XVA Models: Why Banks Aren’t Changing Course | Banking Dive

Banks Largely Rely on Established Models for Valuation Adjustments: Risk.net Research

Despite increasing complexity in financial markets, most banks continue to rely on well-established models for calculating valuation adjustments (XVA), according to new research from Risk.net. The findings, stemming from Risk.net’s inaugural XVA Benchmarking study, suggest a cautious approach prevails among dealers’ valuation adjustment desks, with a dominant methodology employed within each asset class.

Dominance of Traditional Approaches

Interest rate modeling is particularly concentrated, with four-fifths of respondents utilizing variations of the Heath-Jarrow-Morton (HJM) framework. Further solidifying this trend, a majority – 59% – lean on either the Vasicek or Hull-White models. This reliance on “tried-and-trusted” methods indicates a preference for established techniques, even in the wake of events like the Archegos Capital Management collapse, which highlighted potential risks in valuation practices.

“Most dealers’ valuation adjustments (XVA) desks rely on a single dominant approach to modelling valuation adjustments within each asset class,” the research indicates.

did you know? – Valuation adjustments, or XVA, are calculations that account for factors like credit risk, funding costs, and capital requirements when pricing financial instruments. They impact profitability and risk management.

Exploring Alternatives for Wrong-Way Risk

While HJM and its variants remain dominant, some institutions are exploring more elegant techniques to address specific risks. Copulas, for example, are gaining traction as a tool for modeling “wrong-way risk” – the potential for correlated movements between asset values and counterparty creditworthiness. This exploration appears to be a direct response to events like the Archegos situation, which exposed vulnerabilities in risk management related to concentrated positions and counterparty exposures.

Pro tip: – “Wrong-way risk” is particularly concerning when a counterparty’s credit quality deteriorates simultaneously with the value of the assets they hold, potentially leading to notable losses.

The Archegos Capital Management collapse in March 2021 triggered substantial losses for several major investment banks. Archegos, a family office, amassed highly leveraged positions in a handful of companies. When those positions soured, banks holding derivatives contracts with Archegos faced margin calls they couldn’t meet, resulting in billions of dollars in losses. The event exposed weaknesses in risk management practices,particularly concerning concentrated positions and counterparty credit risk. Banks were forced to unwind Archegos’ positions quickly, contributing to market volatility. The situation prompted regulatory scrutiny and a re-evaluation of risk controls at many financial institutions.

Reader question: – How might increased regulatory scrutiny following events like Archegos impact the adoption of more sophisticated risk modeling techniques?

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