Basel III Credit Valuation Adjustment Capital Charge and Wrong Way Risk

Abstract

As part of a very dynamic financial environment, regulations are always being improvedand enhanced in order to keep the financial markets as transparent and regulated aspossible. Basel is currently shifting towards central clearing of derivatives productsand amending a capital charge, Credit Valuation Adjustment (CVA) capital charge, forthose that are not cleared through Central Counterparty Clearing Houses. In this work,a first part explains the newly proposed approaches for computing the regulatory CVAcapital requirement. Afterwards, the importance of incorporating the Wrong Way Risk(WWR) in the computation of the CVA is detailed. An approach based on Error Correction Models highlights the differing impact of such risk for several counterparties.Applications on interest rate swaps with a single investment grade sovereign counterparty are considered. A first conclusion discusses the divergence between the tworegulatory approaches when dealing with different counterparties within the samerisk bucket. In addition, another result is interpreted following the ECM methods reflecting the changing impact of the WWR for the counterparties considered: even forthe three European investment grade sovereigns, the model reflected a higher WWRfor Spain than the one observed for Ireland or France. A proposed modified scale forBasel methodologies would account for the effective credit quality and WWR of eachspecific counterparty in a way that converges the requested charge under both possible regulatory capital charge methodologies.