that EU corporates are exempt from the CVA volatility charge.
The disclaimer: The group’s capital position may be different should alternative text be agreed. There are potential changes that could result in increases to risk-weighted assets including, for example, the application of a 90-day definition of default for retail assets and the EU corporation exemption from CVA not applying.

Royal Bank of Scotland
The policy: EU corporates, pension funds and sovereigns are assumed to be exempt from CVA volatility charge in calculating risk-weighted asset impacts.
The disclaimer: The actual impact of CRD IV on capital ratios may be materially different as the requirements and related technical standards have not yet been finalised and will ultimately be subject to application by local regulators.