Overview of the Regulatory Treatment of Counterparty Risk

When a bank starts a new derivatives trade or reviews its collateral terms, it estimates how much more capital the trade will need. That estimate rests on the capital adequacy regulation that sets out the SA-CCR and CVA risk frameworks.

What the regulation requires

When a bank trades derivatives, it takes on the risk of losing money if the counterparty defaults, that is, counterparty credit risk (CCR). What this risk involves is covered in What Is Counterparty Credit Risk?. The regulation requires two kinds of capital against CCR. One covers the counterparty's default itself. The other covers changes in the market value of CVA caused by changes in the counterparty's creditworthiness.

The second kind comes from the experience of the financial crisis. During the crisis, losses in the value of derivatives caused by counterparties' deteriorating creditworthiness were in some cases larger than the losses from actual defaults. Basel II had no framework for changes in the market value of CVA, so Basel III, published in 2010, added a capital charge for changes in CVA to the framework for default¹.

A bank that calculates credit risk with the standardized approach converts both parts into credit risk-weighted assets and includes them in the denominator of the capital adequacy ratio²³. Exposures to central counterparties are calculated in a separate chapter from these two and added as well².

Legal basis and supervisor

The supervisor is the Financial Services Agency (FSA). The legal basis is a notice issued under Article 14-2 of the Banking Act, "Standards for determining whether a bank's capital adequacy is appropriate in light of the assets it holds" (our translation; FSA Notice No. 19 of 2006). This page calls it the Notice. Separate notices with the same purpose apply to labor banks, agricultural cooperatives, The Shoko Chukin Bank, and others⁴.

The Notice applies the international standard to banks with overseas operations (overseas subsidiaries or branches) and the domestic standard to all other banks. This page calls them international-standard banks and domestic-standard banks. International-standard banks must meet requirements such as a total capital ratio of at least 8%, and domestic-standard banks must meet a core capital ratio of at least 4%. In calculating risk-weighted assets, domestic-standard banks can use some simpler methods, such as the current exposure method for CCR and the simplified approach for CVA risk⁵.

The parts of the Notice that set capital for CCR are as follows.

Some names in the Notice differ from the terms this site uses. The Notice calls EAD the "credit equivalent amount." In the Notice, the name "internal model method" refers to internal models for market risk, and the internal model for CCR is called the "expected exposure method"⁶.

Three approaches to EAD

EAD for derivative transactions is calculated with SA-CCR (the standardized approach for counterparty credit risk) or the internal model method (IMM; the expected exposure method in the Notice). Domestic-standard banks that meet certain conditions can also use the current exposure method (CEM)⁷. Every approach calculates EAD for each group of trades with a counterparty that is covered by close-out netting, that is, for each netting set. A trade without a legally effective bilateral netting agreement forms a netting set on its own⁸. How close-out netting and netting sets work is covered in Risk Reduction through Netting and Collateral.

SA-CCR derives EAD from the replacement cost and the potential future exposure (PFE). PFE is an estimate of how much the exposure could grow as markets move in the future. The table below shows how the three approaches differ.

EAD under SA-CCR is calculated with the following formula⁹.

$$EAD = 1.4 \times (RC + PFE)$$

$RC$ is the replacement cost. Without a collateral agreement, it is the total market value of the netting set minus collateral, with a floor of zero. The formula for netting sets with a collateral agreement is shown in "How netting and collateral affect capital." The Notice calls $PFE$ the "potential future exposure amount," and SA-CCR estimates it with set formulas from the notional amount, the remaining maturity, and other inputs.

The internal model method calculates future exposure with the bank's own model, and using it requires FSA approval. EAD is $\alpha \times$ effective EPE, where $\alpha$ is 1.4. If the counterparty has specific characteristics, the bank uses a more conservative $\alpha$. To get effective EPE, you first take expected exposure (EE) at each future date and keep it from falling below the value at the previous date, which gives effective EE. Effective EPE is the weighted average of effective EE over the period up to one year¹⁰.

A bank approved for the internal model method is subject to a capital floor. If 72.5% of the capital requirement calculated with the standardized approaches exceeds the requirement calculated with the approved methods, the difference multiplied by 12.5 is added to the denominator. In these standardized approaches, EAD for derivative transactions is calculated with SA-CCR¹¹.

CEM takes the replacement cost at market value and adds an add-on, which is the notional amount multiplied by a factor set for each type of transaction and remaining maturity. Only trades under a legally effective bilateral netting agreement can use a replacement cost in which market values are offset across trades¹². CEM is available to domestic-standard banks that calculate credit risk with the standardized approach, do not use the internal model method for market risk or SA-CVA, and do not have approval for the expected exposure method. A bank that uses CEM uses it for all of its derivative transactions. However, a bank that used SA-CCR on the most recent calculation reference date keeps using SA-CCR, except in cases such as notifying the Commissioner of the Financial Services Agency that it cannot continue for unavoidable reasons⁷.

Whether a bank can use CEM is checked by going through four conditions in order.

Figure description

If the answer to question 1 or 2 is no, or the answer to question 3 is yes, CEM cannot be used, and the bank calculates with SA-CCR or the internal model method. If the answer to question 4 is yes, the bank keeps using SA-CCR, except in cases such as notifying the Commissioner of the Financial Services Agency that it cannot continue for unavoidable reasons.

Consider a hypothetical example in which Bank G is a domestic-standard bank that calculates credit risk with the standardized approach and used CEM on the most recent calculation reference date. It does not use the internal model method for market risk, the expected exposure method, or SA-CVA. The answers to questions 1 and 2 are yes and those to questions 3 and 4 are no, so the bank meets the conditions for using CEM. Now suppose the same Bank G gets approval for SA-CVA and uses it. The answer to the third question becomes yes, so CEM cannot be used. EAD is calculated with SA-CCR (or the internal model method, if approved).

Under every approach, the amount of CVA recognized in financial accounting is deducted from the EAD of each netting set, with a floor of zero⁸.

Three ways to calculate CVA risk

The CVA risk amount covers derivative transactions with counterparties other than qualifying central counterparties and certain others, as well as repo-style transactions measured at fair value in accounting, among others (the Notice calls these "CVA-covered transactions")¹³. A bank calculates the CVA risk amount with BA-CVA or SA-CVA¹⁴. Domestic-standard banks with few derivatives can also use the simplified approach¹⁵.

Like the standardized approach in the new market risk framework (FRTB), SA-CVA multiplies sensitivities by risk weights and aggregates them using correlations¹⁶. It requires FSA approval, and once approved, the bank keeps using it unless the approval is revoked¹⁷. A bank using SA-CVA can still apply BA-CVA to part of its portfolio, netting set by netting set¹⁸.

The requirements for approval include setting up a CVA desk with traders who lead the management of CVA risk and execute hedges. A CVA desk is the unit that carries out CVA hedging, or a clearly defined function with a similar role¹⁹. A bank using SA-CVA calculates its CVA risk amount every month and reports it to the Commissioner of the Financial Services Agency²⁰.

BA-CVA uses the EAD and effective maturity from the CCR calculation as inputs to a set formula. A bank can calculate it even if it does not calculate CVA for accounting²¹. Under the Japanese Notice, the input EAD is the value the bank obtained with SA-CCR, the internal model method, or CEM, and the coefficients in the formula change with the approach²². A bank that reflects hedges of the counterparty's credit spread uses full BA-CVA, and a bank that does not uses reduced BA-CVA²³.

The simplified approach is a method for domestic-standard banks with few derivatives. The CVA risk amount is 12% of the credit risk-weighted assets of derivative transactions, and hedges are not reflected¹⁵.

The final Basel III standards that the BCBS published in December 2017 (the Basel III finalization)²⁴ replaced the methods for CVA risk with BA-CVA, SA-CVA, and the simplified approach¹⁸. For the methods used before that, the FSA's document lists the advanced risk measurement approach, the standardized risk measurement approach, and the simplified risk measurement approach²⁵.

Exposures to central counterparties

The risk weight for trade exposures to qualifying central counterparties is 2%²⁶. Qualifying central counterparties include financial instruments clearing organizations under the Financial Instruments and Exchange Act, and central counterparties abroad that are subject to appropriate regulation and supervision and provide banks with the information needed for the calculation²⁷. EAD is calculated with SA-CCR or another approach, as for bilateral trades²⁶.

The same chapter also covers a bank that clears its trades through a clearing participant instead of directly. The Notice calls this bank an indirect clearing participant and the clearing participant a direct clearing participant. The risk weight for exposures to the direct clearing participant is 2% if conditions are met, and 4% if there is no arrangement to prevent losses when the direct clearing participant and other indirect clearing participants both fail. Contributions to a central counterparty's default fund have their credit risk-weighted assets calculated with a separate formula²⁸.

On the CVA side, trades with qualifying central counterparties are not CVA-covered transactions, so they are outside the calculation of the CVA risk amount¹³.

Application dates in Japan

In Japan, SA-CCR has applied since March 31, 2018. The rules for exposures to central counterparties came earlier and have been in the Notice since March 31, 2013²⁹. The new CVA framework from the Basel III finalization applied on March 31, 2024 and March 31, 2025, depending on the category of bank.

The December 2017 draft proposed letting banks choose either SA-CCR or CEM as the standardized approach for EAD of derivative transactions⁴. Under the current Notice, only domestic-standard banks that meet the conditions described in "Three approaches to EAD" can use CEM⁷. The international implementation date of the Basel III finalization was postponed by one year, from the original January 2022 to January 2023³².

How netting and collateral affect capital

Under SA-CCR, netting and collateral change EAD mainly through the replacement cost. Within a netting set, market values offset each other, and variation margin received narrows the gap between market value and collateral, which lowers the replacement cost. Posted initial margin that is not segregated can raise the replacement cost⁹.

Collateral terms also enter PFE. With a margin agreement, PFE uses an adjustment based on the margin period of risk (MPOR) instead of the remaining maturity³³. The MPOR is 10 business days in principle for netting sets whose variation margin is adjusted through daily marking to market, and 20 business days for netting sets with illiquid collateral and others³⁴. The replacement cost formula, the numerical example with five states, and the MPOR categories are covered in The Standardized Approach for Counterparty Credit Risk (SA-CCR).

Collateral and hedges also affect capital on the CVA side. BA-CVA uses EAD as an input, so when collateral lowers EAD, the CVA risk amount falls too²¹. SA-CVA can reflect hedges of the market factors that drive exposure, in addition to hedges of the counterparty's credit spread¹⁸.

Notes

1. Financial Services Agency and Bank of Japan, "「信用評価調整（CVA）リスクの最低所要自己資本」の概要" (Overview of "minimum capital requirements for credit valuation adjustment (CVA) risk") (February 2018), "１．これまでの経緯" (1. Background), page 2 (in Japanese). ↩

2. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (Standards for determining whether a bank's capital adequacy is appropriate in light of the assets it holds, under Article 14-2 of the Banking Act, our translation; FSA Notice No. 19 of 2006), Article 48, paragraph 1 (page 136) (in Japanese). The same rule for banks using the internal ratings-based approach is on page 265. ↩ ↩²

3. The same Notice, Article 2, item 3 (pages 26–27). This is the formula for the consolidated total capital ratio under the international standard. ↩

4. Financial Services Agency, "自己資本比率規制（第１の柱・第３の柱）に関する告示の一部改正（案）等の公表について" (Publication of draft partial amendments to the notices on capital adequacy regulation (Pillar 1 and Pillar 3), and related documents) (December 22, 2017), "１．自己資本比率規制に関する告示等" (1. Notices on capital adequacy regulation, etc.) (in Japanese). ↩ ↩² ↩³

5. Financial Services Agency, "バーゼル規制の概要" (Overview of the Basel framework) (August 2026), "国際統一基準と国内基準" (International standard and domestic standard), page 16, and "国際統一基準と国内基準の差異" (Differences between the international standard and the domestic standard), page 17 (in Japanese). The Notice defines international-standard banks and domestic-standard banks in Article 1, items 10-2 and 10-3 (page 10). ↩

6. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), table of contents (Chapter 9, Section 2), Article 79 (page 188), and Article 79-3 (page 206) (in Japanese). Financial Services Agency, "バーゼル規制の概要" (August 2026), "リスク計測手法" (Risk measurement methods), page 14, gives the names SA-CCR, IMM, CEM, BA-CVA, SA-CVA, and the simplified approach (in Japanese). ↩

7. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), Article 79, paragraphs 1 to 3 (page 188) (in Japanese). For banks using the internal ratings-based approach, Article 157, paragraph 7 (page 280) applies Article 79 with the exception of paragraphs 2 and 3, so CEM is an option only for banks that calculate credit risk with the standardized approach. ↩ ↩² ↩³

8. The same Notice, Article 79, paragraph 7 (pages 189–190). ↩ ↩² ↩³

9. The same Notice, Article 79-2, paragraphs 1 and 2 (pages 190–191). ↩ ↩² ↩³

10. The same Notice, Article 79-3, paragraphs 1 and 2 (pages 206–207). ↩

11. The same Notice, Article 13, paragraphs 1 and 3 (pages 62–63). ↩ ↩²

12. The same Notice, Article 79-4, paragraphs 1 to 3 (pages 218–219). ↩

13. The same Notice, Article 270-2 (pages 393–394). ↩ ↩²

14. The same Notice, Article 270-2-2, paragraph 1 (page 394). ↩

15. The same Notice, Article 270-5 (page 429). ↩ ↩²

16. Financial Services Agency and Bank of Japan, "「信用評価調整（CVA）リスクの最低所要自己資本」の概要" (February 2018), "５．標準的方式(SA-CVA)" (5. Standardized approach (SA-CVA)), page 6 (in Japanese). ↩

17. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), Article 270-4 (page 400) (in Japanese). ↩

18. Financial Services Agency and Bank of Japan, "「信用評価調整（CVA）リスクの最低所要自己資本」の概要" (February 2018), "３．CVAリスクの見直しの概要" (3. Overview of the revision of CVA risk), page 4 (in Japanese). ↩ ↩² ↩³

19. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), Article 270-4-38, paragraph 2, item 3 (page 426), and Article 1, item 77-6 (page 22) (in Japanese). Financial Services Agency and Bank of Japan, "「信用評価調整（CVA）リスクの最低所要自己資本」の概要" (February 2018), "５．標準的方式(SA-CVA) ～主な要件①～" (5. Standardized approach (SA-CVA): main requirements (1)), page 7 (in Japanese). ↩

20. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), Article 270-4-6 (page 401), and Articles 270-4-36 and 270-4-37 (page 425) (in Japanese). ↩

21. Financial Services Agency and Bank of Japan, "「信用評価調整（CVA）リスクの最低所要自己資本」の概要" (February 2018), "６．基礎的方式(BA-CVA)" (6. Basic approach (BA-CVA)), page 9 (in Japanese). ↩ ↩²

22. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), Article 270-3-3, paragraph 2 (pages 396–397) (in Japanese). The $\alpha$ in the formula is 1 when the bank uses CEM, and 1.4 when it uses SA-CCR or the expected exposure method. ↩

23. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), Article 270-3 (page 395) (in Japanese). The Notice calls the two methods "完全なBA―CVA" (full BA-CVA) and "限定的なBA―CVA" (reduced BA-CVA). ↩

24. Financial Services Agency, "自己資本比率規制等（バーゼル規制）について" (On capital adequacy regulation (the Basel framework), etc.) (web page), the "バーゼル規制の概要" (Overview of the Basel framework) section (in Japanese). ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶

25. Financial Services Agency, "バーゼル規制の概要" (Overview of the Basel framework) (August 2026), "リスク計測手法" (Risk measurement methods), page 14, the row for CVA risk (in Japanese). ↩

26. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), Article 270-7, paragraphs 1 and 2 (pages 429–430) (in Japanese). ↩ ↩²

27. The same Notice, Article 1, item 7-3 (page 9). ↩

28. The same Notice, Article 270-7, paragraphs 2 and 6 (pages 430–431), and Article 270-8 (page 431). ↩

29. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (FSA Notice No. 19 of 2006), supplementary provisions (FSA Notice No. 81 of December 7, 2012), Articles 1, 3, and 4 (pages 583–584) (in Japanese). The amendment took effect on March 31, 2013, with transitional measures for Article 270-8 and Article 1, item 7-3. ↩ ↩²

30. Financial Services Agency, "バーゼル銀行監督委員会による最終規則文書「カウンターパーティ信用リスクエクスポージャーの計測に係る標準的手法」の公表について" (Publication of the Basel Committee on Banking Supervision's final standard "The standardised approach for measuring counterparty credit risk exposures") (April 2, 2014) (in Japanese). ↩

31. Financial Services Agency, "「自己資本比率規制（第１の柱・第３の柱）に関する告示の一部改正（案）」等のパブリックコメントの結果等について" (Results of the public consultation on the draft partial amendments to the notices on capital adequacy regulation (Pillar 1 and Pillar 3), and related matters) (March 23, 2018), "３．公布・適用日" (3. Promulgation and application dates) (in Japanese). The content of the draft amendments is in Financial Services Agency, "自己資本比率規制（第１の柱・第３の柱）に関する告示の一部改正（案）等の公表について" (December 22, 2017) (in Japanese). ↩ ↩²

32. Financial Services Agency, "バーゼル規制の概要" (Overview of the Basel framework) (August 2026), "バーゼルⅢ最終化の実施時期" (Implementation dates of the Basel III finalization), page 10 (in Japanese). ↩

33. The same Notice, Article 79-2, paragraph 11, item 7 (page 196). This is the rule for interest rate derivatives, and the other asset classes have rules of the same form. ↩ ↩²

34. The same Notice, Article 79-2, paragraph 3, item 2, and paragraph 4 (pages 191–192). ↩ ↩²

35. Financial Services Agency and Bank of Japan, "「信用評価調整（CVA）リスクの最低所要自己資本」の概要" (February 2018), "４．CVAヘッジの取り扱い" (4. Treatment of CVA hedges), page 5 (in Japanese). ↩