Changes to Capital Requirements for Valuation Adjustments of OTC Derivatives

Document Properties

  • Type of Publication: Letter
  • Date: June 18, 2021
  • To: Banks / Bank Holding Companies / Federally Regulated Trust and Loan Companies

OSFI is releasing revisions to its Capital Adequacy Requirements (CAR) Guideline, Chapter 8 on Credit Valuation Adjustment (CVA) risk for public consultation. In addition, OSFI is releasing revised guidance, for consultation, on the treatment of market risk hedges of other valuation adjustments of over-the-counter (OTC) derivatives, collectively referred to as XVA.

As a member of the Basel Committee on Banking Supervision (BCBS), OSFI participated in the development of the Basel III reforms, which included finalization of CVA requirements in July 2020. In developing OSFI’s domestic guidance on CVA risk, the Basel framework was used as a starting point and has been adjusted, where necessary, to reflect the Canadian market. The intention of the updated requirements is to improve risk sensitivity while continuing to promote the safety and soundness of deposit-taking institutions (DTIs).

Key changes in the draft CAR Guideline, Chapter 8 include:

  • Enhanced risk sensitivity - the current CVA capital framework does not give any recognition to market risk sensitivities and/or hedges. Previously, OSFI determined these hedges represented acceptable risk management practices and should not be capitalised as open risk positions under the market risk capital requirements. Given the revised CVA capital framework will recognize hedging and capture the effects of market risk factors on CVA, the exemption in the market risk framework will be removed upon implementation of the updated guidance.

  • Increased robustness - CVA is a complex risk. Accordingly, new approaches for its capitalization are prescribed, i.e., a new standardized approach (SA), which captures market risk sensitivities similar to OSFI’s proposed market risk capital requirements, and a basic approach (BA), which is benchmarked to the standardized approach.

  • Scope of application - the scope of application will be DTIs that are subject to OSFI’s market risk capital requirements.

Further, in March 2020, OSFI instructed DTIs to remove market risk hedges of funding valuation adjustments (FVA) from market risk capital requirements during the period of heightened market volatility caused by the onset of the COVID-19 pandemic. OSFI believes that affected institutions can and should manage portions of this risk and, further, sees parallels between FVA and collateral valuation adjustments (ColVA). As a result, OSFI proposes that the hedges of the exposure component of FVA and ColVA, subject to regulatory verification of sound governance and risk management arrangements, may be removed from a DTI’s market risk capital requirements. The remainder, which includes hedges of a DTI’s cost of funds component of FVA and all other XVAs, must be capitalized under the market risk capital requirements as set out in the revised Chapter 9 of the CAR Guideline. Draft wording has been provided in the annex of this letter. Final language will be included in the publication of a final CAR Guideline, Chapter 9, expected in late 2021.

Implementation Timelines

The revised CAR Guideline, Chapter 8 covering CVA risk and the paragraph relating to the treatment of market risk hedges of XVA (to be included in CAR Guideline, Chapter 9) will come into effect in fiscal Q1-2024.

Request for Feedback

OSFI welcomes questions and comments on all aspects of the changes to the guidance noted above. Questions and comments should be sent to OSFI by email at Consultations@osfi-bsif.gc.ca no later than July 30, 2021. A non-attributed summary of industry comments along with OSFI’s responses will be posted on OSFI’s website upon publication of final guidance.

Yours truly,

Ben Gully
Assistant Superintendent
Regulation Sector

Annex proposed treatment of other XVAs

The following text is proposed for consultation and will ultimately be inserted into the CAR Guideline, Chapter 9 upon finalization:

Paragraph XX. The revised CVA framework (see Chapter 8) now captures both the risk and hedges of CVA (including both the credit risk and exposure components). As such, any transactions related to the management of CVA risk will not be covered in the market risk framework. In addition, institutions are not permitted to include sensitivities to other valuation adjustment (commonly referred to as XVA) in the market risk framework. However, any market risk hedges of XVA risk must be included in the market risk framework with the following exceptions:

  • Any market risk hedges of ColVA (sometimes referred to as overnight indexed swap or OIS discounting) that meet the conditions for eligibility listed in the paragraph below; and
  • Any market risk hedges of the exposure component of funding VA (FVA)Footnote 1.

Hedges of ColVA and hedges of the exposure component of FVA can be excluded from the market risk framework if the following conditions are met:

  • Institutions have a well-defined and nominated trading desk that satisfies the organizational structure described in paragraph 55. That structure must include an independent risk control unit responsible for the design, documentation, and implementation of the measurement of FVA and ColVA risk. This unit should report directly to senior management of the institution;

  • The excluded hedges are evidenced to be risk reducing at their inception according to the documented measure of FVA and/or ColVA risk through the use of risk factor identification processes, regular backtesting, P&L assessment and stress testing programs as described in paragraph 271 and subject to an independent model validation process (paragraph 272);

  • The excluded hedges are initiated, tracked and managed as a hedge of either ColVA or the exposure component of FVA in accordance with internal protocols for compliance that are consistent with paragraph 277 and internal audit/validation functions in paragraph 280.

Institutions must measure and monitor the effectiveness of the excluded hedges in normal conditions and in times of stress. Institutions should assess any material residual or basis risk as part of their stress testing programs (e.g. ICAAP, etc.) and account for this in Pillar 2 capital in excess of minimum requirements commensurate with their risk profile.

Footnotes

Footnote 1

FVA can be split into a funding (or cost of funds) component and an exposure component. Hedges of the cost of funds component must be included in the market risk framework.

Return to footnote 1