Impact of Credit Valuation Adjustment (CVA) for SA Corporates
The global financial crisis and European sovereign debt crisis experienced between 2008 and 2011 created the need for more accurate pricing of credit at inception of transactions and the dynamic quantification of credit exposures throughout the life of a trade. Incorporating this will more accurately reflect the inherent underlying credit risk.
Credit risk relates to the risk that a counterparty will default before the maturity of a transaction and will consequently be unable to meet all contractual payments, thereby resulting in a loss for the other party to the transaction. A valuation adjustment for credit reflects the amount at which such risk is measured by a market participant. This is referred to as a credit valuation adjustment (CVA) – i.e. an adjustment reflecting the credit risk exposure to the counterparty – and a debt valuation adjustment (DVA) – i.e. an adjustment reflecting the corporate’s own credit risk to which the counterparty is exposed.
The progression of IFRS requirements and changing regulations for banks are encouraging corporates and banks, respectively, to apply CVA/DVA as best practice.
The requirements of IFRS 13: Fair Value Measurement have amplified the focus on incorporating credit risk in asset and liability fair valuations. Even though IFRS does not provide specific guidance on how this can be achieved or calculated, 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 has resulted 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 and can identify scenarios where corporates are being charged a higher credit premium than warranted.
DVA is recognised to be in compliance with the IFRS 13 accounting requirements of including an assessment of an entity’s own credit risk in the fair valuation of its financial liabilities. The DVA calculation represents one of the potential methods available to a corporate to include credit risk into the fair value calculation. It also ensures congruency between the financial liability presented by the issuer (net of DVA) and the financial asset presented by the holder (net of CVA).
Arguments used to rationalise not recognising DVA relate to counter-intuitive accounting results when a gain is recognised in the Statement of Comprehensive Income in the event of a deterioration in the credit profile of an entity. In addition, an entity’s own credit risk (introduced through the recognition of DVA) can be challenging to hedge and the use of credit derivatives to mitigate the risk are often restricted by the industry regulators.
The calculation and implementation of CVA/DVA into the financial reporting, risk management and trading processes of an organisation, hold many advantages as well as challenges for South African corporates.
KPMG offers an extensive range of financial engineering and risk consulting services applicable to CVA/DVA training, implementation and assessment. We are able to provide an “end-to-end” approach: governance and strategy, valuation models and methodologies, independent price verification, operating models and processes, software/automation solutions and structuring solutions for risk management and hedging.
If you need further clarification or assistance on the impact of Credit Valuation Adjustment, please send us an email on firstname.lastname@example.org and we will be in touch with you.