Credit Valuation Adjustment (CVA) is a measure of the “market value of counterparty risk” and is effectively the long term credit loss that could be expected on a counterparty’s portfolio of transactions.
CVA is calculated by applying a default probability (usually derived from Credit Default Swap data or proxies) and expected recovery to the expected exposure of a counterparty’s positions. CVA increases as a counterparty’s credit quality deteriorates, as measured by the increased cost of buying credit protection.
Historically, CVA has been computed in accordance with the accounting standards requiring financial institutions to take counterparty credit risk into account in the fair value of OTC derivatives. In the aftermath of the financial crisis it was found that the CVA losses for many banks exceeded their realized credit losses due to counterparty defaults. Banks were not, however, required to hold regulatory capital against CVA losses and the financial system as a whole was under-capitalized for CVA. In response to this the regulators imposed the CVA capital charge, requiring banks to hold regulatory capital for their CVA.
Subjecting transactions to collateralization under a netting agreement, both on a cleared and non-cleared basis, significantly reduces the CVA regulatory capital charge. There is therefore a large incentive from the perspective of regulatory capital management to collateralize as many transactions as possible.