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Basel III reforms: how easy will it be to mitigate CVA capital charges?

One of the most important, and also controversial, reforms under the Basel III framework is the introduction of credit valuation adjustment into calculations of counterparty credit risk capital. In addition to maintaining capital against counterparty default, banks will also soon be required to calculate a CVA capital charge to protect against a deterioration in the credit quality of their counterparties in respect of their OTC derivative transactions.

The CVA capital charge aims to address the fact that almost two thirds of counterparty credit losses during the financial crisis stemmed from deteriorations in counterparty credit quality, rather than actual counterparty default. Under the current Basel III implementation timeline, the CVA capital charge will come into effect from 1 January 2013, although many banks are already factoring the charge into their derivative transactions with clients. In Europe, the Basel III reforms relating to CVA risk are likely to be incorporated into Chapter 6 of the Capital Requirements Regulation.

Bakers & McKenzie analyse Article 375 (Eligible hedges) of the draft Capital Requirements Regulation to see whether it sheds any light on the types of hedging instruments and other structures which can legitimately be used to reduce and mitigate CVA capital charges.