By Dwight Cass
Europe alone plans to exempt banks’ corporate business from Basel III CVA charge.
The first leg of the battle to protect commercial hedging activities from penalization by new, stricter derivatives regulations in the US and Europe was a qualified win. Both jurisdictions have exempted commercial hedging from the central clearing and electronic exchange trading requirements of their respective OTC derivatives reform measures. But corporate lobbyists might have won a battle but lost the war.
That’s because Basel III could crimp corporate hedging just as effectively via its new capital regime. The Accord’s new credit valuation adjustment (CVA) charge on bilateral OTC derivatives will make those instruments very expensive. But not all jurisdictions plan to apply the charge to commercial hedging transactions. And that could cause difficulties for the OTC market’s global community of dealers and possibly for the market itself.
Some exemptions
The Council of the European Union (EU), members of the European Parliament and the European Commission conducting what have become known as the “Trialogue Negotiations” over Basel III implementation have decided to exempt commercial hedging from the CVA, along with hedging by pensions and sovereigns, according to a series of recent articles in Risk magazine and elsewhere. The CVA is expected to boost the capital that banks are required to hold against such transactions, so this exemption is a relief to corporate hedgers in Europe.
Industry lobbyists argued that boosting capital reversed the intent of the corporate exemption from central clearing. As the Association for Financial Markets in Europe argued, in a comment letter on CRD IV, as the Basel III implementing legislation is known, in 2011: “Certain non-financial corporate counterparties, which are not systemically important, have been exempted from clearing obligations under EMIR. Clearing exemptions granted to such counterparties should not be undermined with higher and disproportionate capital charges under CRD IV.”
The problem is, no other jurisdiction is providing such an exemption. The banks in jurisdictions that have already implemented Basel III’s CVA charge—including Australia, Singapore and Hong Kong, are crying foul since the EU’s move gives its banks a big cost advantage when providing corporate OTC derivatives over non-EU rivals. Banks in the US are equally miffed, since they have asked regulators for a corporate exemption but reportedly have been rebuffed.
The CVA is a new charge introduced by Basel III meant to cover the risk of banks’ mark-to-market losses on OTC derivatives. Those transactions that banks clear through central counterparties will attract a nominal CVA capital charge. But the charge for bilateral transactions will be calculated using an internal risk model (typically VaR-based) that is designed to respond to changes in the counterparty’s credit spreads. Corporate and bank lobbies say the new capital charge will be some three times higher. Banks have told their clients that they will have to pass the cost on to end users, who in turn have told regulators that this will make commercial hedging expensive.
Three German industrial and treasury groups, the Deutsches Aktieninstitut, the Bundesverband der Deutschen Industrie and the Verband deutscher Treasurer, hired KPMG to conduct a study of 17 large industrial companies in 2011 and this determined that the additional hedging cost for these companies alone would be Eur124 million per annum.
Non-Balkan Balkanization
Non-EU banks that are not given this exemption will be at a significant competitive disadvantage. Their cost of providing hedging instruments to corporates will be much higher than their European rivals, which will not have to bake the CVA capital cost into the price of the derivatives.
Non-EU dealers made increasingly desperate attempts to head off the exemption in the last month. Last month, during a panel discussion at a Risk conference, Henry Wayne, senior adviser on regulatory reform and risk at Citi, argued that granting the exemption would cause banks to hedge less. According to an article about the conference on Risk.net, Wayne said, “Imagine you are a firm that actively hedges your CVA by buying credit protection against a sovereign or corporate counterparty that has been exempted from the CVA capital charge. These hedges are essentially naked in the trading book. So you have a situation where your hedges to your accounting CVA are generating a capital charge. For those firms that actively manage their CVA there is a capital incentive not to hedge—how crazy is that?”
However, since that ship has already sailed, bankers are turning up the heat on the Basel Committee to take some leadership on the issue. Leaving such a potentially divisive issue to jurisdictions to work out could lead to a balkanization of the Basel III accord, if BCBS does not put its foot down, the banks say.
Miffed US Banks asked regulators for an exemption but reportedly were rebuffed.
Citi’s Wayne, in the same Risk.net article, is quoted as saying, “…the danger is that Basel’s own credibility is a little bit at stake here.” He continued, “Europe is saying: ‘We asked Basel, and Basel said it was not interested,’ and Europe is now saying it will do something different, which means the US faces a dilemma. We do worry about the competitive landscape but we are more worried about providing the right credit at the right cost in all markets.”
CVA: A Dealer’s Nightmare
For corporates in jurisdictions outside of Europe, here are some of the problems your dealer will face when selling you hedges:
- Irrational market risk exposure. A hedged dealer P&L will become negative overnight if a counterparty’s credit spread widens or, crazily enough, if the dealer reports strong financials and its credit spread narrows.
- Because of this new credit exposure, dealers that are not credit traders suddenly have to trade credit.
- Many counterparty credit exposures created by CVA cannot be hedged.
- CVA makes risk modeling more difficult since it eliminates the concept of a deal’s fair value—the deal’s value depends on the counterparty’s credit, not the market supply and demand conditions.
What’s Next?
It’s unclear whether the BCBS will provide any guidance to head off such an eventuality. The Trialogue’s negotiations finished in March, and although the text had not been released by press time, a plenary session of the European Parliament has been scheduled for April 15. If, as expected, the target implementation date is January 1, 2014, the texts must be published in the EU Official Journal by June. By that point, the controversy over the corporate exemption should be over.