Best CVA practices in Japan

At a recent roundtable in Tokyo, banks and regulators discussed progress on credit valuation adjustment (CVA). While, in many respects, the work towards implementing best practices in the country is on track, challenges remain in resourcing and technology infrastructure

 

Localising an international standard 

The accounting treatment of CVA in Japan has brought challenges and even significant apparent losses, as banks’ profit and loss (P&L) statements are hit by recalculations that consider default risks of derivatives contracts on their balance sheets. While international banks have reported CVA as a matter of practice for years, local financial institutions are struggling to find reliable methods of pricing this risk into transactions, given that the standard tool used in hedging this risk – credit default swaps (CDS) – are even more illiquid in Japan for single-name corporate bonds than elsewhere. Some large corporate names trade only once or twice a year, and Japanese broker-dealers hold only about 1% of the global CDS market in notional terms.

The relative scarcity of single-name CDS has increased basis risk as hedges must rely on CDS index prices, leaving dealers unsure of how best to calculate creditworthiness when determining the fair value of CVA in their accounting statements. International Financial Reporting Standard 13 specifies CVA should be based on quoted market prices where possible – or other unobservable inputs if such data is not reliable. IHS Markit observes that it is common market practice to create a proxy curve for low-liquidity CDS single names. 

“Although the proxy curve can capture the systemic component of the credit risk with the three factors – region, sector and rating – such a curve cannot capture the individual risk for the single curve, known as idiosyncratic risk,” says Hiroyuki Yoshizawa, product management director, fixed income pricing at IHS Markit in Japan.

 

Implementation challenges – Technical difficulties 

Calculations for valuation adjustment (XVA) require at least 1,000 times more computing power compared with traditional market value-at-risk, while computing requirements for XVA sensitivity for hedging increases by another factor of 1,000. As such, banks still looking to price CVA into their transactions should not overlook the time and resources required to set up a dedicated XVA desk capable of handling the intricate work of measuring the impacts of each trade, and accurately reflecting this data in their P&L statements. Such a desk can also assist with the complex task of creating proxy curves for pricing data, which is often essential given low levels of liquidity in underlying assets, while also helping manage counterparty risk.

In IHS Markit’s recent survey of 17 financial institutions in Japan, upgrading technology including model construction and system development were most challenging. Another challenge for banks is merging their credit data into a market risk management platform. Major players have tens of thousands of counterparties – while credit risks are typically managed with a traditional database. An integrated platform built with XVA implementation in mind can take a comprehensive, market risk-oriented view of future technology needs.

Around half of institutions surveyed say they have implemented or are considering implementing accounting CVA, with 30% saying they already incorporate CVA pricing into derivatives transactions. “Japanese institutions decided to take a phasing approach, starting from accounting CVA,” says Yoshizawa.

Implementing the right organisational change can also present difficulties as it involves more than just talent acquisition. Simply adding a new XVA desk is not enough, as the function should cover such diverse tasks as P&L control, credit spread marking, discussions on credit support annex agreements and communicating with credit managers and the treasury department. As such, cross-departmental collaboration is needed – starting with talking to the credit risk department about which spreads to use, followed by other inputs including proxy data and loss given defaults for the calculation of CVA and XVA values; once this is done, the results of sensitivity analysis can be used for hedging by trading desks. 

In summary, XVA – which includes CVA – does not confine itself to a single desk; its impact affects multiple departments. As a multilateral project, this requires a collaborative approach – integrating technology, talent and organisational structure. Given the huge impact this can have on a business, it requires a clear project road map, comprehensive impact analysis and adequate preparation to maintain competitiveness in today’s market.

 

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