Implementation of CVA and DVA can help manage credit risk

The International Financial Reporting Standards (IFRS) are changing banking regulations to encourage corporates to apply Credit Valuation Adjustment (CVA) and Debt Valuation Adjustment (DVA) to their operations in order to focus on incorporating credit risk in financial instrument valuations.

Credit risk is when a financial reward is lost because the borrower could not repay a loan, but is expecting to use future profits to pay off a current debt. The European sovereign debt crisis between 2008 and 2011 left a number of Eurozone member states unable to repay their government debt. This highlighted the need for accurate credit pricing at the start of transactions and the exposure of trade credit to predict credit risk early.

The crisis also revealed that there were weaknesses in how financial institutions were incorporating credit risk into their disclosure, risk management and the valuation of financial instruments (real or virtual documents representing a legal agreement involving monetary value).

This week it was reported that Deutsche Bank’s credit risk has risen and the bank’s bondholders are concerned that a sale of the retail business in order to concentrate on investment banking would deprive them of deposits needed for funding. Prior to situations like this occurring, adoption of particular regulations would be beneficial as a preventative practice.

While DVA is a valuation technique related to how a company handles changes in its fixed income security, CVA is essentially the market value of counterparty credit risk, which involves the other party in a financial transaction.

CVA enables a corporate team member to characterise the risk components of a financial instrument’s pricing by allowing credit risk to be separated from other pricing risks. Alongside this, it allows the corporate to question the pricing offered by the banks as they were not required to disclose profit information in the past. Banks have historically been considered as risk-free but this is now not the case and as a result, this attitude is changing with the introduction of CVA and DVA.

DVA is based on the compliance of the IFRS 13 accounting requirements that provides a framework for measuring fair value which is the unbiased estimate of the potential market price of a service, good or asset.

Kevin Hoff, Senior Manager at KPMG explains how the adoption of CVA and DVA has become accepted but should not be thought of as an expensive, unnecessary solution. “CVA and DVA have become the generally accepted methods for estimating the valuation adjustment to financial asset and liability prices for credit risk. The adoption of CVA shouldn’t automatically translate into additional costs or escalated pricing for corporates entering into financial instrument transactions. CVA is resulting in more accurate estimation of the potential counterparty credit risk that a bank is exposed to from a corporate over the life of an instrument.”

Hoff explores the challenges that implementing this new process can pose which include the technicality of CVA methodologies, that can involve complex mathematical calculations and the realisation that there are limited treasury management systems that currently offer automated solutions to calculate CVA or DVA.

However, Hoff identifies that there are many advantages to implementing CVA or DVA into the financial reporting of the company, such as the ability to accurately manage credit risk, verify financial instrument pricing and comply with the IRFS 13 regulation.

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