Enhancing Model Risk Management for XVA Pricing at Banks

As model risk management (MRM) continues to evolve, banks are challenged to satisfy expanding regulatory requirements, particularly in a multi-regulatory environment where continually changing regulations can overlap and vary by region. XVA pricing, a collective term for valuation adjustments relevant in the trading portfolio for derivative instruments, is especially challenging.

A bank’s ability to run a profitable derivatives business depends on knowing all the costs involved in trading derivative contracts. However, these XVAs have grown both in size and complexity over the last decade driven by new regulations, such as bilateral initial margin and regulatory risk capital. This changing landscape is making existing credit valuation adjustment (CVA) systems obsolete as they struggle to meet requirements that they were never designed to address. At the same time, since the fallout from the Global Financial Crisis, XVAs have become increasingly critical for banks for pricing, risk, and capital purposes.

These adjustments account for counterparty credit risk, capital costs (KVA), funding costs (FVA), and more. The accuracy and reliability of XVA pricing heavily depends on the robustness of the underlying models. Implementing and exercising strong model risk management is the best way to mitigate the risks associated with model errors or misuse.  

Attention to MRM is being driven by new regulations, such as the UK’s Prudential Regulation Authority (PRA) that has recently issued a set of principles (PS6/23: Model risk management principles for banks) that are key in establishing an effective MRM framework. The PRA considers MRM as a risk discipline in its own right and proposes to embed these principles, in a proportionate manner, as supervisory expectations for all regulated UK-incorporated banks, building societies, and PRA-designated investment firms.

Steps for Model Validation in XVA Pricing

When evaluating a model, there are three key areas to consider: (1) the model design should be examined to understand its theoretical basis, assumptions, and limitations, (2) the model inputs should be checked, including the sources of market data, the quality of the data, and the calibration process, and (3) the model implementation needs to be verified to ensure that it has been correctly implemented in the system and is functioning as intended. The S&P Global Market Intelligence (“Market Intelligence”) XVA solution can be used as a challenger model to benchmark in-house and other third-party XVA models to confirm the design, inputs, and implementation.

The key steps for a bank to perform model validation on their XVA pricing technology are all supported by this solution, including:

1. Evaluation of risk factor simulation, including testing simulated paths and changing the calibration regime.
2. Benchmarking of pricing models in a derivatives portfolio against chosen production models and assumptions.
3. Assessing the impact of credit curve selection, including the performance of chosen proxies.
4. End-to-end model framework testing, which includes seeding and convergence testing.

Market Intelligence specialists have worked with clients to ensure that they can run the required test cases and achieve satisfaction for MRM approvals.  Market Intelligence Solutions for XVA and counterparty credit risk are used by both sell-side and buy-side financial institutions for front office valuation adjustments and risk and capital management (including regulatory approval) across North American, EMEA, and Asia-Pacific regions and all major capital markets and asset classes.

A Path Forward

While banks are being pressured to update their MRM processes, they are also struggling with burgeoning compliance costs. Market Intelligence has worked with clients – including tier-1 and tier-2 global banks and systemically important banks (SIBs), plus subsidiaries with smaller quantitative and technical resource pools – across aspects of model testing and validation and achieving regulatory approvals, such as internal model methodology (IMM) and IFRS13 for fair value accounting. A fully hosted XVA pricing and CVA platform accelerates the time to implement a new risk solution and significantly reduces operational cost and complexity.

The Market Intelligence XVA solution provides:

Fast and easy setup – Users can start measuring XVAs instantly. They just need to log in, select their parameters, and start pricing trades and XVAs. No implementation is required.

Trusted data and technology – The XVA solution is pre-loaded with Market Intelligence’s best-in-class market data and industry-leading cloud-based analytics that are used by the largest institutions in the world.

Evolution with changing needs – Ongoing functionality updates and calibration to market conditions are standard. No upgrades are required and there are no maintenance windows.

Full visibility of valuation adjustments – Measures cover MTM, CVA, DVA, FVA, FCA, FBA, as well as XVA sensitivities (i.e., DV01, FX01, CS01). The solution also includes exposure and collateral balance profiles.

The XVA solution delivers deal-time insights to the front office XVA desk with a comprehensive view of the valuation adjustments arising from counterparty credit risk, funding, collateral, and regulatory capital. The solution can run risk-neutral alongside real-world simulation models in one system, realizing efficiencies across potential future exposure (PFE) risk management and XVA trading.

In conclusion, model validation is a critical requirement for establishing robust XVA pricing practices at banks. By following the steps described above, banks can ensure the accuracy and reliability of their XVA pricing models, thereby enhancing their risk management capabilities and regulatory compliance. As the financial landscape continues to evolve, banks that prioritize robust model validation will be well-positioned to navigate the complexities of XVA pricing.