FRM Exam Part II · High-level Summary of Basel III Reforms

Basel III CVA Risk Framework and Capital Charge

Updated 11 October 2026 · Fact-checked

The CVA risk capital charge covers losses from changes in the market value of counterparty credit risk on OTC derivatives, not from default itself. The revised Basel III framework offers a basic approach (BA-CVA) and a standardised approach (SA-CVA, needs supervisory approval). The internal model approach was removed. Banks with small books can use 100% of the counterparty risk charge instead.

Understand Credit Valuation Adjustment (CVA) Risk Framework

Credit valuation adjustment (CVA) is the market price of counterparty credit risk on a derivative. It is the gap between the risk-free value of a trade and its value after allowing for the chance that the counterparty defaults. When the counterparty's credit spread widens or exposure rises, CVA rises and the bank books a loss, even if no default occurs.

This matters because, in the 2007-09 crisis, most counterparty credit losses came from CVA mark-to-market losses, not from actual defaults. The default risk capital charge for counterparty credit risk did not capture them. So Basel introduced a separate CVA risk capital charge to cover the variability of CVA.

The revised framework (finalised in the Basel III reforms and aligned with the FRTB) has a hierarchy of approaches. The basic approach (BA-CVA) is a simple formula based on counterparty risk weights and exposures. It has a reduced version (no hedge recognition) and a full version (recognises eligible hedges). The standardised approach (SA-CVA) is more risk-sensitive. It is built on sensitivities of CVA to risk factors, in the style of the FRTB sensitivities-based method, and a bank needs supervisory approval to use it.

The internal model approach (advanced CVA, based on VaR models) was removed. Reasons: the models were hard to compare across banks, the capital outcomes varied a lot, and the framework aimed at more consistency and comparability. It also fitted the move away from internal VaR towards the FRTB. A bank can also choose a simple option: if its aggregate notional of non-centrally cleared derivatives is at or below €100 billion, it may choose to set the CVA charge equal to 100% of its counterparty credit risk capital requirement. This is subject to supervisory discretion, so the supervisor can still require the bank to calculate CVA capital. Transactions with central counterparties (qualifying CCPs) and certain securities financing transactions are generally outside the scope.

For the exam, remember the logic: CVA risk is a market-risk-type loss on a credit-driven valuation adjustment. Know which approach is more risk-sensitive, which one needs approval, what was removed, and why.

Key formulas to remember

CVA (concept): CVA ≈ LGD × Σ EE(tᵢ) × PD(tᵢ₋₁, tᵢ) × discount factor; Unilateral CVA is the discounted expected loss from counterparty default. Higher exposure, spread or LGD raises it.
BA-CVA reduced version: K_reduced = √[(ρ × Σ SCVA_c)² + (1 − ρ²) × Σ SCVA_c²], with ρ = 50%; SCVA_c = (1/α) × RW_c × Σ_NS (M_NS × EAD_NS × DF_NS), with α = 1.4; SCVA_c is the stand-alone CVA of counterparty c. The counterparty risk weight RW_c sits outside the sum. The sum runs over the netting sets NS of that counterparty, using the effective maturity M_NS, the exposure EAD_NS and the supervisory discount factor DF_NS for each. The 1/α scaling (α = 1.4) is already inside SCVA_c. Do not confuse DF with the 0.65 scalar, which is applied later. ρ = 50% is the supervisory correlation of systematic parts.
BA-CVA with hedges: K_full = β × K_reduced + (1 − β) × K_hedged, with β = 0.25; Hedging recognition is limited. Eligible hedges are single-name CDS, single-name contingent CDS and index CDS used to hedge counterparty credit spread risk. K_hedged also includes an indirect hedge component and a hedge-misalignment component.
BA-CVA capital charge in the capital stack: Capital requirement = DS_BA-CVA × K, with DS_BA-CVA = 0.65; The discount scalar of 0.65 applies to the BA-CVA charge. It is separate from the supervisory discount factor DF inside SCVA.
SA-CVA structure: Charge = Delta + Vega risk across risk classes (IR, FX, counterparty credit spread, reference credit spread, equity, commodity), scaled by the CVA multiplier m_CVA = 1 by default; No default risk charge or curvature charge in SA-CVA. The charge is scaled by the CVA multiplier m_CVA, which is 1 by default; supervisors may require a higher value. It is aggregated like the FRTB sensitivities-based method.
Simplified option: CVA capital = 100% × counterparty credit risk capital; A bank may choose this option if its aggregate notional of non-centrally cleared derivatives is ≤ €100 billion. The supervisor keeps discretion to require a CVA calculation instead.

How to solve Credit Valuation Adjustment (CVA) Risk Framework questions

Use this order for any exam question on the CVA risk framework.

1Identify what is asked: the purpose (why CVA capital exists), which approach applies, a calculation, or why the internal model approach was removed.
2Check scope: is it a non-centrally cleared OTC derivative or relevant securities financing transaction? Trades with qualifying CCPs are excluded.
3Pick the approach: SA-CVA needs supervisory approval and a bank must have the systems; otherwise BA-CVA applies. Check the €100 billion notional option for small banks.
4Decide on hedging: if hedges are mentioned, check they are eligible. The reduced BA-CVA gives no hedge credit; the full version gives limited credit.
5For BA-CVA, compute each counterparty's stand-alone CVA, then aggregate with ρ = 50%, then apply the 0.65 discount scalar.
6For SA-CVA, identify the risk class and whether delta and vega only apply. Recall that m_CVA = 1 by default (supervisors may require a higher value) and that there is no curvature or default risk charge.
7State the interpretation: the charge covers CVA mark-to-market volatility, not default itself, and the outcome should be comparable across banks.

Quickest way: Approach-selection shortcut

When to use it: Use for conceptual MCQs that ask which approach, what changed or why.

Ask: does the bank have supervisory approval and the sensitivity systems? If yes, SA-CVA; if no, BA-CVA.
Ask: is the question about internal models? The answer is that the model approach is gone.
Ask: is the key idea hedging? Reduced BA-CVA gives none; full BA-CVA gives limited credit; SA-CVA recognises more hedges.
For numbers, remember 50%, 0.25 and 0.65, plus m_CVA = 1 by default for SA-CVA, then eliminate options that mismatch.
Reject any option saying CVA capital covers actual default losses only.

Common mistakes in Credit Valuation Adjustment (CVA) Risk Framework

Saying CVA capital covers losses from counterparty default.
CVA sounds like credit risk, so students link it to default losses.
Fix: Remember default losses sit in the counterparty credit risk charge. CVA capital covers mark-to-market losses from spread and exposure changes.
Thinking the internal model approach is still available to banks with approval.
Basel II.5 and earlier rules allowed advanced VaR-based CVA.
Fix: The revised framework removed it. Choose between BA-CVA and SA-CVA.
Treating SA-CVA as the default approach for all banks.
It is more risk-sensitive, so students assume it is standard.
Fix: SA-CVA needs supervisory approval. BA-CVA is the fallback for banks without approval.
Confusing the reduced and full versions of BA-CVA.
Both use the same stand-alone CVA inputs.
Fix: Reduced means no hedge recognition. Full adds eligible hedges, with β = 0.25 blending the two.
Including centrally cleared trades in the CVA charge.
Students forget scope exclusions.
Fix: Transactions with qualifying CCPs are excluded. Focus on bilateral OTC exposures.
Forgetting the discount scalar or multiplier.
Students stop after computing the aggregated K.
Fix: For BA-CVA multiply by 0.65. For SA-CVA apply the CVA multiplier m_CVA, which is 1 by default and which supervisors may raise.

Worked examples

Example 1

A bank uses the reduced BA-CVA with two counterparties. Stand-alone CVA values (SCVA, already computed with the 1/α term and the supervisory discount factors) are $40 million and $30 million. Using ρ = 50%, compute K_reduced and the capital charge after the 0.65 scalar. Give answers to two decimals.

Show the solution

Sum of SCVA = 40 + 30 = 70. Systematic term = ρ × 70 = 35. Squared = 1,225.
Sum of squares = 1,600 + 900 = 2,500. Idiosyncratic factor (1 − ρ²) = 0.75. Term = 0.75 × 2,500 = 1,875.
Total = 1,225 + 1,875 = 3,100.
K_reduced = √3,100 = 55.68.
Capital = 0.65 × 55.68 = 36.19.

Answer: K_reduced ≈ $55.68 million; capital charge ≈ $36.19 million.

Example 2

Why did Basel remove the internal model approach for CVA, and what should a bank without SA-CVA approval and with €150 billion of non-centrally cleared derivative notional use?

Show the solution

The internal model approach produced widely different capital results across banks and was hard to compare or supervise.
Basel aimed for consistency and comparability, and aligned CVA with FRTB, which also limited reliance on internal models.
Check the simplified option: it needs aggregate notional ≤ €100 billion. The bank has €150 billion, which is above that threshold, so the 100% option is not available.
Without SA-CVA approval, the bank must use BA-CVA.

Answer: The model approach was removed for comparability and consistency; the bank must use BA-CVA.

Exam tips

Expect conceptual MCQs: which approach, what was removed, and why. Know the three-part hierarchy.
Memorise 50%, 0.25 and 0.65 and match each to the correct approach. Remember that m_CVA is 1 by default in SA-CVA and supervisors may raise it.
Watch for scope traps such as centrally cleared trades.
If a question gives numbers, check whether the reduced or full version is intended before computing.

Practice questions from High-level Summary of Basel III Reforms

Credit Valuation Adjustment (CVA) Risk Framework: frequently asked questions

What is the CVA risk capital charge?

It is the capital held against losses from changes in the market value of counterparty credit risk on OTC derivatives. It is separate from the capital for default of the counterparty.

What is the difference between BA-CVA and SA-CVA?

BA-CVA is a simple formula using counterparty risk weights, exposures and maturities. SA-CVA is sensitivity-based, more risk-sensitive and recognises more hedges, but needs supervisory approval.

Why was the internal model approach for CVA removed?

Internal models gave inconsistent capital outcomes across banks and were hard to compare. Basel preferred standardised approaches for consistency, in line with the FRTB direction.

Do centrally cleared trades attract a CVA charge?

Transactions with qualifying central counterparties are generally excluded from the CVA risk capital charge. The framework targets bilateral exposures.