The recent
requirements by banking regulators and the adoption of IFRS 9 by financial
institutions draws some startling parallels to Credit Value Adjustments (CVA)
for derivative exposures. On trading books, the price of counterparty risk is
called CVA. In essence CVA is the difference between the price of a derivative
negotiated with a riskless counterparty and the price of a derivative
negotiated with a credit risky counterparty. IFRS 9, which is a new requirement
on performing loan books is to recognize loan loss allowances or provisions
before a default event occurs, based on the measurement of an Expected Credit
Loss (ECL).
IFRS 9 provisioning as measured through ECL measures similar
effects as CVA but involves different modelling challenges. Thus ECL and CVA
are similar concepts, one quantifying levels of provisions for a banking book
and the other for a trading book. Trading desks have lately expanded
provisioning measures for different aspects of market risk under a class of
measures known as xVA.
The concept
of provisioning is well established on the banking book and there are stringent
requirements for such from regulators and accountants. Capital markets participants on the trading
book, however, have extensive experience with financial modelling which is not
the case with their counterparts on the banking book.
CVA in
essence measures ECL as seen by the market on a derivative instrument. The main
attributes of for the expected loss is the exposure (amount) to a counterparty
and credit spread of the counterparty which is market observable. This
contrasts with IFRS 9 provisions which are not market observable but are fundamentals driven aiming to measure
forthcoming credit losses and how they are influenced by macroeconomic factors.
The significant challenge for measure ECL for IFRS 9 therefore lies in the
ability to accurately measure the significant risk deterioration (such as Loss
Given Default (LGD)) and default probability term structure for any tenor.
Participant on the banking loan book can learn a lot on the financial modelling techniques required for IFRS 9 from their trading book counterparts.
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