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FRM Part II · FRM Exam Part II · Credit Value Adjustment

A risk committee objects to counting DVA in regulatory capital. Which is the most appropriate rationale for the Basel framework's treatment of DVA?

Basel removes DVA gains from CET1 because they arise when the bank's own credit worsens and cannot be realised unless the bank defaults, nor can they be hedged practically. Counting them would let deteriorating credit raise capital, which is perverse.

  1. ADVA gains from own credit deterioration cannot be realised without the bank defaulting or hedged practically, so they are derecognised from CET1Correct
  2. BDVA is always zero for investment-grade banks, so no adjustment is needed
  3. CDVA doubles the CVA capital charge because it is added to CVA
  4. DDVA is included in full because it reflects fair value under accounting rules

Explanation

Basel requires derecognition of unrealised fair value gains from changes in own credit risk, including DVA, in CET1. Such gains arise as the bank worsens and cannot be monetised without default, and they are hard to hedge. The other options misstate the rule.

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