Publication of the draft ECB guide on the assessment methodology (EGAM) for the internal model method and advanced CVA capital charge for counterparty credit risk

Frequently asked questions (FAQs)

What is the purpose of the guide?

The guide addresses the supervisory assessment methodology for models used by banks to calculate the capital requirements for counterparty credit risk (CCR) and covers initial approvals, changes and extensions of internal models as well as ongoing model monitoring. The respective internal models are used to determine the capital requirements to be applied when banks enter into derivative or securities financing transactions with customers.

These capital requirements act as a safety buffer if the bank is confronted with unexpected losses from such transactions. Banks can use internal models to calculate the exposure from these transactions resulting from a potential default of the counterparty, which is then used to determine their capital requirement.

An assessment methodology determines which model components need to be investigated by supervisors and the minimum level of depth and detail needed to form a supervisory judgement on the model's compliance with existing regulation. Of course, supervisors can always opt to go beyond the minimum requirements defined in an assessment methodology.

The guide aims to provide a common understanding of the supervisory approach to assessing the compliance of these internal CCR models with existing regulations. These models comprise the internal model method (IMM) as part of credit risk, providing the exposure value, and the advanced method for calculating own funds requirements due to credit valuation adjustment risk (A-CVA). The guide should not be construed as going beyond the current applicable EU and national laws and is therefore not intended to replace, overrule or affect said laws.

The assessment methodology outlined in the EGAM can also be used for the self-assessments of credit institutions that have or are preparing internal CCR models.

Why are you publishing the guide? Why does it focus on counterparty credit risk?

The European Banking Authority (EBA) is mandated by Regulation (EU) 575/2013 to draft regulatory technical standards that set out assessment methodologies for the initial approval, extensions and changes to banks' internal models for credit risk, operational risk and market risk for later adoption by the European Commission. However, mandatory standards are not envisaged for the IMM and A-CVA models, which are not as widely used by banks.

The ECB therefore considered it helpful to provide supervisory guidance for those institutions it supervises directly on how to assess the compliance of such models with existing regulations, drawing as far as possible on the approaches already defined by the EBA for other risk types.

Why are you conducting a public consultation and what would be the next step?

As previously announced, ECB Banking Supervision decided to use a two-step approach to ensure that this guide is transparent and invite experts to give their opinions. Industry feedback was initially collected in December 2017. After updating the guide on the basis of this feedback, including in the light of the finalised ECB guide to internal models, the ECB is now conducting a public consultation and intends to publish the guide on assessment methodology in 2020.

What are counterparty credit risk and credit valuation adjustment risk?

The guide deals with models used to calculate CCR risks for over-the-counter (OTC) derivatives and securities financing transactions (SFT). In this context, the counterparty risk covered by the IMM represents a bank’s expected exposure for portfolios of such transactions in the event that the counterparty defaults. The expected exposure is the expected cost to the institution of replacing the transaction by entering into an equivalent new transaction with a new counterparty.

The CVA is a fair value adjustment for OTC derivatives and SFTs reflecting the expected loss from such a transaction in the event that the counterparty defaults. This adjustment is not constant over time because the credit quality of the counterparty can improve or worsen. CVA risk is a measure of the risk associated with the volatility resulting from these changes.

Under the Capital Requirements Regulation, financial institutions:

  • can apply to use the IMM to calculate the exposure value used in regulatory procedures to calculate capital requirements for credit risk related to the counterparty for OTC derivatives and/or SFTs
  • must use the A-CVA to calculate the capital requirements related to the risk of changing CVA immediately after IMM approval if the institution also has approval to use an internal model for the specific risks of debt instruments

What are OTC derivatives and SFTs?

Derivatives are contracts that derive their value from financial data such as the values of indices or underlying financial assets. OTC derivatives are contracts that are traded and privately negotiated directly between two parties, without going through an exchange, but include transactions with central counterparties where contracts are based on novation. Examples of OTC derivatives are an interest rate swap or an equity option. SFTs are transactions in which securities are used to borrow cash or vice versa. An example of an SFT is a repurchase transaction, where a security such as a bond is sold for a cash amount and the receiver of the cash amount simultaneously agrees to buy the security back at a later date.

The market values of derivatives depend on the underlying asset in the case of an option and the security in the case of an SFT, as well as interest rates and potentially also foreign exchange rates.

Why are you focusing on OTC derivatives and SFTs?

In line with the applicable regulation on CCR, which is restricted to these deal types, the guide focuses on the CCR of OTC derivatives and SFTs. In fact, for these products the exposure is calculated in a different way than for a traditional loan. The exposure of a traditional loan is, to a large extent, fixed. In the case of OTC derivatives and SFTs, the exposure depends on the development of market risk factors, such as interest rates and foreign exchange rates, over the term of the product. It is this exposure to developments in market risk factors that introduces additional complexity when calculating the exposure values.

Which banks does the guide apply to?

The majority of banks use standardised approaches to calculating both their expected exposures to counterparty credit risk and their credit valuation risk capital requirements. The guide is only applicable to institutions directly supervised by the ECB that have permission to implement an IMM in accordance with Article 283 of the CRR, that have implemented an advanced method for calculating CVA risk in accordance with Article 383 of the CRR, and institutions seeking approval for IMM or CVA internal models.