02 July 2014

EBA: Technical advice to the EC on the treatment of own credit risk related to derivative liabilities

The EBA published a technical advice to the EC on the use of a prudential filter for gains and losses arising from banks' own credit risk of derivatives. The EBA considers as appropriate not to deviate from the current prudential approach applied at the international level under the Basel III rules.

The measurement of own credit risk of derivatives (debit valuation adjustment - DVA) depends on several valuation inputs such as interest rates, an institution's own credit standing and other market factors that can affect the exposure value. The analysis of the EBA highlighted that at present it is challenging to measure own credit risk in a robust way. In addition, it is difficult to isolate in a consistent way the changes in own credit risk that are stemming only from changes in an institution's own credit standing.

In its advice, the EBA analyses different approaches of treating fair value gains and losses arising from institutions' own credit standing and concludes that it would be appropriate not to deviate from the Basel approach, i.e. full deduction of own credit risk adjustment from capital at inception. The Basel approach also ensures a conservative outcome and a level playing field at the international level and has the merit of addressing such a complex and ongoing issue in a rather simple way.

The prudential requirements could possibly be revised in the future, if necessary and if an agreement is reached on the current issues under debate. In the meantime, a close monitoring of institutions' practices related to own credit risk from derivatives seems appropriate, says the EBA.

The analysis of the issues in the application of the current Article 33(1)(c) of the Capital Requirements Regulation (CRR) highlighted the following.

- IFRS 13 Fair Value Measurements does not prescribe the approach to be used when calculating own credit risk. The valuation practices for own credit risk are still evolving and there is, in some situations, no consensus on the best approach to be applied; therefore different valuation approaches are currently used by institutions to measure own credit risk.

- Due to the specificities of measuring derivatives (including the estimated exposure mainly being influenced by the volatility of an underlying value; the several valuation inputs involved; and the netting with other exposures within a netting set), the measurement of own credit risk can be heavily reliant on the particular valuation method applied and the assumptions used by an institution, which could be different from one institution to another.

- One of the main conceptual concerns regarding the recognition of own credit risk in own funds is the uncertainty of its realisation. In addition, the appropriateness of the recognition and the measurement of any funding valuation adjustments is still under discussion, in particular defining the extent of the possible interaction between own credit risk and funding valuation adjustments.

- During the EBA’s brief outreach, some respondents explained that they currently apply a full derecognition of own credit risk mainly due to the lack of clarity of the CRR text and its objective, and to be consistent with Basel III requirements. 

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Technical advice

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