European banks tire of CVA guessing game

Continued political wrangling over Europe’s CVA exemption increases uncertainty for dealers

Regulatory uncertainty is not a new thing. But some regulations go through more twists and turns than others.

Ever since the capital treatment for credit valuation adjustment (CVA) risk was finalised as part of the Basel III reforms package in 2011, banks subject to Europe’s version of the rules have had to endure a series of mixed messages and about-turns from regulators – often leaving them baffled about out how their businesses would be affected.

For banks, the stakes are high: CVA risk is a big part of the cost of capital on many derivatives trades, and a key factor in determining how competitive a price a bank can offer its clients. It can’t be priced on the hoof.

In 2013, transactions with certain corporates were exempted from Pillar 1 regulatory capital as part of European regulations implementing Basel III. Similar exemptions do not exist outside the EU. While European banks rejoiced, the move was greeted with a severe backlash from banks and regulators in other jurisdictions.

Fearing the exemption left banks under-provisioned for corporate credit risk, the European Banking Authority (EBA) recommended repealing the exemption in 2014, and in the meantime suggested national regulators should apply Pillar 2 add-ons to cover what it dubbed the excess risk.

At that point, it seemed like only a matter of time before European banks were forced onto a level playing field with their peers elsewhere. But now, the EBA has decided to drop both plans.

Pushing for a removal of the exemption was ruled out because of Basel’s unexpected decision to remove the more risk-sensitive internal modelling approach from its revised CVA risk capital framework – a move that could double capital charges, according to industry estimates.

Issuing guidance for national regulators to incorporate the charge into Pillar 2 requirements on the other hand will pose legal risks, because it would be an attempt to impose a charge on a risk that was exempted by legislators.

European banks might have thought that left them in the clear – but the drama doesn’t end there. An amendment in the draft capital requirements directive (CRD V) published by the European Commission in November will explicitly allow national authorities to require specific add-ons under Pillar 2 for risks exempt under the capital requirements regulation. It also calls for the EBA to define how to measure them via a binding regulatory technical standard (RTS), and not guidelines.

The EBA says it hasn’t given up on issuing guidelines yet – but when and how it would do so is unclear: issuing them before the revised CRD would mean trying to harmonise a charge that appears not to be levied currently by national competent authorities. Otherwise, they could wait for CRD V to be finalised.

The clause in question – Article 104 of CRD V – is part of a broader, controversial push to reform Pillar 2. Lawmakers want to narrow Pillar 2 add-ons to firm-specific risks and take out macro-prudential considerations – but then tighten how those firm-specific risks are calculated across institutions.

There has been some high-level criticism of those efforts, which means it won’t necessarily be smooth sailing to get the legislation through the trialogue process. Danièle Nouy, chair of the European Central Bank supervisory board has made it clear she thinks prescriptive calculation methodologies would increase risk. Sven Giegold, a member of the European Parliament, has also criticised the proposals, calling them a “de facto lowering of the Pillar 2 requirements” and a “gift to big banks”.

For now, the repeal of the exemption seems highly unlikely. But given the proposed amendment to CRD V, banks will have to figure out how to price new Pillar 2 add-ons. What those add-ons will be is unclear; national regulators could end up imposing their own charges, or the add-ons could be dictated by guidance or RTS issued by the EBA

For now, uncertainty is the only constant.