Quantifi, a provider of analytics and risk management solutions for the global OTC markets, has published a joint whitepaper with consultant Jon Gregory exploring the difference in capital charges between the simple and more advanced approaches and the capital relief that can be achieved.
The paper is entitled “Comparing Alternate Methods for Calculating CVA Capital Charges under Basel III”.
Gregory (pictured), partner at Solum Financial Partners, says: “To be competitive, OTC businesses need to be able to accurately measure and manage their regulatory capital charges under Basel III. This whitepaper will help banks understand the different approaches allowed under Basel III and the impact that hedging has on these charges.”
The Basel III proposals, first published in December 2009, introduced changes to the Basel II rules that reflected the need for a new capital charge against the volatility of CVA. There are two ways for banks to compute CVA VaR, standardised and advanced methods, depending on their current regulatory approval. Furthermore, firms can potentially reduce the capital charges via eligible hedges.
This paper reviews the two regimes by:
• Describing and comparing the various methodologies for calculating counterparty credit risk capital under Basel regulations
• Analysing these methods in detail and demonstrating that both standardised and advanced formulas can be interpreted as 99 per cent VaR of losses due to CVA volatilities; thus simple comparative analysis can be done based on CVA volatilities and correlations implied by the methods
• Running simple tests for three methods: standardised (CEM), standardised (IMM) and advanced to investigate which one performs better for various maturities and different types of counterparties
• Analysing results for a real portfolio and highlighting that the difference in capital between the simple and more advanced approaches when considering hedging can be significant
Dmitry Pugachevsky, director of research at Quantifi, says: “In the current environment, when different regulatory capital charges are drastically reducing return on equity (ROE) targets, it is extremely important to understand the structure of some of the largest charges, in particular Basel III CVA capital charge. This white paper demonstrates that using more advanced methodologies and applying optimal hedges can significantly reduce these charges and improve ROE for OTC businesses.”