Credit score adjustment

The credit rating adjustment or adaptation of the credit rating ( English credit valuation adjustment , abbreviated CVA) is a correction without sufficient consideration of credit risk market assessment carried out by the costed credit risk. The correction term itself is also often named with this term.

In the case of marketable securities such as bonds, the associated credit risk is usually already factored into the market value; An important tool here is the credit rating with the help of rating codes . Since the granting of loans is the classic core business of banks, proven procedures are also used here to assess and evaluate the credit risk.

However, in the financial crisis from 2007 onwards , decisive deficiencies in handling credit risks emerged. Numerous financial products have been created in which the credit risk has become opaque for the buyer through bundling, repackaging and side agreements. This set in motion a kind of pyramid scheme that coincided with the increased occurrence of credit risks from the underlying individual loans.

Another point in the crisis, which can be briefly referred to as the “lack of credit rating adjustment”, was the following: Financial institutions have underestimated or ignored the counterparty risk of counterparty default in derivatives traded over the counter . This point revealed a “blind spot” in the view of financial institutions on the risks inherent in bilateral transactions. This can be explained by the fact that such transactions were largely only priced on the basis of models due to the lack of marketability, with the usual models evaluating the transaction while eliminating the risk of default. This misjudgment could turn into a systemic risk for the entire financial market, since at that time a high proportion of these transactions were not subject to any other security mechanisms such as clearing .

Historical background

The counterparty credit risk of financial institutions is the latest since the bankruptcy of Herstatt Bank became visible 1974th When, on June 26, 1974, the Federal Supervisory Office (today: BaFin ) withdrew the Herstatt Bank's banking license in accordance with Section 35 (2) No. 4 KWG , it also ordered the company to be wound up and ordered it to be liquidated immediately until further notice Cease payments . This so-called moratorium on raising funds meant that the Herstatt Bank was no longer allowed to make payments to credit institutions that were due even if they had already provided their consideration .

In the financial crisis that began in 2007, it became apparent that institutions significantly underestimated the counterparty default risk for derivatives traded over the counter. A failure of such a large institute as Lehman Brothers was - explicitly or implicitly - considered impossible (" Too Big to Fail "). That is why the G20 summit in September 2009 called for derivatives to be cleared through a central counterparty (CCP). This requirement was implemented in 2012 with Regulation (EU) No. 648/2012 (Market Infrastructure Regulation) . Clearing via a central counterparty makes the replacement of failed instruments far more likely, as all clearing members have to deposit collateral with the central counterparty, which the central counterparty must use in the event of a member defaulting. This three-level control and monitoring system is "three lines of defense" ( english three lines of defense called).

In his work Counterparty Credit Risk and Credit Value Adjustment in August 2012 , Jon Gregory dealt extensively with counterparty default risk. Since the financial crisis in 2007, he regards this risk as the decisive financial risk in banks. Gregory emphasizes the bilateral nature of the counterparty default risk in over-the-counter derivatives (depending on the performance) as distinct from credit risks from debt relationships. He views counterparty default risk as a combination of market risk and credit risk . The market risk is reflected in the market value , while the credit risk reflects the credit quality. Accordingly, a counterparty with a high probability of default and a low market value is not preferable to one with a higher market value and a lower probability of default.

Since the financial crisis, regulators have also paid more attention to the credit rating adjustment (CVA). The BaFin commented in BaFin Journal 01/2014 some basic questions about the CVA. The Capital Adequacy Ordinance (CRR), which has been in force since 2014, contains provisions on CVA in Articles 381 to 386. The methods for calculating CVA specified there will soon be replaced; the relevant provisions come from the Basel Committee on Banking Supervision.

Terms

The credit rating adjustment can be explained as the difference in value between a risk-free portfolio and an identical portfolio, taking into account the counterparty risk of default; the adjustment amount represents the market value of the counterparty risk.

The umbrella term valuation adjustment (VA for short) is made up of the following components:

CVA - English credit valuation adjustment ; the credit value adjustment by the counterparty's default risk
DVA - English debt valuation adjustment ; the credit value adjustment by the own default risk ( impairment ).
KVA - English capital valuation adjustment ; the amount that has to be retained as a reserve due to regulatory requirements. The amount of the KVA corresponds to the CVA calculated in accordance with the regulations.
FVA - funding valuation adjustment ; the impairment due to liquidity risks .

These components of the rating adjustment (VA) are collectively referred to as XVA .

content

Regulation (EU) No. 575/2013 (Capital Adequacy Regulation) (CRR), which has been in force since January 2014, understands the CVA to mean " adjusting the valuation of a portfolio with a counterparty to the valuation at average market value" (Art. 381 CRR). This adjustment reflects the market value of the counterparty's credit risk vis-à-vis the evaluating institution. This means that the value of receivables on derivatives is adjusted due to the counterparty default risk. This risk arises due to potential market value losses due to increased credit spreads at the counterparty. The current market value can be calculated in favor of the counterparty using the credit spread from a hypothetical credit default swap . The CVA is important as long as the counterparty does not default, but only its creditworthiness deteriorates. One speaks of CVA when the counterparty's default risk (in the case of positive market values) has to be taken into account, and DVA when the own credit risk (in the case of negative market values) has to be taken into account. The DVA does not play a role in the counterparty default risk.

scope

The CVA credit rating adjustment affects all contracts where delivery of the underlying asset and payment are postponed beyond two trading days. This includes futures , swaps , derivatives or similar transactions. These transactions are to be booked into an internal bank credit line , which is known as the “pre-settlement limit”, because the counterparty can default before the settlement date. This credit line is the result of a positive credit decision , as credit institutions may not enter into a business relationship with a counterparty without having subjected it to a credit check (Art. 286 (2a) CRR). The transactions are valued with the expected replacement cost at the mean market value.

The CVA credit rating adjustment is waived for transactions with central counterparties (Art. 382 No. 3 CCR), non-financial counterparties (Art. 382 No. 4a CRR) and with counterparties to which a risk weight of 0% is assigned (Art. 382 No. 4d CRR).

Accounting law

The CVA credit valuation adjustment also found its way into international accounting law in January 2013 . According to IFRS 13, these are value adjustments within the framework of the fair value of derivative financial instruments . The characteristics of the asset to be measured , which a market participant would take into account when pricing the asset on the measurement date, must be taken into account (IFRS 13:11).

calculation

The Basel Committee on Banking Supervision (BCBS) is currently revising the CVA Risk Framework . As a result, there will be new rules for calculating the CVA. The original consultative document envisaged three options; It can now be assumed that there will only be two: the so-called Standard Approach (SA-CVA) and the Basic CVA (BA-CVA). The SA-CVA is an adaptation of the standard approach for calculating market risk . This approach will be used by banks with more complex risk management . For this approach, it is necessary to calculate the sensitivities of the CVA depending on various risk factors. The supervisory authorities must check and confirm that the respective institute is sufficiently capable of doing this.

To calculate the SA-CVA all transactions are first divided across five asset classes ( interest rate swaps , currency swaps , credit derivatives , equity derivatives , commodities ) and in turn to so-called risk groups (English risk buckets ) (interest rate swaps as the currency of transactions). The total CVA corresponds to the sum of the CVA of the five exposure classes. This is made up of the contribution of the individual risk groups as follows:

{\ displaystyle K = m _ {\ mbox {CVA}} \ cdot {\ sqrt {\ sum _ {b} K_ {b} ^ {2} + \ sum _ {b} \ sum _ {c \ not = b} \ gamma _ {bc} K_ {b} \ cdot K_ {c}}}}

The sizes and are parameters prescribed by supervisory law. The sizes are determined from the sensitivities to individual risk factors (how these are to be determined is left to the banks) and specified parameters such as risk weights or correlations . ${\ displaystyle m _ {\ mbox {CVA}}}$ ${\ displaystyle \ gamma _ {bc}}$ ${\ displaystyle K_ {b}}$

The BA-CVA must be used by all institutes that do not meet the above criteria. These will typically be smaller banks or non-banks . The BA-CVA is calculated as follows:

{\ displaystyle K = K _ {\ mbox {spread}} + K _ {\ mbox {EE}}}

A distinction is made between whether the CVA has been saved or not. The unsecured case is given as an example: ${\ displaystyle K _ {\ mbox {spread}}}$

{\ displaystyle K _ {\ mbox {spread}} ^ {\ mbox {unhedged}} = {\ sqrt {(\ rho \ cdot \ sum _ {c} S_ {c}) ^ {2} + (1- \ rho ^ {2}) \ cdot \ sum _ {c} S_ {c} ^ {2}}}}

There is a predefined correlation parameter and the “supervisory expected shortfall”, which is calculated (among other predefined parameters) from the term and the default loan amount . The SA-CCR is therefore also required to implement the BA-CVA. ${\ displaystyle \ rho}$ ${\ displaystyle S_ {c}}$

For simply applies: ${\ displaystyle K _ {\ mbox {EE}}}$

{\ displaystyle K _ {\ mbox {EE}} = \ beta \ cdot K _ {\ mbox {spread}} ^ {\ mbox {unhedged}}}

with as a given factor. ${\ displaystyle \ beta = 0.5}$

literature

Sven Ludwig, Marcus RW Martin, Carsten S. Wehn: Counterparty Risk. Assessment, control, backing according to Basel III and IFRS . Schäffer-Poeschel, Stuttgart 2012, ISBN 978-3-7910-3176-7 .

Individual evidence

^ Preliminary remarks Section 81 of the CCR
^ ^A ^b Jon Gregory: Counterparty Credit Risk and Credit Value Adjustment . John Wiley & Sons, 2012 (English, limited preview in Google Book Search - 480 pages).
↑ BaFin Journal 01/2014 of January 2014, CRD IV, p. 22 f.
↑ Regulation (EU) No. 575/2013 of the European Parliament and of the Council , accessed on June 27, 2018
↑ ^a ^b Consultative Document. Review of the Credit Valuation Adjustment Risk Framework. Basel Committee on Banking Supervision, July 2015, accessed on June 27, 2018 .
↑ ^a ^b Reducing variation in credit-risk weighted assets - constraints on the use of internal model approaches. Basel Committee on Banking Supervision, March 2016, accessed on June 27, 2018 .

[1] Preliminary remarks Section 81 of the CCR

[Gregory2012-2] A ^b Jon Gregory: Counterparty Credit Risk and Credit Value Adjustment . John Wiley & Sons, 2012 (English, limited preview in Google Book Search - 480 pages).

[3] BaFin Journal 01/2014 of January 2014, CRD IV, p. 22 f.

[4] Regulation (EU) No. 575/2013 of the European Parliament and of the Council , accessed on June 27, 2018

[BCBS_325-5] Consultative Document. Review of the Credit Valuation Adjustment Risk Framework. Basel Committee on Banking Supervision, July 2015, accessed on June 27, 2018 .

[BCBS_362-6] Reducing variation in credit-risk weighted assets - constraints on the use of internal model approaches. Basel Committee on Banking Supervision, March 2016, accessed on June 27, 2018 .