Risk Annual Summit: DVA hedging creates systemic risk, says Brigo

King's College professor of finance Damiano Brigo says regulators should clamp down on dealers looking to hedge debit value adjustment gains by selling CDS protection on closely correlated names

Banks that seek to hedge debit value adjustment (DVA) by selling credit default swap (CDS) protection on their peers are creating systemic risk, and the practice should be clamped down upon by regulators, according to Damiano Brigo, a professor of finance at King's College London.

Speaking at the Risk Annual Summit today, Brigo said a proxy hedge of this type may offset DVA variations in normal times, but a sudden default in the reference entity would mean the bank has to pay out on the CDS contract – presumably, at a time of crisis in the banking sector.

"From a spread point of view, it may be fine – but from the point of view of jump-to-default risk, it's really crazy and exacerbates systemic risk," he said.

DVA reflects the impact of a bank's increasing default risk on its own liabilities – as credit spreads widen, the chance of it failing to meet it obligations increases, and the value of those liabilities falls. To hedge this, a bank would need to buy back its own debt or sell credit protection on itself. Banks aren't allowed to do the latter, so an alternative is to write CDS protection on a correlated entity – for instance, another bank.

"If you think about this strategy in 2008, a bank selling protection on Lehman Brothers would have to pay out the settlement in the middle of the crisis, pushing it closer to default. Regulators should be very concerned about this proxy hedging – it's very dangerous and if everybody starts doing it, it's going to be a very critical situation."

Only one bank is thought to be hedging DVA across its business – Goldman Sachs. Other dealers are also looking at the issue, including Credit Suisse, UBS and UniCredit.