CVA has traditionally been a charge for counterparty risk that is incorporated in a transaction in favour of the stronger credit quality counterparty. Historically, banks trading with corporate counterparties have charged CVAs linked to the credit quality of the corporate and the exposure in question. A corporate would not have been able to credibly question such a charge since the probability that a bank would default was considered remote (and indeed the credit spreads of banks have traditionally been very tight and the credit ratings very strong). The suggestion that a large bank such as Lehman Brothers would default was, until 2008, an almost laughable concept.
Now let us fast-forward to the credit crisis beginning in 2007. Gradually, the idea of “default-free” counterparties became not credible and credit spreads of the “strong” financial institutions widened dramatically. Consider the following situation.