EBA advises on the prudential filter for gains and losses from own credit risk related to derivatives

The European Banking Authority (EBA) published today its technical advice to the European Commission on the use of a prudential filter for gains and losses arising from banks' own credit risk of derivatives. The Authority considers as appropriate not to deviate from the current prudential approach applied at the international level under the Basel III rules, i.e. full deduction of institutions' own credit risk of derivatives. The work of the EBA will inform the work of the EU Commission on the topic.

The measurement of own credit risk of derivatives (debit valuation adjustment - DVA) depends on several valuation inputs such as interest rates, an institution's own credit standing and other market factors that can affect the exposure value. The analysis of the EBA highlighted that at present it is challenging to measure own credit risk in a robust way. In addition, it is difficult to isolate in a consistent way the changes in own credit risk that are stemming only from changes in an institution's own credit standing.

In its advice, the EBA analyses different approaches of treating fair value gains and losses arising from institutions' own credit standing and concludes that it would be appropriate not to deviate from the Basel approach, i.e. full deduction of own credit risk adjustment from capital at inception. The Basel approach also ensures a conservative outcome and a level playing field at the international level and has the merit of addressing such a complex and ongoing issue in a rather simple way.

The prudential requirements could possibly be revised in the future, if necessary and if an agreement is reached on the current issues under debate. In the meantime, a close monitoring of institutions' practices related to own credit risk from derivatives seems appropriate, says the EBA.

Legal basis and background

The EBA technical advice follows a call for advice from the European Commission aimed at assessing the appropriateness of the application of Article 33(1)(c) of Regulation (EU) No 575/2013 of the Capital Requirements Regulation (CRR), stating that that institutions shall not include in any element of own funds, fair value gains and losses on derivative liabilities of the institution that result from changes in the own credit standing of the institution. Taking into account the work of the EBA, the EU Commission will prepare a report on this issue that will be delivered to the European Parliament and the Council by 31 December 2014.

Due to the limited time between the call for advice and its expected delivery date, the EBA took into consideration the current prudential treatment of own credit risk under Basel III, as well as existing best practices, industry analysis and the feedback received from a brief outreach to professional associations and some large institutions.