Source: Business Standard
Context: The Reserve Bank of India has proposed a revised framework governing how commercial banks must set aside capital against the risk of losses on their derivative trades, replacing rules in place since 2011. Comments have been invited until 28 August, with the rules proposed to take effect from 1 April 2027.
Applicability: all commercial banks, excluding small finance banks, payments banks and local area banks.
What CVA Is
Credit Valuation Adjustment (CVA) is an adjustment banks make to the price of a derivative contract to account for the possibility that the counterparty on the other side of the trade could default. The capital charge ensures banks set aside enough capital to cover such potential losses.
In simple terms: if a bank enters a ten-year interest rate swap with a corporate, the swap may be worth money to the bank — but only if the corporate is still solvent when payment falls due. CVA is the value the bank subtracts to reflect that risk, and the CVA capital charge is the buffer held against the risk that this adjustment itself moves adversely as the counterparty’s credit quality deteriorates.
Why the Change
- The existing framework was based on Basel Committee on Banking Supervision (BCBS) standards issued in 2010.
- The BCBS has since revised its guidelines as part of the final Basel III framework, prompting the RBI to update its rules to align with global standards.
The Proposed Approach
Banks must use the Basic Approach for CVA (BA-CVA), with a choice between two versions:
| Version | Feature | Suited to |
|---|---|---|
| Reduced BA-CVA | Does not recognise any hedges taken against CVA risk | Banks that do not hedge this risk |
| Full BA-CVA | Allows banks to factor in eligible hedges — such as single-name and index credit default swaps — provided they meet specific conditions linking the hedge to the counterparty | Banks that actively hedge CVA risk |
The Simplified Treatment for Smaller Books
- Banks whose aggregate notional amount of non-centrally cleared derivatives is ₹10 trillion or less may skip the BA-CVA computation altogether.
- Instead, they may set their CVA capital requirement equal to 100% of their capital requirement for counterparty credit risk.
- Such banks cannot recognise any CVA hedges under this simpler treatment.
- The RBI’s supervisory arm can deny a bank this option if it finds the bank’s CVA risk material to its overall risk profile.
Background Concepts
- Derivative: a contract whose value derives from an underlying asset, rate or index — interest rate swaps, currency forwards, credit default swaps.
- Counterparty credit risk: the risk that the other party to a derivative defaults before final settlement. Distinct from ordinary credit risk because the exposure varies with market movements and can be positive or negative.
- Central clearing: trades routed through a central counterparty (in India, the Clearing Corporation of India Ltd) are far less risky, since the CCP guarantees performance. This is why the ₹10 trillion threshold applies specifically to non-centrally cleared derivatives — those are where CVA risk actually resides.
- Credit default swap (CDS): a contract that pays out if a specified entity defaults — effectively insurance against counterparty failure, and hence an eligible CVA hedge.
- Basel III: the post-2008 global regulatory framework covering capital adequacy, leverage and liquidity, issued by the BCBS, which is hosted by the Bank for International Settlements at Basel.
Exam Relevance
RBI Grade B — Very high relevance for Phase II Paper III. This is core prudential regulation and precisely the technical territory RBI papers reward.
