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29-583: Basel I was developed through deliberations among central bankers from major countries. In 1988, the Basel Committee published a set of minimum capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992. A new set of rules known as Basel II was developed and published in 2004 to supersede the Basel I accords. Basel III

58-721: A number of banks had released Deutschmarks (the German currency) to the Herstatt Bank in exchange for dollar payments deliverable in New York City . Due to differences in the time zones , there was a lag in the dollar payment to the counterparty banks; during this lag period, before the dollar payments could be effected in New York, the Herstatt Bank was liquidated by German regulators. This incident prompted

87-517: A portion of profits on uncollateralized financial derivatives. These reserved profits can be viewed as the net present value of the credit risk embedded in the transaction. Thus, as outlined, under IFRS 13 changes in counterparty risk will result in earnings volatility; see XVA § Accounting impact and next section. In the course of trading and investing, Tier 1 investment banks generate counterparty EPE and ENE (expected positive/negative exposure ). Whereas historically, this exposure

116-490: A revised securitisation framework, and a standardised approach to counterparty credit risk (SA-CCR) to measure exposure to derivative transactions. A specific framework for exposures to central counterparty clearing was introduced. The BCBS also published regulatory standards for the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR); In subsequent years, the Basel Committee updated

145-513: A specific capital charge under Basel III , and may also result in earnings volatility under IFRS 13 , and is therefore managed by a specialized desk. In financial mathematics one defines CVA as the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty 's default. In other words, CVA is the market value of counterparty credit risk . This price adjustment will depend on counterparty credit spreads as well as on

174-578: Is an "adjustment" to a derivative's price, as charged by a bank to a counterparty to compensate it for taking on the credit risk of that counterparty during the life of the transaction. CVA is one of a family of related valuation adjustments, collectively xVA ; for further context here see Financial economics § Derivative pricing . "CVA" can refer more generally to several related concepts, as delineated aside. The most common transactions attracting CVA involve interest rate derivatives , foreign exchange derivatives , and combinations thereof. CVA has

203-467: Is the time of default, E ( t ) {\displaystyle E(t)} is the exposure at time t {\displaystyle t} , and P D ( s , t ) {\displaystyle \mathrm {PD} (s,t)} is the risk neutral probability of counterparty default between times s {\displaystyle s} and t {\displaystyle t} . These probabilities can be obtained from

232-547: Is via a Monte-Carlo simulation on all risk factors; this is computationally demanding. There exists a simple approximation for CVA, sometimes referred to as the "net current exposure method". This consists in: buying default protection, typically a Credit Default Swap , netted for each counterparty; and the CDS price may then be used to back out the CVA charge. The CVA charge may be seen as an accounting adjustment made to reserve

261-725: The United States . Over 100 other countries also adopted, at least in name, the principles prescribed under Basel I. The efficacy with which the principles are enforced varies, even within nations of the Group. Basel I incentivized global banks to lend to members of the OECD and the IMF's General Arrangements to Borrow (GAB) while disincentivizing loans to non-members of these institutions. Credit valuation adjustment A Credit valuation adjustment ( CVA ), in financial mathematics ,

290-456: The financial crisis of 2007–2008 , the Basel III reforms were published in 2010/11. The standards set new definitions of capital, higher capital ratio requirements, and a leverage ratio requirement as a "back stop" measure. Risk-based capital requirements (RWAs) for CVA risk and interest rate risk in the banking book were introduced for the first time, along with a large exposures framework,

319-460: The Basel Committee consisted of representatives from central banks and regulatory authorities of the Group of Ten countries plus Luxembourg and Spain . Since 2009, all of the other G-20 major economies are represented, as well as some other major banking locales such as Hong Kong and Singapore . The Committee does not have the authority to enforce recommendations, although most member countries as well as some other countries tend to implement

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348-487: The Basel I framework. It introduced "three pillars": Capital requirements for operational risk were introduced for the first time. The ratio of equity and credit is 8% under Basel II. The standards were revised several times during subsequent years. Bank regulators in the United States took the position of requiring a bank to follow the set of rules (Basel I or Basel II) giving the more conservative approach for

377-733: The Basel III, may further contribute to these skewed incentives. New liquidity regulation, notwithstanding its good intentions, is another likely candidate to increase bank incentives to exploit regulation. In an October 24, 2020 speech at the Bund Financial Summit in Shanghai, Jack Ma described the Basel Accords as a "club for the elderly." Basel I Basel I is the first Basel Accord . It arose from deliberations by central bankers from major countries during

406-487: The Committee's policies. This means that recommendations are enforced through national (or EU -wide) laws and regulations, rather than as a result of the committee's recommendations - thus some time may pass and, potentially, some unilateral changes may be made, between the international recommendations for minimum standards being agreed and implementation as law at the national level. The regulatory standards published by

435-778: The G-10 nations to form the Basel Committee on Banking Supervision in late 1974, under the auspices of the Bank for International Settlements (BIS) located in Basel , Switzerland. Basel I, that is, the 1988 Basel Accord, is primarily focused on credit risk and appropriate risk-weighting of assets . Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of 0% (for example cash, bullion , home country debt like Treasuries), 20% (securitisations such as mortgage-backed securities (MBS) with

464-613: The bank. Because of this it was anticipated that only the few very largest US banks would operate under the Basel II rules, the others being regulated under the Basel I framework. However Basel II standards were criticised by some for allowing banks to take on too much risk with too little capital. This was considered part of the cause of the US subprime mortgage crisis , which started in 2008. The Basel 2.5 revisions introduced stressed VaR and IRC for modelled market risk in 2009-10. Following

493-413: The changes are substantial enough to warrant that title and the Basel Committee refer to only three Basel Accords. These new standards came into effect on 1 January 2023, although national implementation of the standards is generally running behind this schedule and still ongoing. The framework's approach to risk which is based on risk weights derived from the past was criticised for failing to account for

522-550: The committee are commonly known as Basel Accords. They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel , Switzerland and the committee normally meets there. The Basel Accords is a set of recommendations for regulations in the banking industry . Deliberations by central bankers from major countries resulted in the Basel Capital Accord , which

551-590: The highest AAA rating ), 50% (municipal revenue bonds, residential mortgages), 100% (for example, most corporate debt), and some assets given no rating. Banks with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA). The tier 1 capital ratio = tier 1 capital / all RWA The total capital ratio = (tier 1 + tier 2 capital) / all RWA Leverage ratio = total capital/average total assets Banks are also required to report off-balance-sheet items such as letters of credit, unused commitments, and derivatives. These all factor into

580-410: The late 1970s and 1980s. In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel , Switzerland, published a set of minimum capital requirements for banks. It is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992. The Committee was formed in response to the messy liquidation of Cologne -based Herstatt Bank in 1974. On 26 June 1974

609-403: The longest transaction in the portfolio, B t {\displaystyle B_{t}} is the future value of one unit of the base currency invested today at the prevailing interest rate for maturity t {\displaystyle t} , L G D {\displaystyle LGD} is the loss given default , τ {\displaystyle \tau }

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638-407: The market risk factors that drive derivatives' values and, therefore, exposure. It is typically calculated under a simulation framework . (Which can become computationally intensive; see .) Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation can be written as where T {\displaystyle T}   is the maturity of

667-785: The risk weighted assets, which are reported to regulators. In the United States, the report is typically submitted to the Federal Reserve Bank as HC-R for the bank-holding company and submitted to the Office of the Comptroller of the Currency (OCC) as RC-R for just the bank. From 1988 this framework was progressively introduced in member countries of G-10, comprising 13 countries as of 2013 : Belgium , Canada , France , Germany , Italy , Japan , Luxembourg , Netherlands , Spain , Sweden , Switzerland , United Kingdom and

696-464: The standards for market risk, based on a “ Fundamental Review of the Trading Book ” (FRTB). In addition, further reforms of the framework were published by the Basel Committee in 2017 under the title Basel III: Finalising post-crisis reforms . These reforms were sometimes referred to as "Basel IV". However, the secretary general of the Basel Committee said, in a 2016 speech, that he did not believe

725-405: The term structure of credit default swap (CDS) spreads. Assuming independence between exposure and counterparty's credit quality greatly simplifies the analysis. Under this assumption this simplifies to where E E ∗ {\displaystyle \mathrm {EE} ^{*}} is the risk-neutral discounted expected exposure (EE): The full calculation of CVA, as above,

754-542: The uncertainty in the future. A recent OECD study suggest that bank regulation based on the Basel accords encourage unconventional business practices and contributed to or even reinforced adverse systemic shocks that materialised during the financial crisis. According to the study, capital regulation based on risk-weighted assets encourages innovation designed to circumvent regulatory requirements and shifts banks' focus away from their core economic functions. Tighter capital requirements based on risk-weighted assets, introduced in

783-509: Was a concern of both the Front Office trading desk and Middle Office finance teams , increasingly CVA pricing and hedging is under the "ownership" of a centralized CVA desk . In particular, this desk addresses volatility in earnings due to the IFRS 13 accounting standard requiring that CVA be considered in mark-to-market accounting. The hedging here focuses on addressing changes to

812-449: Was a set of enhancements to in response to the financial crisis of 2007–2008 . It does not supersede either Basel I or II but focuses on reforms to the Basel II framework to address specific issues, including related to the risk of a bank run . The Basel Accords have been integrated into the consolidated Basel Framework , which comprises all of the current and forthcoming standards of the Basel Committee on Banking Supervision. Formerly,

841-408: Was published in 1988 and covered capital requirements for credit risk . The Accord was enforced by law in the Group of Ten (G-10) countries in 1992. The Basel Accord was augmented in 1996 with a framework for market risk , which included both a standardised approach and a modelled approach, the latter based on value at risk . Published in 2004, Basel II was a new capital framework to supersede

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