Derivative valuation adjustments - frequently asked questions
These frequently asked questions (FAQs) provide information to assist regulated entities to interpret Prudential Standard APS 111 Capital Adequacy: Measurement of Capital with respect to the treatment of derivative valuation adjustments (XVAs) in the measurement of capital base and Prudential Standard APS 116 Capital Adequacy: Market Risk with respect to the market risk arising from changes in the Funding Valuation Adjustment (FVA).
Last updated: 8 May 2019
1: What are APRA’s expectations when using a derivative valuation adjustment in the measurement of an Authorised Deposit-taking institution’s regulatory capital under APS 111?
References:
APS 111 Attachment A paragraph 15 requires that valuation adjustments that need to be made must impact on CET1 Capital and may exceed those made under Australian Accounting Standards. A derivative valuation adjustment (XVA) amount may either reduce CET1 Capital (for example, a credit valuation adjustment) or increase CET1 Capital (for example, a net funding valuation adjustment if it is an asset). Furthermore, APS 111 paragraph 19 outlines the characteristics of CET1 Capital which has informed the guidance below.
In measuring the XVA amount used to calculate an ADI’s regulatory capital (such as CET1 Capital), APRA has the following expectations:
Credit valuation adjustment (CVA) – Probability of default (PD) inputs will be market implied rather than estimated from historical default data. Where liquid market prices are available for a specific counterparty, then they will be used to imply PDs. Otherwise, market based proxies that reflect the risk profile of the counterparty will be used. Loss given default (LGD) assumptions used in the CVA calculation will be internally consistent with those used to calculate the market implied PD. Where appropriate, adjustment for differences in seniority can be made.
Debit valuation adjustment (DVA) – an ADI will not include any DVA amount (a derivative valuation adjustment for an ADI’s own creditworthiness) in the measurement of its regulatory capital.
Funding valuation adjustment (FVA) – an ADI that includes FVA in its valuations will not include the net FVA amount in the measurement of its regulatory capital if it is an asset, unless the ADI has satisfied APRA that the net FVA asset can be realised under a range of possible insolvency scenarios (including the insolvency of the ADI itself). Where the net FVA amount is a liability, it should be included in the regulatory capital measurement.
Any new derivative valuation adjustment – the ADI will discuss with APRA, prior to implementation, the appropriate treatment of any new XVA that it intends to use (for example, a margin valuation adjustment for initial margin).
2: How is market risk from changes in the funding valuation adjustment (FVA) expected to be treated under APS 116?
References:
• APS 116 Attachment C paragraph 17
Where an ADI includes an FVA amount in its valuations, the ADI may choose to account for the risk of potential losses from changes in the FVA amount by incorporating FVA into its APS 116 internal model. In doing so, risk from changes in the funding cost curve will be capitalised. However, an ADI that includes FVA in its valuations, but that does not include FVA in its APS 116 internal model, will need to approach APRA with a proposed methodology for the calculation of a capital add-on. This treatment is to ensure that market risk exposures arising from changes in FVA amounts are subject to regulatory capital requirements.
An ADI using the standardised approach for market risk that incorporates FVA in its valuations will need to provide APRA with an assessment of materiality in relation to its FVA-related market risk exposure.
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