Beyond Basel 4: Integrating Over-the-Counter Derivatives Risk Capital Requirements

Abstract

Over-the-counter (OTC) derivatives are subject to counterparty credit risk (CCR), in that a counterparty could jump to default or its credit spread could vary over time. In Basel 3 and 4, OTC market risk, CCR risk, and credit valuation adjustment (CVA) risk capital requirements are designed on a standalone basis, against Basel’s own wishes of integrated market and credit risks. This global regulatory framework—whilst an honest attempt to treat a subject as complex as OTC counterparty risk—is severely fragmented and burdensome, because of its astronomical implementation, operational and regulatory costs, and inability to accommodate newly emerged valuation adjustments. This article presents a holistic OTC-derivatives risk capital framework, based on an integrated pricing model of market risk and CCR. The proposed framework drops CVA capital and CCR in the hope of pulling OTC derivatives closer to their real economic risk, streamlining Basel capital requirements rules, cutting costs, and revitalizing the limited uncollateralized OTC customer businesses.