Basel III, the new capital accord, is shaping up as a major pain point for banks in terms of counterparty credit risk and regulatory capital.
Enhancing counterparty credit risk management practices is a key focus for banks in response to changes in accounting rules and new prudential and market regulations which have tightened substantially following the financial crisis.
Collectively, these changes are having a deep impact on the market and have driven banks to invest significantly in better pricing and reporting capability and in the active management of counterparty credit risk.
“Regulatory mandates continue to drive change and will have a major impact on OTC businesses for most banks. Not only does it change the way in which banks address counterparty credit risk and credit value adjustment (CVA), it will also require them to undertake significant process and system changes,” said Dmitry Pugachevsky, director of research at Quantifi. “New minimum capital ratios will drive new methods of measuring and allocating capital as banks will be required to hold more capital and higher quality of capital to cover CVA risk.”
The majorities of banks have Basel III projects in progress (71%) but are still not ready for the counterparty credit risk elements of Basel III, according to a survey of senior traders and chief risk officers by Quantifi.
Banks continue the trend of creating centralized counterparty risk management groups (CVA desks) to more actively monitor and hedge credit risk (50%). A significant number of banks, however, continue to manage across multiple groups (35%).
Data management (45%), performance and scalability (18%), and analytics (16%) are considered the most important components of an effective counterparty risk solution. This is consistent with earlier surveys in 2011 and 2013 by Quantifi.
The new IFRS accounting standard on fair value measurement and the new charge under Basel III related to valuation adjustments as a result of credit mean institutions have to fundamentally rethink their approach to managing counterparty credit risk.
“Determining the fair value of derivatives contracts continues to be one of the key issues for the banking sector,” said Shankar Mukherjee, senior manager, financial services advisory at Ernst & Young. “The financial crisis led to significant changes in the valuation of derivatives contracts with a number of banks introducing new valuation methodologies over the last two years as assumptions that held true in the pre-crisis era have lost their validity.”
Despite all the talks of tightening bank capital requirements globally, specific loopholes in regards to internal ratings based ("IRB") approach to credit risk and risk-based capital will not be identified and closed anytime soon, according to Ron D'Vari, CEO and co-Founder at NewOak Capital Advisors.
The latest study through Regulatory Assessment Consistency Programme ("RCAP") by Basel Committee has identified that there is about 20% variation in the internal ratings-based approaches in estimating credit risk across various investments among various banks.
“RCAP's study results indicated a potential structural bias toward underestimating risks and overstating capital ratios in certain jurisdictions, more so in certain asset classes,” D’Vari said.
The degree of flexibility permitted in implementing risk-weighted capital rules using internal models in various jurisdictions has been criticized, particularly in Europe. While the study indicates that the U.S. banks were in general above standardized approach, the banks from the rest of the world were dispersed on both sides.
"While the discrepancies among banks' internal rating-based models have been suspected by market participants and regulators, RCAP's latest report puts additional pressure on regulators to impose fresh new rules and tighten the existing ones,” D’Vari said.
"No doubt the rule setting committee is searching for finding ways to narrow the deviations and reduce use of loopholes to artificially look stronger on capital adequacy,” he said. “Some have suggested instituting a minimum risk-weighted capital as way of fixing the inconsistency. However the latest report doesn't hint at any clear solutions."
