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Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition by Jon Gregory

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19.1 Key Components

19.1.1 Regulatory Capital and Regulation

It was always inevitable, given the scale of the global financial crisis, that regulators would restrict leverage and impose much higher capital charges on banks. Nor was it surprising that, as one of the defining components of the crisis, counterparty risk would emerge as very severely hit in this respect (on a relative basis). Counterparty risk capital is defined as the sum of a number of components, such as the default risk charge, CVA VAR and charges with respect to centrally cleared transactions. In addition, different institutions may use simpler approaches (such as the current exposure method or the standardised approach for CVA VAR) or more complex ones (e.g., the internal model method or CVA VAR advanced approach). A number of changes required by Basel III, such as an increased margin period of risk and use of stressed data, are also required. A large part of the future landscape will be driven by capital requirements and the ways in which capital relief can be achieved. To some extent, only time will tell how well the capital rules are aligned with the actual risk-taking (and mitigating) practices of banks.

Additionally, regulators have imposed greater constraints around aspects such as backtesting, stress testing and wrong-way risk. This will create a significantly increased operational burden and require significant investments from a quantitative and technological perspective. However, it should also allow ...

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