CP16/22 – Implementation of the Basel 3.1 standards: Credit valuation adjustment and counterparty credit risk

Overview

7.1 This chapter sets out the Prudential Regulation Authority’s (PRA) proposals to implement the Basel 3.1 standards on credit valuation adjustment (CVA) risk. These comprise the introduction of three new methodologies for calculating CVA capital requirements: the alternative approach (AA-CVA), the basic approach (BA-CVA), and the standardised approach (SA-CVA). The proposed CVA risk framework and methodologies would replace the existing calculation methodologies for CVA capital requirements.

7.2 The proposals in this chapter would:

• complement HM Treasury’s (HMT) proposed revocation of certain Capital Requirements Regulation (CRR) articles and associated technical standards;
• delete the Credit Valuation Adjustment Risk (CRR) Part of the PRA Rulebook (Appendix 4);
• introduce a new Credit Valuation Adjustment Risk Part of the PRA Rulebook to replace the CRR requirements (Appendix 4);
• amend the Counterparty Credit Risk (CRR) Part of the PRA Rulebook (Appendix 4); and
• amend Supervisory Statement (SS) 12/13 – ‘Counterparty credit risk’ (Appendix 17).

7.3 In accordance with the Basel 3.1 standards, the PRA proposes to remove the use of internal models for CVA capital requirement calculations. Instead, the PRA proposes to introduce the Basel 3.1 standardised approach, which is based on sensitivities that would allow firms to include the effects of market risk factors on CVA risk. The PRA considers that the reduced reliance on models would promote consistency across firms in capturing CVA risk.

7.4 The proposals set out in this chapter would implement the new CVA risk framework finalised by the Basel Committee on Banking Supervision (BCBS) in 2019. The new framework is intended to improve the risk-sensitivity and comparability of CVA capital requirements, and incorporates the following improvements relative to the existing framework:

• a more comprehensive treatment of CVA risks and a better recognition of CVA hedges;
• closer alignment with industry CVA practices for accounting purposes;
• new methodologies, which have less reliance on modelling; and
• alignment with the new market risk framework methodology (set out in Chapter 6 – Market risk) in the case of the most advanced method (SA-CVA).

7.5 This chapter also sets out the PRA’s proposals for the overall scope and calibration of capital requirements for derivative exposures, following a holistic review of the appropriateness of the aggregate capital requirements from the CVA risk and counterparty credit risk (CCR) frameworks. As a result of the review, and in addition to implementing the new CVA risk framework’s methodologies, the PRA proposes to make the following changes to the scope and calibration of the CVA risk and CCR frameworks:

• increase the scope of application of the CVA risk framework, relative to the CRR, to include exposures to sovereigns, non-financial counterparties, and pension funds. Legacy trades would have transitional arrangements available;
• apply a targeted reduced risk weight in the CVA risk framework compared to the Basel 3.1 standards for exposures to pension funds; and
• apply a reduced ‘alpha factor’ of one in the standardised approach to counterparty credit risk (SA-CCR) framework for calculating exposures to non-financial counterparties and pension funds.

7.6 The PRA proposes to retain the existing CRR exemption for client clearing transactions. Regarding intragroup transactions, HMT has set out its intention to retain the existing exemption from CVA capital requirements, while creating flexibility in legislation for the PRA to create firm-specific rules. The PRA proposes to utilise this flexibility to introduce an additional approach for intragroup transactions to be exempted from CVA capital requirements, supplementing the existing approach under the CRR, based on a series of risk-based conditions.

7.7 The total amount of capital requirements for derivative exposures to counterparties is therefore a combination of the new methodologies and the increase in scope of application of the CVA risk framework, as well as the targeted reduced recalibrations across the CVA and SA-CCR frameworks. In considering the CVA risk and CCR frameworks together, the PRA considers the proposed package would result in a more coherent and consistent framework, assigning the appropriate amount of capital against relevant risks.

7.8 The proposals in this chapter are relevant to PRA-authorised banks, building societies, PRA-designated investment firms, and PRA-approved or PRA-designated financial holding companies or mixed financial holding companies (‘firms’). The proposals would not apply to UK banks and building societies that meet the Simpler-regime criteria and choose to be subject to the Transitional Capital Regime proposals.^{footnote [1]}

Credit valuation adjustment risk framework

7.9 The PRA proposes to implement the CVA risk framework set out in the Basel 3.1 standards by introducing a new Credit Valuation Adjustment Part of the PRA Rulebook, which would introduce new rules that:

• define the scope of application for transactions to be included in CVA capital requirements (section ‘Scope of application’);
• introduce a notifications process for firms intending to use the alternative approach, and a permissions process for firms wishing to use the standardised approach (section ‘Eligibility for different approaches’);
• implement the following methodologies:
  • the alternative approach (AA-CVA) for firms with limited non-centrally cleared derivatives (see ‘The alternative approach (AA-CVA)’ section in this chapter);
  • the basic approach (BA-CVA) that can be used by all firms (see ‘The basic approach (BA-CVA)’ section in this chapter); and
  • the standardised approach (SA-CVA) that can be used by firms that have been granted supervisory approval (see ‘The standardised approach (SA-CVA)’ section in this chapter).

Scope of application

7.10 Consistent with the Basel 3.1 standards, the PRA proposes that CVA capital requirements would need to be calculated by all firms undertaking covered transactions in both the non-trading book and trading book. Covered transactions include:

• over-the-counter (OTC) derivatives that are not cleared with a qualifying central counterparty, or that are not client clearing transactions;^{footnote [2]} and
• securities financing transactions (SFTs) that are fair-valued by a firm for accounting purposes and where CVA risk arising from these transactions is material, in accordance with PRA Supervisory Statement 12/13 – ‘Counterparty credit risk’.

7.11 Following the PRA’s holistic review of the calibration of capital requirements for derivative exposures, the proposed implementation would no longer exempt transactions with sovereigns, non-financial corporates, and pension funds. These proposals are set out in more detail in the ‘Calibration of capital requirements for derivative exposures (CCR and CVA risk)’ section in this chapter.

7.12 The PRA proposes to retain the existing CRR exemption from CVA capital requirements for client clearing transactions, given that the PRA considers their risk to be low due to high levels of collateralisation, and the broader systemic benefits of clearing.

7.13 The PRA notes that HMT proposes to retain the existing CRR exemption from CVA capital requirements for specific intragroup exposures that meet the requirements set out in the European Market Infrastructure Regulation (EMIR). Under this approach, intragroup transactions may be exempted from CVA capital requirements where certain conditions are met. For cross-border groups, EMIR requires the group counterparty be established in a third country that has an equivalence determination under Article 13 of EMIR.

7.14 Consistent with the flexibility intended to be provided by HMT for the PRA to create firm-specific rules for intragroup exposures, the PRA also proposes that, as an additional approach, following notification to the PRA, both domestic and cross-border intragroup transactions would be exempt from CVA capital requirements if firms meet the following conditions:

• firms include in the same accounting or prudential consolidation all counterparties to which the exemption would be applied;
• both the counterparty and the firm are subject to appropriate centralised risk evaluation, measurement, and control procedures; and
• there are no current or foreseen material practical or legal impediments to the prompt transfer of own funds or repayment of liabilities from the counterparty to the firm.

Proposed transitional arrangement for legacy trades

7.15 The PRA proposes to apply a transitional arrangement to CVA capital requirements for legacy trades with previously exempt counterparties. Legacy trades that would be exempt from CVA capital requirements immediately before application of these requirements would continue to be exempted from CVA capital requirements for five years following the implementation of the proposals set out in this Consultation Paper (CP). However, the PRA proposes firms may opt not to apply this transitional arrangement and can include legacy trades with previously exempt counterparties in their CVA capital requirements.^{footnote [3]} Where firms choose not to apply the transitional arrangement to individual trades upon implementation of the proposals set out in this CP, the transitional arrangement could not be applied to these trades at a later date. As the total amount of capital requirements for derivative exposures to counterparties is determined by the CVA and CCR frameworks, this proposal should be considered alongside a related transitional arrangement for the targeted recalibration of the SA-CCR framework, described in the ‘Calibration of capital requirements for derivative exposures (CRR and CVA risk)’ section in this chapter.

Question 43: Do you consider the proposed CVA transitional arrangement appropriate from risk and operational perspectives?

PRA objectives analysis

7.16 The proposals in this section are intended to ensure that CVA capital requirements are commensurate with the risk from transactions that firms engage in, and therefore support the PRA’s primary objective of promoting safety and soundness of firms.

7.17 The global financial crisis demonstrated the materiality of CVA risk to firms. Under the CRR, transactions with certain counterparties are exempted from CVA capital requirements. In some cases, CVA risks arising from transactions with sovereigns, non-financial counterparties, and pension funds could be material, and the PRA does not consider it to be prudentially sound for there to be no capital held against CVA risks. The proposals set out in this section would aim to ensure that, in those cases, adequate capital is held. These proposals, combined with the proposed recalibrated SA-CCR for certain counterparties (section ‘Calibration of capital requirements for derivative exposures (CCR and CVA risk)’), would result in a risk framework that advances the PRA’s safety and soundness objective.

7.18 In contrast, the PRA considers that client clearing trades have immaterial CVA risk due to high levels of collateralisation. Given this, and the broader financial stability benefits that arise from client clearing, the PRA considers that the proposal to retain the exemption for client clearing transactions remains consistent with promoting the safety and soundness of firms.

7.19 Similarly, the PRA considers that it would be consistent with its primary objective for intragroup transactions that have immaterial CVA risk to continue to be exempt from CVA capital requirements. The proposed conditions for the additional approach for intragroup trades would aim to ensure only those transactions with immaterial CVA risk on a firm-specific basis would be exempted from CVA capital requirements.

7.20 The PRA considers that the proposal to provide an additional approach for firms to exempt intragroup transactions from CVA capital requirements, which is not linked to equivalence determinations under EMIR, would facilitate effective competition by providing a means for a wider range of firms to apply the exemption.

‘Have regards’ analysis

7.21 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relative standing of the UK as a place to operate (FSMA CRR rules) and competitiveness (HMT recommendation letter):

• The PRA considers its proposals would improve the alignment of the UK’s rules with most other jurisdictions. As such, they would enable firms operating in the UK, both domestic and global, to apply a more consistent approach to CVA risk across their businesses. By removing the existing exemptions, the proposed approach provides regulatory certainty to firms operating within the UK while providing a proposed transitional arrangement that gives firms time to adjust their portfolios and for legacy trades to mature.
• The introduction of an additional approach for intragroup transactions, in addition to the existing link to EMIR equivalence, would also provide greater regulatory certainty for international groups operating in the UK.
• The PRA considers that the overall impact on the UK’s relative standing as a place to operate should be viewed in combination with the targeted reductions in the calibration of SA-CCR covered in the ‘Calibration of capital requirements for derivative exposures (CCR and CVA risk)’ section in this chapter.

2. Finance for the real economy (FSMA CRR rules) and sustainable growth (FSMA regulatory principles):

• The PRA has reviewed the available evidence, including a derivatives pricing survey conducted in 2021, and considers that increases or decreases to CVA capital requirements are not automatically passed on to counterparties through higher, or lower prices. Derivatives are part of a broader product set offered to firms’ clients, and firms regularly cross-subsidise between products. To the extent any cost is passed on, it is not clear to the PRA that these costs are economically material, or disproportionate to the risk. Most jurisdictions (eg USA, Switzerland, Australia, Hong Kong, Singapore, and Canada) do not provide for similar CVA exemptions to those in the CRR, and the PRA has not seen evidence that this lack of exemptions has been problematic in those jurisdictions. In light of evidence of the limited impact of regulatory costs on derivatives pricing, and the broader drivers of client demand beyond derivatives, the PRA does not consider that the removal of certain CVA exemptions would impact the provision of finance to the real economy and its support of sustainable growth.

3. Relevant international standards (FSMA CRR rules):

• The PRA considers that the proposals would be materially aligned with international standards, and significantly more so than if the existing exemptions were maintained.

4. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006):

• The proposals in this section support the proportionality of the framework by more closely aligning risk with capital requirements. The proposals would also simplify the processes required by firms in monitoring the application of a range of exemptions.

Eligibility for different approaches

7.22 Consistent with the Basel 3.1 standards, the PRA proposes to introduce the three new CVA risk methodologies. The implementation of these methodologies would remove the use of internal models, which the PRA considers would improve consistency across firms. As such, the PRA proposes to implement new eligibility conditions to use the different approaches, which would be included in the Credit Valuation Adjustment Risk Part of the PRA Rulebook.

7.23 Consistent with the Basel 3.1 standards, the AA-CVA would allow firms to calculate the CVA capital requirement by holding an additional 100% of their counterparty credit risk capital requirements. The PRA proposes that the AA-CVA would be available to a firm if its aggregate notional amount of non-centrally cleared derivatives is less than or equal to GBP 88 billion.^{footnote [4]} The PRA proposes that firms would pre-notify the PRA if they intend to use the AA-CVA. The PRA would consider use of its firm-specific requirements powers under FSMA to remove this option for a firm where it considers the approach does not adequately reflect risk for the firm.

7.24 The BA-CVA is a simplified methodology to measure CVA risk intended, in the Basel 3.1 standards, to be available to all firms. Consistent with those standards, the PRA proposes that no approval or notification would be needed for firms to use BA-CVA.

7.25 Consistent with the Basel 3.1 standards, the PRA proposes that firms would need to receive an initial permission to be able to use SA-CVA, the most advanced CVA risk approach in the Basel 3.1 standards. The permission could cover a firm’s entire portfolio of covered transactions or a subset of the portfolio. In addition, an annual attestation that the firm continues to meet the requirements for use of SA-CVA would be expected. The PRA’s proposed expectations for the attestation are set out in Appendix 17, in the PRA’s draft amendments to SS12/13.

7.26 Consistent with the Basel 3.1 standards, the PRA proposes that firms may use a combination of BA-CVA and SA-CVA, but firms would need to justify their approach to the PRA when applying to use SA-CVA. Firms using AA-CVA would not be able to use any other method for calculating CVA capital requirements.

7.27 As detailed in the ‘standardised approach (SA-CVA)’ section in this chapter, firms using SA-CVA would be allowed to proxy credit spreads for the calculation of the probability of default (PD) by using one of three methodologies. If firms intend to use proxy credit spreads, the PRA proposes that as part of their application for permission to use SA-CVA, firms would be required to set out clear policies for when and how they would use each of the three methodologies.

PRA objectives analysis

7.28 The PRA considers that introducing the three methodologies advances the PRA’s primary objective of safety and soundness. The PRA considers that AA-CVA would be a simple, conservative methodology appropriate for smaller firms. BA-CVA would provide a more risk-sensitive approach to estimating risks for firms with moderate CVA risk, while SA-CVA would provide an appropriate level of risk-sensitivity for firms with material CVA risks. The proposed CVA risk framework would advance the PRA’s primary objective by enhancing firms’ capture of CVA risk in their capital requirements, according to the size and complexity of their derivatives activities. Moreover, the removal of the internal modelled approach should advance the PRA’s primary objective by improving consistency in calculating CVA capital requirements across firms.

7.29 The PRA further considers that the proposals would support its secondary objective by reducing excessive variability from the current use of internal models and providing greater comparability of outcomes between firms across different approaches. Eligibility for the AA-CVA, as well as the BA-CVA, would enable firms with smaller derivatives business to compete effectively for business where the derivatives sought by clients may be ancillary to the commercial relationship.

‘Have regards’ analysis

7.30 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relevant international standards (FSMA CRR rules):

• The PRA’s proposals on available approaches and eligibility align with the Basel 3.1 standards.

2. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006):

• The PRA considers that the proposal to implement three different methodologies, each with a different level and risk-sensitivity, would provide an appropriate range of alternatives that are proportionate to the levels of CVA risk faced by different firms.

3. Efficient and economic use of PRA resources (FSMA regulatory principles):

• The proposals would deploy PRA resources efficiently by restricting the approval process to firms wishing to use the more risk-sensitive SA-CVA. The PRA considers that its proposal would simplify the permissions process for those firms using the more advanced approaches.

The alternative approach

7.31 The Basel 3.1 standards introduce an alternative approach (AA-CVA) for firms with limited non-centrally cleared OTC derivatives (based on notional amounts).

7.32 Firms using the AA-CVA would set their CVA capital requirements equal to 100% of their CCR capital requirements.

7.33 The PRA proposes to introduce the AA-CVA into the Credit Valuation Adjustment Risk Part to provide a proportionate but conservative approach to measuring CVA risk for those firms with minimal non-centrally cleared OTC derivatives exposures.

PRA objectives analysis

7.34 The PRA considers that introducing the AA-CVA advances the PRA’s primary objective of safety and soundness by allowing firms with smaller derivatives business to hold adequate capital for CVA risk in their portfolio in a simplified manner that reflects the sophistication of their risks and operations.

7.35 The PRA considers its proposal supports competition by improving the relativity between simpler and more advanced CVA methodologies. Under the CRR, the simplest methodology to measure CVA risk would require firms to multiply their CCR exposure calculated under the most conservative CCR methods by a factor of 10. Consistent with the Basel 3.1 standards, the AA-CVA would instead multiply the CCR exposures calculated under any CCR method by a factor of 1. The PRA considers that the implementation of the AA-CVA would, for firms with limited derivative activities, impose minimal CVA-related operational costs, reducing the barriers to entry to engaging in derivatives activity, and would make smaller firms that use this approach more competitive.

‘Have regards’ analysis

7.36 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006):

• The PRA considers that the AA-CVA would enhance the proportionality of the CVA risk framework by providing a simple, conservative approach for measuring CVA risk for firms with limited derivatives activity.

The basic approach

7.37 The Basel 3.1 standards introduce the basic approach (BA-CVA). The approach comprises two methodologies, the ‘reduced’ BA-CVA, and the ‘full’ BA-CVA, and would require firms to:

• calculate CVA capital requirements either via a reduced version or full version of the BA-CVA. The reduced version is a simplified methodology for firms that do not hedge CVA risk. The full version of BA-CVA is intended for firms that hedge the counterparty credit spread component of CVA risk;
• calculate CVA capital requirements per counterparty on a stand-alone basis, using a methodology which:
  • maps the counterparty to its relevant risk category to determine the risk weight;
  • takes into account the exposure, maturity (maturity adjustment factor), and a supervisory discount factor in each netting set; and
• aggregate stand-alone CVA capital requirements using a formula that recognises a fixed correlation between counterparty credit spreads.

7.38 The BA-CVA full version recognises the effect of counterparty credit spread hedges. Consistent with the Basel 3.1 standards, the PRA proposes that where a netting set is subject to BA-CVA capital requirements, it may cap the maturity adjustment factor to 1 in the internal ratings based (IRB) approach risk weight formula for CCR (see also Chapter 4 – Credit risk – internal ratings based approach).

7.39 The PRA proposes to implement both the reduced and full versions of the BA-CVA, aligned with the Basel 3.1 standards, as set out below. However, the PRA proposes a recalibration of risk weights for transactions with pension fund counterparties, set out in the ‘Calibration of capital requirements for derivative exposures (CCR and CVA risk)’ section in this chapter.

Reduced BA-CVA

7.40 The reduced BA-CVA calculation is a simplified version of the full BA-CVA calculation.

7.41 Under the PRA’s proposals, firms would first calculate CVA capital requirements for a counterparty on a stand-alone basis. This stand-alone CVA capital requirements calculation would reflect the exposure at default of the counterparty, and the volatility of its counterparty credit spread via a risk weight based on its sector and credit quality. The calculation would also consider the effective maturity and a discount factor for each netting set associated to the counterparty. No recognition would be given for hedges.

7.42 The PRA’s proposed methodology would then aggregate the stand-alone CVA capital requirements across all counterparties in a way that recognises portfolio diversification. This reflects that some CVA risks are common to all firms (ie systematic risks), and some risks are firm-specific (ie idiosyncratic risks). The final reduced BA-CVA capital requirements would therefore recognise that the portfolio of risks is different from the risks posed by each counterparty in isolation.

Full BA-CVA

7.43 The PRA proposes that the full version of BA-CVA would be a weighted sum of the reduced BA-CVA, and a ‘hedged’ BA-CVA. The hedged version would be a CVA exposure calculation that recognises the risk-reducing effect of counterparty credit spread mitigants (ie hedges). The full BA-CVA capital requirements would be the sum of 25% of the reduced BA-CVA capital requirements, and 75% of the hedged BA-CVA capital requirements. This aggregation is intended to act as a conservative means to prevent CVA capital requirements reaching zero, to recognise that hedges are not perfect.

7.44 The proposed hedged BA-CVA calculation shares similarities with the reduced BA-CVA. However, the aggregation methodology in the hedged BA-CVA differs as it recognises the reductions in CVA risk arising from (i) hedges that reference single names, in both systematic and idiosyncratic risk, and (ii) hedges that reference indices to reduce systematic risk. The methodology also adjusts the capital requirements to reflect that some components of indirect hedges are not aligned with counterparties’ credit spreads.

7.45 The PRA proposes that single-name credit default swaps (CDS), single-name contingent CDS, and index CDS can be eligible CVA hedges in the hedged BA-CVA calculation. Additionally, eligible single-name credit instruments would need to either:

• reference the counterparty directly; or
• reference an entity legally related^{footnote [5]} to the counterparty; or
• reference an entity that belongs to the same sector and region as the counterparty (eg proxy credit spreads).

PRA objectives analysis

7.46 The PRA considers that introducing BA-CVA advances the PRA’s primary objective of ensuring the safety and soundness of firms by better aligning capital requirements and risk. The PRA considers that BA-CVA represents an improvement to the existing framework to account for advances in CVA risk estimation and management since the existing methodology was implemented. In particular, it would expand the range of acceptable hedges for firms using the full BA-CVA and would adjust the maturity of transactions for CCR purposes where rating transition risks are otherwise captured.

7.47 The PRA considers that its proposals would advance the PRA’s secondary objective of competition, as they would enable firms to engage in derivatives while requiring relatively low CVA-related regulatory operational costs, eg limiting the need for firm-specific inputs.

‘Have regards’ analysis

7.48 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relevant international standards (FSMA CRR rules) and relative standing of the UK as a place to operate (FSMA CRR rules):

• The PRA considers that its proposal to introduce the BA-CVA would be a faithful implementation of the methodology set out in the Basel 3.1 standards. The PRA considers that this proposal supports the relative standing of the UK as a place to operate, given that BA-CVA would address the shortcomings in the existing CVA risk framework. This would enhance the UK’s reputation for having a robust regulatory environment, thus preserving its position as an attractive domicile for internationally active financial institutions.

2. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006) and different business models (FSMA regulatory principles):

• The PRA considers its proposals would support proportionality of the CVA risk framework. They would implement a relatively simple framework that provides a risk-sensitive methodology for firms wishing to hedge CVA risk, while providing a simple reduced version that is proportionate to the risks for firms that do not actively hedge CVA risk. The introduction of this method would therefore contribute to the adaptability of the proposed framework to different types of business models.

The standardised approach

7.49 The Basel 3.1 standards introduce the standardised approach (SA-CVA) for use by firms that have approval from their supervisors.

7.50 The SA-CVA methodology:

• relies on firm-computed CVA risk sensitivities to counterparty credit spreads and market risk factors, where these sensitivities estimate the movement of CVA risk due to changes in the value of each risk factor (‘delta risk’), and changes in the volatility of each risk factor (‘vega risk’);
• recognises the hedging of both counterparty credit spread and market risk drivers of CVA risk; and
• specifies criteria for the use of substitute data for the calculation of the PD and expected loss given default (ELGD), where spread data is not directly available (known as ‘proxy credit spreads’).

7.51 The Basel 3.1 standards also specify that where CVA capital requirements for a netting set are calculated using SA-CVA, the IRB risk weight formula for CCR would allow for the maturity adjustment factor to be capped at 1 (see also Chapter 4).

7.52 The PRA considers that the SA-CVA methodology represents an improvement in the consistency of measurement of CVA risk and aligns more closely to the market risk framework. Therefore, the PRA proposes to implement SA-CVA consistent with the Basel 3.1 standards, but with a recalibration of risk weights for pension fund transactions set out in the ‘Calibration of capital requirements for derivative exposures (CCR and CVA risk)’ section in this chapter.

7.53 The PRA proposes that for permission to be granted to use SA-CVA, a firm would need to demonstrate to the satisfaction of the PRA that:

• it is able to calculate, and report to the PRA, its own funds requirement for CVA risk in accordance with the requirements of the SA-CVA approach;
• it has a CVA desk (or a similar dedicated function) responsible for risk management and hedging of CVA risk; and
• it complies with the SA-CVA qualitative requirements.

Definition of regulatory CVA

7.54 To improve consistency of CVA capital requirement calculations across firms, the PRA proposes that the SA-CVA capital requirements would need to be calculated from a regulatory CVA measure instead of each firm’s accounting CVA measure. To achieve greater consistency and to help ensure that accounting CVA best practice is followed, the PRA proposes that regulatory CVA is calculated with specified data necessary for the calculations. Specifically:

• a term structure of market-implied PD that would need to be estimated from observed credit spreads, or proxy credit spreads if these are not available;
• market consensus ELGD, which would need to be calculated by using a risk-neutral PD from credit spreads; and
• simulated paths of discounted future exposure, which would need to be calculated by pricing all derivative transactions with the counterparty along simulated paths of relevant market risk factors.

Calculation methodology

7.55 The PRA proposes that the calculation of SA-CVA capital requirements would rely on firm-computed CVA sensitivities to counterparty credit spreads and market risk factors. These sensitivities would indicate how much the regulatory CVA would fluctuate due to delta risk and vega risk for each risk factor.

7.56 The proposals would require firms to group similar risks into risk classes (eg interest rates). Within each class, firms would then allocate risk drivers into buckets (eg a different tenor of an interest rate curve). CVA risk for delta and vega would then be calculated separately for each bucket, before being aggregated with some recognition of diversification across buckets. The PRA’s proposals within each of the above steps include the following elements:

• Risk classes: the capital requirements for delta and vega risks would be calculated independently for six risk classes: interest rate; foreign exchange; counterparty credit spread (delta risk only); reference credit spread; equity; and commodity;
• Risk buckets: the PRA proposes to define specific buckets within the six risk classes, where firms would calculate CVA capital requirements at a bucket level by aggregating CVA risk sensitivities from each risk factor specific to the risk class, separately for delta and vega risks; and
• Correlation: bucket-level capital requirements would be aggregated into CVA capital requirements at risk class level, separately for delta and vega risks, by recognising the correlation between buckets within each risk class.

7.57 The PRA proposes to maintain the existing eligibility of instruments that hedge the counterparty credit spread component of CVA risk. The proposals also recognise hedging instruments which mitigate CVA risk from market risk factors, to better align firms’ risk management and CVA capital requirements. Finally, the PRA proposes that both proxy hedges and index hedging are recognised in the SA-CVA methodology. Where the hedge instrument is an index, firms would be required to calculate sensitivities to all risk factors upon which the value of the index depends. Consistent with the Basel 3.1 standards, the PRA proposes that instruments that can be used to hedge two risk classes (eg credit spread risk and reference credit spread) are only applied to one risk class for the purpose of determining CVA capital requirements.

7.58 For firms that have been granted approval for their IRB models, the PRA proposes they would use internal ratings for the purpose of calculating CVA capital requirements for those counterparties where there is no external rating available.

Proxy credit spreads for the calculation of the probability of default

7.59 The credit spreads of a firm’s counterparties are a key input into a firm’s calculation of regulatory CVA. Where a counterparty’s credit spreads are not readily observable, the PRA proposes that firms would use available close substitutes to estimate this risk (‘proxy credit spreads’). The PRA proposes three approaches for how firms may proxy credit spreads for counterparties, as detailed below. These approaches are important to provide consistency across firms to calculate similar risks:

1. Using credit spreads observed in the market using a methodology that identifies appropriate peers based on at least the following three factors: a measure of credit quality (eg rating), industry, and region.
2. In certain cases, mapping an illiquid counterparty to a single liquid reference name. In these cases, the PRA proposes that firms would need to be able to justify to its supervisor, if requested, each case of mapping an illiquid counterparty to a single liquid reference name.
3. When no credit spreads of any of the counterparty's peers are available, a more fundamental analysis of credit risk to proxy the spread of an illiquid counterparty. In this case, where historical PDs are used as part of this assessment, the PRA proposes that the resulting spread could not be based on historical PD only; it would need to consider current market-based data.

The calculation of ELGD

7.60 The PRA considers that market-consensus ELGD is a key input into a firm’s calculation of CVA capital requirements. It sets out the loss a firm is expected to incur given the default of the counterparty. Consistent with the Basel 3.1 standards, the PRA proposes that firms would need to calculate ELGD using the risk-neutral PD from credit spreads. Where the seniority of derivatives differs from that of senior unsecured bonds, the PRA proposes firms may reflect that difference in ELGD, but would be required to be able to justify such adjustments to their supervisor if requested.

PRA objectives analysis

7.61 The PRA considers that introducing SA-CVA would advance the PRA’s primary objective of ensuring the safety and soundness of firms by providing a more risk-sensitive methodology for firms subject to significant CVA risk. Implementing the proposal would better align capital requirements with risk, when compared to existing approaches, by improving recognition of hedging and taking account of a wider range of factors that affect CVA risk.

7.62 The proposal would support the PRA’s secondary competition objective by creating greater consistency in CVA capital requirements across firms due to the removal of modelling from the most advanced existing approach.

‘Have regards’ analysis

7.63 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relevant international standards (FSMA CRR rules) and relative standing of the UK as a place to operate (FSMA CRR rules):

• The proposals use the same methodologies as set out in the international standards. The PRA considers that this would support the UK’s relative standing as a place to operate. SA-CVA would address shortcomings in existing CVA methodologies, notably through recognising movements in the exposure component of CVA, as well as expanding the scope of hedge recognition. These changes would serve to enhance the UK’s reputation for having a robust regulatory environment, thereby preserving its position as an attractive domicile for internationally active firms.

2. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006) and different business models (FSMA regulatory principles):

• The proposals would provide a risk-sensitive methodology for determining capital requirements for firms with substantial CVA risk. By standardising many elements of the methodology, it provides a proportionate balance between simplicity and risk-sensitivity where necessary, through targeted use of firms’ own estimates, including incorporating firms’ market risk estimates where relevant. The PRA considers that this proposal has had regard to different business models, as SA-CVA would be the most complex methodology and is intended for firms with large derivative activities that actively manage CVA risk. The permissions regime would allow the PRA to assess whether the firms have the appropriate skill and expertise to utilise SA-CVA.

3. Efficient and economic use of PRA resources (FSMA regulatory principles):

• The PRA considers that the proposed permissions regime, including the annual attestation process, would be an efficient and economic use of the PRA’s resources. It would enable the PRA to focus its resources into the areas of most risk or prudential concern in relation to CVA risk.

Calibration of capital requirements for derivative exposures (CCR and CVA risk)

7.64 In 2021, the PRA implemented the Basel SA-CCR methodology. In feedback provided to responses received as part of the consultation process,^{footnote [6]} the PRA noted that it would holistically review the overall level and balance of capital requirements for derivatives exposures in both the SA-CCR and CVA risk frameworks as part of the implementation of the Basel 3.1 CVA risk framework.

Calibration of SA-CCR alpha factor, CVA calibration, and exemptions

7.65 The PRA has considered the aggregate capital requirements from SA-CCR and the Basel 3.1 CVA risk framework. As a result, the PRA proposes to:

• reduce the SA-CCR ‘alpha factor’^{footnote [7]} from 1.4 to 1 for transactions with pension funds and non-financial counterparties;
• remove the existing exemptions from requiring CVA capital requirements for transactions with sovereigns and non-financial counterparties;
• remove the existing temporary exemption from requiring CVA capital requirements for transactions with pension funds, and introduce a new risk weight category for pension funds in BA-CVA and counterparty credit spread delta risk calculations in SA-CVA, which would reduce the calibration set out in the Basel 3.1 standards;
• introduce an additional approach for firms to apply the intragroup exemption directly into the PRA Rulebook; and
• retain the exemption from requiring CVA capital requirements for client clearing transactions.

7.66 The proposals would be included in the new Credit Valuation Adjustment Part, and result in amendments to the Counterparty Credit Risk (CRR) Part.

SA-CCR alpha factor

7.67 The PRA has undertaken analysis of data provided by firms on the exposure values for derivatives calculated using SA-CCR and the Internal Models Method (IMM). The PRA’s analysis identified that, when compared to IMM exposure estimates, SA-CCR calculates exposure significantly above IMM for pension funds and non-financial counterparties. The PRA considers that the level of conservatism, for exposures to these counterparty types, is excessive. The PRA therefore proposes to reduce the calibration of SA-CCR for these counterparty types. To achieve this overall recalibration, the PRA proposes to reduce the alpha factor from 1.4 to 1 for exposures to non-financial corporates and pension funds.

7.68 The PRA considers that a SA-CCR transitional arrangement linked to the CVA transitional agreement proposed in the ‘Scope of application’ section in this chapter is necessary to make sure that legacy transactions with non-financial corporates and pension funds benefiting from both the reduction in the alpha factor and the CVA transitional arrangement would have appropriate capital requirements.

7.69 Since SA-CCR groups together all trades with a counterparty when it calculates exposures, the PRA considers that it is appropriate that firms would be permitted to adopt an alpha factor equal to 1 on both legacy transactions and new transactions with pension funds and non-financial corporates. Firms would, however, be required to hold additional capital in Pillar 1 equal to the day 1 capital benefit from the reduction of the alpha factor for legacy trades. This add-on would be reduced linearly over five years, or until all trades with counterparties where alpha is set to one are voluntarily incorporated into the CVA calculation of capital requirements. The PRA considers the alternative approach - requiring firms to split netting and hedging into legacy trades and new trades - would impose a disproportionate operational burden on firms.

Question 44: Do you consider the SA-CCR transitional arrangement appropriate from risk and operational perspectives?

CVA exemptions

7.70 The CRR currently exempts several types of transactions from CVA capital requirements:

• transactions with sovereigns that meet specified conditions (set out in CRR Article 382(4)(d));
• transactions with UK non-financial counterparties and third country non-financial counterparties below the clearing threshold (set out in CRR Article 382(4)(a));
• a temporary exemption for transactions with pension funds, while there remains an exemption from the pension fund clearing obligation (set out in CRR Article 382(4)(c));
• client clearing transactions (set out in CRR Article 382(3)); and
• intragroup transactions with counterparties that meet specified conditions (set out in CRR Article 382(4)(b)).

7.71 As noted in the ‘Scope of application’ section in this chapter, given the potentially material risks these transactions pose, the PRA proposes to remove the exemption on exposures to pension funds, non-financial corporates, and sovereign transactions. The PRA also proposes to introduce a five-year transitional arrangement for these CVA legacy trades, as noted in the ‘Scope of application’ section.

7.72 The PRA considers however, that while pension funds should be in scope of CVA capital requirements, the treatment of pension funds in the Basel 3.1 standards may be overly conservative. The Basel 3.1 standards apply the same treatment to pension funds as all other types of financial services counterparties, which may not be sufficiently granular given the differing risk profiles. To address this concern, the PRA proposes to introduce a separate risk weight for pension funds. Pension funds would receive a risk weight of 3.5% for investment grade, and 8.5% for unrated and high yield exposures, both in BA-CVA and in SA-CVA. This represents an approximately 30% reduction compared to the Basel 3.1 standards.

7.73 As noted in the ‘Eligibility for different approaches’ section in this chapter, the PRA proposes to maintain the existing CVA exemption for client clearing trades, and introduce an additional approach where intragroup trades are likely to have immaterial CVA risk.

Question 45: To what extent do you consider the targeted recalibration on risk weights for pension funds and the proposed reduction in the SA-CCR alpha factor to be appropriate?

PRA objectives analysis

7.74 The proposals would advance the PRA’s primary objective of ensuring the safety and soundness of firms by ensuring that material risks are not exempted from CVA capital requirements. The PRA considers that it is prudentially sound to exempt client clearing transactions, given their very low risk nature, and the broader financial stability value of continuing to support client clearing. The PRA also considers that the intragroup exemption would not give rise to safety and soundness concerns due to the low CVA risk of those transactions. However, the global financial crisis demonstrated the materiality of CVA risk to firms. Under the CRR, transactions with certain counterparties are exempted from CVA capital requirements. Data provided to the PRA by firms in 2021 shows that CVA risk for transactions with certain sovereigns, non-financial counterparties, and pension funds is material. The PRA does not consider exempting them from capital requirements to be prudentially sound. The proposals would aim to ensure that in those cases adequate capital is held.

7.75 The PRA considers the data it has collected shows that, for some counterparties, the SA-CCR calibration compared to IMM is overly conservative. The PRA considers it appropriate that targeted recalibrations can be made without undermining the safety and soundness of firms. The PRA considers that, by implementing targeted recalibrations of the SA-CCR and CVA risk frameworks for certain exposures, the PRA would be improving risk-sensitivity by ensuring the risks are captured appropriately.

7.76 The PRA considers that the proposed package of amendments across the two frameworks would not materially impact effective competition between firms. Competition in derivative markets depends on many factors, of which capital requirements is a relatively small element. The CVA proposals would apply consistently across the BA-CVA and SA-CVA approaches, and the SA-CCR proposals reduce the over-calibration of SA-CCR relative to IMM, which make it a more credible alternative to IMM for firms.

‘Have regards’ analysis

7.77 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relative standing of the UK as a place to operate (FSMA CRR rules) and competitiveness (HMT recommendation letter):

• The PRA considers its proposals would improve the alignment of the UK with the majority of other jurisdictions. For example, USA, Switzerland, Australia, Hong Kong, Singapore, and Canada, among others, do not have CVA exemptions. As such, the PRA’s proposals would enable both domestic and global firms operating in the UK to apply a more consistent approach to CVA risk and CVA capital requirements across their businesses. By removing temporary exemptions, the proposed approach would provide regulatory certainty to firms operating within the UK.
• The PRA considers its proposed CCR and CVA recalibration and exemptions package balances the reduction in the alpha factor with the removal of specific exemptions and is justified by data. The evidence the PRA has available indicates that the nature of client relationships are driven by a wider set of products beyond derivatives pricing alone. The PRA, therefore, considers that these proposals would not materially affect the competitiveness of the UK.

2. Relevant international standards (FSMA CRR rules):

• The PRA considers that the proposals would be materially aligned with international standards, and significantly more so than if the existing exemptions were maintained.

3. Finance for the real economy (FSMA CRR rules) and sustainable growth (FSMA CRR rules):

• Having appropriate capital requirements for CVA risk is important to support firms’ robustness to market movements and ability to provide finance in the medium term, supporting sustainable growth. The PRA considers available evidence from firms demonstrates that changes to CVA capital requirements are not consistently passed on to counterparties through higher or lower prices. To the extent such costs are passed on, it is not clear that they are economically material, or disproportionate to the risk.
• The PRA is not aware of evidence from jurisdictions that have not had CVA exemptions over the last decade that this has impacted the provision of finance to the real economy or sustainable growth. The PRA considers that the reduction of the alpha factor balances any potential impact of removal of CVA exemptions.
• Consequently, the PRA considers that the proposed package across the two frameworks as a whole would not give rise to concerns that provision of finance to the real economy and sustainable growth may be negatively impacted.

4. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006):

• The PRA considers its proposals are proportionate as they more closely align risk with capital requirements. The proposals simplify the approach required by firms in removing the complicated set of exemptions and align with accounting CVA.

Question 46: To what extent do you think the proposed CVA and SA-CCR package appropriately aligns the risks with the capital requirements for derivatives transactions?