The adoption of accounting credit valuation adjustment (CVA) began in April 2021 amid an economy in disarray and the enforcement of various financial restrictions due to the Covid‑19 pandemic. Financial institutions are now accelerating their adoption measures while carefully studying the status of their global competitors.

Keeping this in mind, this feature offers an overview of the current situation regarding valuation adjustments - collectively known as XVA - as well as an outlook for valuation management, based on the paper Latest trends regarding valuation in Japan, which was discussed at the 2021 Risk Japan XVA panel session held in September 2021.

Recent developments for accounting CVA in Japan

First, let's outline the current situation for CVA in Japan. In preparation for the adoption of XVA, megabanks have been looking for ways to obtain information necessary for the calculation of XVA: that is, capturing a variety of consensus market data, and establishing a simplified process to systematically input counterparty credit information, transaction data and market data, including credit default swaps (CDS). IHS Markit has had several cases of its data used in this way.

Banks need to manage XVA risk with accurate and efficient hedge operations. The pandemic, followed by a rapid economic downturn, quickly lowered liquidity in the 2020 CDS market. The turmoil was so intense that iTraxx Japan recorded a spike in the CDS basis surpassing 180. This high level of market volatility made larger hedge operations necessary, and served as a reminder of the importance of XVA risk management. During this period, one bank used iTraxx EUR instead of iTraxx Japan to hedge the spread volatility of Japanese credit, given the liquidity. It's a good example of how XVA operation requires innovative and data-driven strategy.

This fiscal year, IHS Markit has had dozens of accounting CVA adoptions in other institutions, including regional and major domestic banks. However, establishing an XVA-dedicated department, the function of which includes hedge operation - as is the case in megabanks - remains rare. Most determine that their firms' CVA/debit valuation adjustment (DVA) amounts do not justify the efforts and resources needed for management by a dedicated desk.

That said, accounting CVA is critical due to its impact of fair-value measurement on derivatives assets and liabilities on balance sheets. Without information based on market consensus data, it becomes more difficult to produce an accurate balance sheet according to the 'exit price' accounting standard requirement. Additionally, a certain level of risk management framework is required for fluctuating CVA/DVA numbers. CVA adoption improves counterparty risk management, which is why it is not just part of an accounting debate, but extends to risk management too.

SA‑CVA or BA‑CVA?

The next challenge for banks that have adopted accounting CVA is the CVA risk asset assessment in Basel III. Deciding between the standardized approach to CVA (SA‑CVA) and the basic approach to CVA (BA‑CVA) can be an important bifurcation point within a general hedging strategy.

SA‑CVA is one method of greatly reducing risk-weighted assets (RWAs). Its effectiveness is also established when it comes to hedging against credit risk, as well as interest rate and foreign exchange risks. By setting up an XVA desk as part of a hedging strategy, financial institutions opting for SA‑CVA can expect a positive impact on the management of their RWAs.

Some believe BA‑CVA - which is regarded as an upgrade of the current standard formula for risk measuring - can result in bigger capital requirements compared with the current standard formula. But others hold the opinion that BA‑CVA is easy to adopt, as system developments can remain limited in scale. At any rate, studying the strength of one's bank's portfolio and derivatives strategy, before settling on what to do and how far to go, is the logical next step in maintaining a stable computational system. It is undeniable that this end-goal is of the utmost importance.

IHS Markit's outlook on XVA management: towards stabilised management of risk

As previously discussed, institutions that have already adopted CVA will probably proceed with data organisation and improved simulations. In a recent discussion with the market, a firm in an advanced stage of its XVA journey said: "If our funding curves and lending curves are the same, we are basically giving traders an opportunity to cherry-pick. So we're debating where we should set our funding curve." Examples such as this demonstrate why we believe there remains a high level of interest in more XVA. IHS Markit has also spoken with many banks about funding XVA as the counterparty valuation function against the mark-to-market discounting setting for trades.

Regarding market value adjustment, capital valuation adjustment (KVA) and their usefulness in hedging operations, we expect a growing interest in new sets of data (historical data, for example). In addition, collecting and exploiting this data might require an overhaul of IT systems. The 2021 Risk Japan XVA panel session discussed the challenge of maintaining human and technological resources around XVA calculation even in major banks.

Previously, we often heard that cloud services presented a security risk. However, as banks are increasingly asked to improve their derivatives valuations and portfolio management, we have been told by many institutions that, given the difficulty of handling operations in-house, they were naturally considering using cloud services.

It appears CVA adoption comes hand-in-hand with all kinds of organizational adjustments, and IHS Markit understands that those should be the most relevant and take the shortest amount of time. Our goal is to support the stable development of institutions through the critical data and unique solutions we offer.

Learn more about XVA Solutions from IHS Markit.

This article was first published in Risk.net on 27 January 2022.

Posted 07 February 2022 by Hiroyuki Yoshizawa, Executive Director, Market Data, Valuations & Analytics; Japan, S&P Global Market Intelligence