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Banking Essentials - Part I

This pathway will walk us through the basics of banks, starting with some of the different types and their main functions, then starting to look at the regulation faced by the banks, both before and after the Global Financial Crisis.

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Greenwashing is the act of distributing false information about something being more environmentally friendly than it actually is.

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Expert led content

+1,000 expert presented, on-demand video modules

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Keep track of learning progress with our comprehensive data

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Gain CPD / CPE credits and professional certification

Managed learning

Build, scale and manage your organisation’s learning

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Connect Finance Unlocked to your current platform

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In this video, Max discusses the cost-of-living crisis currently enveloping the UK. He examines its impact on households as well as the overall economy.

CSR and Sustainability in Financial Services

In the first video of this two-part video series, Elisa introduces us to sustainability. She begins by looking at the difference between sustainability and corporate social responsibility, two terms that can be easily confused.

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Introduction to KVA

Introduction to KVA

Steven Marshall

25 years: Derivatives trading

In this next video within the XVA pathway, Steven Marshall discusses the cost of capital in derivative trades, the KVA. He will first explain the emergence of KVA after Basel III and then discuss how to calculate KVA.

In this next video within the XVA pathway, Steven Marshall discusses the cost of capital in derivative trades, the KVA. He will first explain the emergence of KVA after Basel III and then discuss how to calculate KVA.

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Introduction to KVA

10 mins 15 secs

Key learning objectives:

  • Understand the background of KVA

  • Outline KVA

Overview:

Another factor impacting derivative pricing is capital. This has become more prominent in recent years due to the increased capital requirements following the financial crisis. With increased capital requirements on derivative transactions, firms are having to price in this cost of capital in trade prices, this is known as KVA.

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Summary

How did KVA emerge?

Before the financial crisis, capital requirements for derivatives were very light, with the main rule being Counterparty Credit Risk (CCR), which treated capital being similar to a loan to the countparty in an amount equivalent to the current exposure of the derivative. This caused two issues:

Firstly, as credit ratings are used to determine CCR capital, and CDS spreads used in CVA (the pricing of credit risk on derivatives) valuations, there were billions in CVA losses in the crisis as CDS spreads widened massively, but ratings didn’t move. 

Secondly, the calculation of CCR only looks at the current exposure of a derivative, whereas CVA charges are driven by the exposure profile. 

These two issues lead to a cyclical movement in capital. I.e. the economy does well, CCR and CVA are low. In crisis times, CVA increases, then finally capital increases as counterparties are downgraded. This then lead to significant capital requirements on firms at the same time they were struggling with CVA losses. 

Basel III provided a buffer for CVA losses as well as realised counterparty losses with the aim of being less cyclical. CCR remained and firms could move to a standardised or advanced CVA model. 

Why did Basel III cause KVA?

The introduction of Basel III significantly increased the amount of capital required to be held, especially for uncollateralised derivative trades. 

Many firms left the industry, but for the firms still involved the requirement to hold significantly more collateral resulted in lower returns on capital and firms realised the cost had to be reflected in both pricing and trading.

There were two outcomes from this: 

  1. Clearing became more common due to beneficial capital treatment. 
    For trades requiring higher capital, banks priced in a mark-up at the time of execution.
  2. Estimating this cost of capital over the life of a trade became known as KVA, the expected value of the cost of capital. 


How is KVA calculated?

Calculating KVA is as much of an art as it is a science. Many transactions may be unwound or restructured during their lifetime. This is especially true for loan hedges. How much will economic hedges for CVA benefit or hinder the regulatory calculation? This cannot be answered precisely and it can have a significant impact on return metrics. Also, capital management is not as dynamic as funding. 

KVA is used as a guide for firms when they are pricing up new transactions as to how much mark-up to put on a trade so that they are not deploying capital at too cheap a rate.  It is not held as an accounting adjustment, and this creates a potential mismatch between when revenues are declared (usually on day one due to mark-to-market accounting) and the capital that is held over the life of a transaction.

KVA is at the cutting edge of pricing derivative transactions, and there is still a lot of discussion around best practice and how it will be developed going forward.

 

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Steven Marshall

Steven Marshall

Steven Marshall has over 25 years of experience in Global Markets and Investment Banking trading both interest and credit derivatives, most recently running the Global Business Resource Management Team at Nomura International. Steven is now the CEO and co-founder of RegRisk Technology where he provides innovative technology solutions to aid with regulatory compliance at financial firms and is currently providing XVA consultancy services via Tensilo Limited.

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