As risk of US Basel delay grows, Europe is in a bind over CVA

European Union legislators are learning something many surgeons already know. Operating may provide the only solution to alleviate a patient’s pain, but it can lead to complications.

The European Commission was given the ability to operate on one limb of a package of several reforms that will implement the Basel Committee on Banking Supervision’s global standards, known as Basel III. The EC’s scalpel was the power to delay the start date for that one part of the package, to make sure the EU aligns with other jurisdictions. Surgery now appears necessary, as a fierce backlash against proposals to implement Basel III in the US puts its start date in jeopardy.

The problem is, if the EC does take the EU’s third capital requirements regulation (CRR III) into the operating theatre, EU banks will have to contend with the disjointed implementation of rules that are supposed to be interconnected. Industry and regulators alike worry about the consequences.

“We are right now looking to see what the consequences of a delay are,” says a European regulatory source.

The Fundamental Review of the Trading Book (FRTB) is the troubled component of Basel III. It has already been fully implemented in Canada and partially so in Japan, but not yet in the EU, UK or US. In the EU, these new market risk capital rules form part of CRR III, which is meant to take effect from January 2025, but the EC has powers to delay the FRTB component for up to two years. A spokesperson for the European Commission recently told Risk.net that the start date of the FRTB should be aligned globally.

Competitive distortions arising from differing rules are more serious for bank trading desks because they can operate more freely across international borders than traditional lending services. Consequently, EU lawmakers felt the EC needed the means to ensure local banks’ trading businesses aren’t put at a disadvantage to rivals in jurisdictions that apply the rules later.

Near-final rules in the UK and the proposals in the US set the go-live date for their versions of Basel III to July 2025, which might well have been considered a tolerably short gap compared with the EU rules. But there are growing fears the US will have to push that date back further.

The natural response to that would be for the EC to trigger a delay to the European version of the FRTB. However, the EC doesn’t have the power to delay the rest of the Basel III package – and implementing the regime in stages risks making the whole thing incoherent.

There are two major drawbacks. One is around how banks should calculate capital for changes in the creditworthiness of derivatives counterparties – known as credit valuation adjustment (CVA). The other is how they should operate a new floor on the output of internal capital models that is meant to apply across the whole framework.

Broken hedges

To calculate CVA capital under CRR III, banks are meant to rely heavily on the risk-weighted assets derived using the FRTB standardised approach – the regulator-defined alternative methodology to banks’ own internal models. Consequently, banks are unnerved by what happens if the EC delays the FRTB but the new CVA framework takes effect as planned in January 2025.

“The CVA framework should be part of that mandate. If you are going to postpone the FRTB, then it makes sense to postpone the new CVA framework with it,” says a regulatory expert at a US bank.

The exact impact for banks if the CVA and FRTB frameworks enter into force at different times is complicated, but, in essence, it would mean implementing the Basel III regime for CVA in two parts.

“Given the interconnection of the CVA framework with the revised market risk framework, we have previously suggested that if the EU considers any kind of change in the timeline, then this needs to be considered holistically,” says Panayiotis Dionysopoulos, head of capital at the International Swaps and Derivatives Association. “I don’t think we have any clarity on that yet.”

The current CVA framework has resulted in banks taking divergent approaches to calculating their capital requirements, which the new version in CRR III is meant to clean up and harmonise.

Current rules allow banks to use a homegrown value-at-risk measure specific to the CVA desk. Previous iterations of CRR only allowed banks to include hedges in the VAR for CVAs that are either single-name credit default swaps (CDS) or index CDS. As a result, market risk hedges designed to hedge factors such as FX or interest rates that increase the size of the exposure to a counterparty are not counted as offsetting trades in the CVA capital framework.

Banks have gone down two different paths to tackle this. The first is simply to capitalise the ineligible hedges separately as directional positions in the trading book, rather than the CVA book. However, this can inflate capital requirements. The alternative is to include the CVA sensitivities that create the need for interest rate and FX hedges within their market risk VAR models instead, so the offsetting positions can be recognised.

To fix the issue once and for all, the new CVA framework allows market risk hedges of CVA exposures to be included within the CVA desk’s capital calculation. However, the EU will continue exempting corporate exposures from CVA capital requirements – but these exposures do still count towards banks’ accounting CVA. As a result, any credit and market risk hedges banks undertake to hedge accounting losses on corporate exposures will be ineligible as CVA hedges.

Moreover, at present, some banks also include on their CVA desk hedges for valuation adjustments related to the funding costs of uncollateralised derivatives. These funding valuation adjustment hedges are ineligible under the existing CVA framework, and will remain so under the new version.

Both these categories of hedges will therefore need to continue being capitalised separately under the market risk framework. Once the FRTB takes effect, that could be via either using the new internal models approach (IMA), for which only three banks in the EU are applying, or the standardised approach. But until then, it will have to be done with the existing market risk VAR model instead.

Consequently, a senior risk manager at an EU bank says, in the event that the FRTB is delayed, the CVA desk will potentially be running the new standardised approach for the CVA risk itself, alongside the older framework for market risk to capitalise ineligible CVA hedges.

“You have to put a boundary down on your desk, which is no longer the old boundary, but a new boundary,” they tell Risk.net.

That will continue until the FRTB is implemented. At which point, the whole exercise will have to be “redone”, generating “additional cost” for the effort of redrawing and “optimising” the calculations twice, says the senior risk manager.

Scar tissue

It all has a touch of déjà vu for EU banks, as they faced a similar situation last year. The original version of the FRTB was published in 2016, and was later amended in 2019. Having already initiated the process of incorporating the FRTB into its bank capital laws – within the last set of major changes to CRR, known as CRR II – EU legislators decided to only implement the FRTB as a reporting requirement. However, the legislation didn’t delay the FRTB’s redesign for the boundary between banks’ trading books and banking books.

Today, banks can lower capital requirements if positions either side of the trading book/banking book boundary offset each other. The FRTB – and, as a result, CRR II – places more restrictions and conditions on the recognition of these offsets. Banks will only be able to offset equity, credit and interest rate risk exposures if hedges in the trading book perfectly match the banking book risk and are transacted with third parties. For interest rate risk exposures, the hedges must be assigned to a dedicated portfolio meant for managing the market risk of internal interest rate hedges, which is capitalised separately from the rest of the trading book.

If you are going to postpone the FRTB, then it makes sense to postpone the new CVA framework with it

Regulatory expert at a US bank

The boundary changes were set to go live on June 28 last year – the date from which CRR II’s authors thought the FRTB capital requirements would also apply. In reality, rather than being able to use the FRTB metrics to capitalise the new banking book market risk desk, banks would have to use the ways defined in the current market risk rules. Four months before the boundary was due to change, the European Banking Authority issued an opinion asking supervisors not to enforce the requirements, which is referred to in the industry as a no-action letter. The EBA stated in its announcement that this would avoid a two-step implementation of the new banking book/trading book boundary.

“It’s a similar situation, that a concept that was supposed to be integrated is being taken apart just because it’s done the implementation separately,” says the senior risk manager at the EU bank.

The EBA’s opinion laying out the no-action relief does not state an explicit end date, but states that supervisors shouldn’t enforce the requirements “until the adoption of the legislative proposal achieving the full implementation of the FRTB”. There are hopes that the EBA can play surgeon’s assistant again and save the day, providing a similar no-action relief for CVA. However, the procedure may not be so straightforward.

With the boundary between the trading and banking books, legislators had provided indications in CRR II that they wanted the changes to be implemented at the same time the FRTB became a capital requirement. There are no such indications for the CVA framework. Risk.net understands legislators were also made aware of the industry’s desire to include CVA within the EC’s powers to delay the FRTB, but the idea was rejected. The EBA issuing a no-action letter could therefore be viewed as going against the original wishes of the lawmakers.

“CVA relies on the FRTB for risk weights for the calculation of the CVA charges, and there is also a read-across for hedge eligibility,” says Jouni Aaltonen, a managing director for prudential regulation at the Association for Financial Markets in Europe. “These are the key issues, and it would be optimal if a solution could be found.”

Post-op complications

CVA isn’t the only complication caused by delaying the FRTB. The European regulatory source says it is also not precisely clear how banks will calculate the new output floor on internally modelled capital requirements.

The floor was agreed by members of the Basel Committee in December 2017. After a long and heated negotiation between EU and US regulators, they agreed to floor the outputs of internal models at 72.5% of those generated by regulator-set standardised approaches.

The FRTB consists of the IMA – which banks can use as long as they pass a series of tests – and a standardised approach.

If the whole of CRR III came into force at the same time, banks would have to use the FRTB’s standardised approach to set the floor for the market risk component. If the FRTB gets delayed, however, the European regulatory source says rulemakers would need to clarify what happens to the calculation of market risk for setting the floor. The source suggests three possible ways: to implement the FRTB standardised approach, even though it would not be in force for calculating market risk capital; to use the old standardised approach; or to carve out market risk from the floor altogether.

The output floor is one of the key reasons banks are abandoning models for market risk, as they find there is no capital benefit derived from the IMA. Internal models are used in Europe to calculate by far the largest risk on the balance sheet – the credit risk of borrowers in their lending books. This risk alone eats up most or all of the room that banks have before they hit the floor, which means market risk internal models can’t really provide much relief on capital requirements.

The FRTB standardised approach was designed to align more closely with the outputs of internal models than its predecessor. Capital requirements for most banks are projected to increase on switching from old internal models to the FRTB metrics, but, in theory, the new standardised approach is meant to be more risk-sensitive than the old version. Therefore, if the previous standardised approach is used as the reference point for the output floor, it potentially means the total output of standardised approaches would increase. That would in turn make the floor more binding.

On the plus side, the European regulatory source says the phasing-in of the output floor from 50%, in its first year, to 72.5%, from January 2030, should absorb any potential tightening of the floor from temporarily using the old market risk standardised approach. Emergency surgery might not be needed after all.

“I don’t think [the floor] will be hitting a lot of banks because you have the phasing with the 50% in the first year, but there may be one or two banks who are hit by this,” says the European regulatory source.

Even with the phase-in, however, the EBA will need to clarify which metrics for the output floor banks will need to disclose for their separate reporting to supervisors and to the public, while waiting for the new standardised approach for market risk to come online. The agency is currently finalising changes to the technical standards that will detail the two reporting requirements. Whatever happens, if the FRTB is delayed, regulators and banks look set to require some medical intervention.

Editing by Philip Alexander