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The Impact of Basel III on Banks' Capital and the Corporate Treasurer Basel III and the emphasis on CVA will place some stringent capital requirements on derivatives - most of which are more onerous than that of Basel II and could have a significant impact on the pricing of OTC derivatives.

The Impact of Basel III on Banks’ Capital and the Corporate Treasurer

by Zaid Moola, Director and Head, Corporate Structured Sales, Global Markets, Jan Brits, Director, Capital Management and Alex Davidson, Director, Corporate Structured Sales, Global Markets, Standard Bank Corporate and Investment Banking

Notwithstanding the 2007 financial crisis, the use of over-the-counter (OTC) derivatives both globally and in South Africa has grown exponentially in recent years. The total outstanding notional value of OTC derivatives was US$592tr in December 2008, according to the Bank for International Settlements, of which 70% was for interest rate derivatives. The 2008 post-Lehman collapse has focused attention on counterparty credit and default risks embedded within these derivatives.

Basel III now brings a number of changes to this environment, and one of the most significant is the so-called CVA adjustment.

The use of over-the-counter (OTC) derivatives both globally and in South Africa has grown exponentially in recent years.

For anyone unfamiliar with the concept, CVA management is an internal function which aggregates and quantifies counterparty risks across the bank. Having quantified this risk, hedging products are then priced accordingly. With the imminent introduction of Basel III this pricing impact will soon become apparent in OTC derivatives within South Africa. With this in mind, there is much that the corporate treasurer needs to begin considering right now.

There is a great deal of uncertainty about the real impact of Basel III on the global economy, and much work still has to go into quantifying each proposed amendment. But based on what we know so far, Basel III with its increased focus on derivative instruments will be a lot more onerous than Basel II. Basel III, which now explicitly provides a framework to attribute capital against CVA, could have a significant impact on derivatives, and the pricing thereof.

CVA is one of the first of many Basel III changes to be implemented and seeks to expand the risk coverage of the Basel accord, resulting in an increase in the quantum of banks capital to be allocated against counterparty credit risk on derivative instruments. Clearly, this will affect the pricing of risk and make OTC derivative instruments more expensive.

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