CVA: the first sign of BCBS strategic change?

Author:Mika Veli-Pekka Viljanen
Position:Faculty of Law, University of Turku, Turku, Finland
Pages:230-251
SUMMARY

Purpose - The purpose of this paper is to aid understanding of the changes in Basel Committee on Banking Supervision (BCBS) regulatory strategies after the global financial crisis. Design/methodology/approach - The author uses the credit valuation adjustment (CVA) charge reform as a test case for inquiring whether BCBS has departed... (see full summary)

 
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CVA: the rst sign of BCBS
strategic change?
Mika Veli-Pekka Viljanen
Faculty of Law, University of Turku, Turku, Finland
Abstract
Purpose – The purpose of this paper is to aid understanding of the changes in Basel Committee on
Banking Supervision (BCBS) regulatory strategies after the global nancial crisis.
Design/methodology/approach – The author uses the credit valuation adjustment (CVA) charge
reform as a test case for inquiring whether BCBS has departed from its pre-crisis facilitative regulatory
strategy path. The regulatory strategy of the CVA charge is discussed.
Findings The charge exhibits a new regulatory strategy that BCBS has adopted. It seeks to
manipulate market structures by imposing risk-insensitive capital charge methodologies.
Originality/value – The paper offers a new heuristic to analyse regulatory initiatives and their
signicance. The CVA charge has not been subject to a regulatory theory-based analysis in prior
literature.
Keywords Banking, Strategy, Capital regulation, Credit valuation adjustment
Paper type Research paper
1. Introduction
1.1 A nasty surprise
The Merrill Lynch 10-Q for second quarter of 2008 informed investors that the bank had
suffered 8.5 billion dollars in cumulative losses during the rst six months of 2008. The
majority of the losses, some 6 and quarter billion dollars, stemmed from credit valuation
adjustments (CVAs). The CVAs were write-offs on exposures to nancial guarantors for
US super senior ABS CDOs (Merrill Lynch & Co., Inc, 2008, p. 88). Merrill Lynch’s huge
losses were no outliers. From 2006 to 2011, the total tally of US CVA losses on monoline
insurers alone amounted to some 56 billion dollars, according to, e.g. an ISDA, the
International Swap and Derivatives Association survey (International Swaps and
Derivatives Association, 2011).
For the Basel Committee on Banking Supervision (BCBS), the global bank regulator,
CVA losses were a blind-side hit. The Basel 2 reforms (BCBS, 2004,2005b,2006) had
recast the global banking rules in 2007. In the course of the reforms, Basel 1 (Basle
Committee on Banking Supervision, 1988) Annex 3 rules on counterparty credit risk
(CCR) had been revised by Basel 2 Annex 4. With the introduction of internal models
method (IMM), the former simplistic Basel 1 regime had been updated to allow
sophisticated banks to use state-of-the-art bank internal risk measurement tools to
determine CCR capital charges. The world’s biggest banks had expended sizeable
resources to build internal risk measurement systems. Consequently, everything should
have been ne with ample capital reserved to guard against counterparty losses.
The article was written while the author was a member in and later the leader of How to rule the
economy, a research project funded by the Academy of Finland.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
JFRC
23,3
230
Journalof Financial Regulation
andCompliance
Vol.23 No. 3, 2015
pp.230-251
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-05-2014-0021
Nevertheless, when the nancial crisis hit, banks suffered huge losses, all resulting from
a risk that had gone unanticipated in the newly minted rules.
The CVA story is one of regulatory failure. The narrative is, however, very
complicated from start to nish. BCBS’s regulatory failure, if anything, was an
ontological misperformance. The Committee had required banks to perform wrong
kinds of risks and, as a consequence, prepared balance sheets against CCR, not CVA
risk.
The BCBS’s response to the counterparty risk methodology failure was Byzantine.
The story has multiple twists and turns. The rst BCBS proposal (BCBS, 2009f,
pp. 32-34) failed in a highly tumultuous consultation process. The nal Basel 3 (BCBS,
2010a) rules (Basel 3 § 97-105) signicantly watered down the Committee’s rst try at a
CVA methodology.
Albeit BCBS did cave in to industry demands, the nal rules constitute a move that is
far from surrender. To the contrary, the CVA saga seems to constitute a watershed event
in the BCBS’s regulatory strategy continuum. I will argue that the charge marks the
emergence of an interventionist BCBS. In the charge, the rst cracks start to appear in
the Committee’s approach to banking regulation. BCBS no more attempts to affect bank
business decisions by replicating risks as realistically as state-of-the-art risk
measurement methods and the Committee’s nerves allow – as it used to do before the
nancial crisis (Young, 2012, pp. 672-674). Now, BCBS is starting to actively shape bank
business models.
The objective of this paper is to illustrate some of the basic tenets of the BCBS’s new
approach to banking-risk regulation. To understand the discussion of the new approach,
the reader must know what the CVA charge is, what it sought to mend and how it was
constructed. Thus, the article, in its second section, provides an overview of the
development of Basel 2 Annex 4 CCR methodologies and describes how and why the
Basel 2 rules failed in the crisis. The third section outlines BCBS’s rst CVA charge
proposal. The fourth section discusses the industry’s views on the proposal. The fth
section describes the nal rules. The sixth and nal chapter of the paper discusses the
characteristics of the BCBS’s new regulatory strategy.
2. Failure
2.1 Two understandings of counterparty-related risk
Counterparty-related risks primarily stem from banks’ derivative assets. Imagine that a
bank concludes, e.g. a ve-year plain vanilla interest rate swap with a non-nancial rm.
The bank agrees to pay the counterparty the three-month oating LIBOR rate on an
agreed notional amount each quarter, while the counterparty promises to pay a xed
rate on the same notional.
The bank can make a loss on the swap in two ways. First, the swap has an inherent
value as a contractual asset. This value is a function of both parties’ future payment
obligations. To arrive at the value, expected payments under both the payer and receiver
legs are discounted to net present value (NPV) (Bicksler and Chen, 1986). The value of
the swap is equal to the difference of the leg NPVs. The party for whom the NPV of its
payments is smaller has an asset. For the other party, the derivative contract is a
liability. This inherent value of the contract and its subsequent variation are the main
worries for both parties. If the markets move against either of the party, the contract will
lose in value for one and appreciate for the other party. If the derivative asset falls under
231
CVA: the rst
sign of BCBS
strategic
change?

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