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CVA: Sector Curves Are Here to Stay

14 December 2017 Gavan Nolan

To stay on top of the mountain of regulation emanating from the various authorities can feel like a Sisyphean task. So one could be forgiven for overlooking a consultation launched by the European Banking Authority in July 2016 (one of 35 that year) that resulted in final draft Regulatory Technical Standards (RTS) published in June 2017.

Nonetheless, institutions calculating Credit Valuation Adjustment (CVA) should pay heed to the EBA's document. The consultation addressed an important issue, namely the use of proxy spreads in CVA. Single name CDS spreads are explicitly required - under Article 383 of the Capital Requirements Regulation - as part of the calculation for own funds requirements for CVA risk. But if single names spreads are not observable for certain counterparties a proxy spread should be used. EU regulations (CRR) in 2013 and 2014 established the three-factor approach - rating, industry and region - to determine proxy spreads.

Sector curves (e.g. a Europe BB Financials curve) are now widely used as proxies in CVA processes. This works well for the vast majority of counterparties. But the EBA's consultation and subsequent RTS addressed the possibility of using alternative approaches based on fundamental analysis of credit risk to proxy the spreads. In particular, this method may be applicable for counterparties that not only they, but also their peers, have no observable CDS spreads.

The EBA's RTS introduces some welcome flexibility to determining proxy spreads. New language was added that allows the use of alternative measures of credit risk, which is likely to include fundamental analysis. Institutions will have to provide a rationale and document the methodology.

However, there are important caveats. Alternative proxy approaches can only be used when CDS spreads or "spreads of other liquid credit risk instruments" are unavailable for the counterparty's peers, i.e. entities that share the same rating, industry and region characteristics. This means that even if CDS spreads are unavailable, the far larger bond universe would first have to be utilized before alternative methods can be implemented. This limits the ability of banks to deviate from the three-factor model and is likely to restrict alternative methods to sectors such as project finance and infrastructure.

In short, the RTS consolidates the use of sector curves as proxy spreads, along with some new, restricted provisions to use fundamental analysis where credit data is lacking. The EBA's summary of responses to the consultation and their analysis also contains important clarifications to the regulation. One respondent suggests a hierarchy should be introduced consisting of: (i) single name CDS; (ii) bond spreads; (iii) CDS sector proxy spread; (iv) bond sector proxy spread; (v) alternative approach based on fundamentals. The EBA's response was illuminating. It reaffirmed that proxy spreads can reflect "other liquid traded credit risk instruments", as well as CDS spreads. This gives the green light to use bond sectors as proxies, which wasn't always clear to many European institutions.

The RTS also provides additional flexibility in using the spread of a parent entity as a proxy for a subsidiary - important for overseas subsidiaries that were previously allocated misleading sector curves as proxies - as well as amendments to the Loss Given Default formula in CVA. But the main thrust of the RTS is that the three-factor approach to determining proxy spreads is here to stay. It follows that sourcing accurate sector curves - both CDS and bonds - remains as important as ever. Indeed, the EBA estimates that proxy spreads are applied for 77% of counterparties. Banks should ensure that sector curves are derived from datasets that are both accurate and extensive, as well as using a methodology that is robust and transparent.

Gavan Nolan, Director, Fixed Income Pricing, IHS Markit
Tel: +44 20 7260 2232
gavan.nolan@ihsmarkit.com

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