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Banks not ready for CVA and counterparty risk elements of Basel III says E&Y

A survey of more than 120 senior traders and chief risk officers attending a London seminar entitled ‘Managing Counterparty Risk and Basel III’ purports to show that the majority of banks have Basel lll compliance projects underway but are still not ready for the credit valuation adjustment (CVA) and counterparty risk elements of the new capital adequacy regime.

Organised by Ernst & Young (E&Y), Quantifi and the Professional Risk Managers' International Association (PRMIA), the London show, held on 19 March of this year, addressed the issue of counterparty credit risk and Basel lll. The survey of attendees is only now being released, and claims to show that banks continue to create centralised counterparty risk management groups in order to deal with the impending regulation.

Data management, analytics, and performance and scalability - in declining order of importance - are considered the most important technology components for an effective counterparty risk solution.

Enhancing counterparty credit risk management practices is a key focus for banks. This is in response to changes in accounting rules and new prudential and market regulations, which have tightened substantially following the 2008 financial crisis. Collectively, these changes emanating from the Pittsburgh G20 meeting and including call for over-the-counter (OTC) trading to effectively go back ‘on exchange’, are having a deep impact on the market. Collectively, the US Dodd-Frank Act, European Market Infrastructure Regulation (EMIR) and other regional initiatives aiming to enforce global standards like Basel III, have driven banks to invest significantly in better pricing and reporting capability and in the active management of counterparty credit risk. Reducing regional variations is of course crucial in establishing an effective global policy framework.

“Regulatory mandates continue to drive change and will have a major impact on OTC businesses for most banks,” comments Dmitry Pugachevsky, director of research at Quantifi. “Not only does it change the way in which banks address counterparty credit risk and CVA, it will also require them to undertake significant process and system changes. New minimum capital ratios will drive new methods of measuring and allocating capital as banks will be required to hold more capital and higher quality of capital to cover CVA risk.”

Key findings of the seminar survey include:

• The majority of banks have Basel III projects in progress (71%) but are still not ready for the counterparty credit risk elements of Basel III.
• Banks continue the trend of creating centralised counterparty risk management groups (CVA desks) to more actively monitor and hedge credit risk (50%). A significant number of banks, however, continue to manage across multiple groups (35%).
• Data management (45%), performance and scalability (18%), and analytics (16%) are considered the most important components of an effective counterparty risk solution.

According to Shankar Mukherjee, senior manager for financial services advisory at Ernst & Young, determining the fair value of derivatives contracts continues to be one of the key issues for the banking sector. “The financial crisis led to significant changes in the valuation of derivatives contracts with a number of banks introducing new valuation methodologies over the last two years as assumptions that held true in the pre-crisis era have lost their validity,” he said. “The new International Financial Reporting Standards (IFRS) accounting standard on fair value measurement, and the new charge under Basel III related to valuation adjustments as a result of credit, also mean institutions have to fundamentally rethink their approach to managing counterparty credit risk.”