1.A credit valuation adjustment (CVA) is an adjustment to the fair value of a derivative instrument to account for counterparty credit risk. CVA is commonly viewed as the cost of counterparty credit risk. For any given position with a counterparty, this cost depends on the market’s perception of the riskiness of the counterparty, as reflected for example in counterparty credit spreads, as well as on the market value of the exposure, which typically depends on underlying market factors.

2.During the financial crisis, banks suffered significant losses due to counterparty risk exposure on over-the-counter (OTC) derivatives. Various analyses have concluded that the majority of these losses came not from counterparty defaults but from fair value adjustments on derivatives. The value of outstanding derivative assets was written down as it became apparent that counterparties had become less likely to meet their obligations. These types of credit-related losses, reflected in changes in CVA, are now widely recognized as a source of risk for banks involved in derivatives activity.

3.Under the Basel II market risk framework, firms were required to hold capital against the variability in the market value of their derivatives in the trading book, but there was no requirement to capitalize against variability in CVA. Counterparty credit risk capital under Basel II was based on the credit risk framework, and designed to provide protection against default and migration risk rather than the potential losses that can arise through variations in CVA.

4.To address this gap in the prudential capital framework, the Basel Committee on Banking Supervision (BCBS) introduced the CVA capital charge as part of Basel III in December 2010. The purpose of the Basel III CVA capital charge is to ensure that bank capital provides adequate protection against the risks of future changes in CVA.

5.In line with the requirements of Basel III, UAE banks are required to calculate risk-weighted assets (RWA) for CVA risk under one of two approaches. Banks must use either:

1. •A standardised approach, described in the Standards and closely based on the standardised approach to CVA risk capital developed by the BCBS; or
2. •A simple alternative approach, under which a bank with an aggregate notional amount of non-centrally cleared derivatives less than or equal to 400 billion AED may calculate RWA for CVA by setting it equal to the bank’s counterparty credit risk (CCR) RWA.

6.The Central Bank is fully aware of the BCBS view that CVA risk cannot be modelled by banks in a robust and prudent manner at this time. Accordingly, the Central Bank has determined that CVA approaches that rely on banks’ internal CVA models, or that use inputs derived from those models, are not appropriate for use in regulatory capital calculations by UAE banks.