14 Autumn 2014

One lesson of the financial crisis is that the value of financial instruments is not necessarily what the owner states it to be, even when it comes to relatively liquid markets such as government bonds. In

fact, in many cases mismatches between assumed and real value were extremely wide, and for some banks poor valuation was a key element in their demise.

One of the first regulators to recognise the damage caused by aggressive valuations was the UK Financial Services Authority (FSA). In 2008 it wrote a letter to firms outlining its concerns, which it followed up with visits to 10 banks to assess product control functions. In its 2011 report into the failure of RBS, the FSA uses the word ‘valuation’ 114 times, for example saying that the rival banks collateralised debt obligation valuations were ‘significantly lower’ than those by RBS.

In 2012 the UK Financial Policy Committee

recommended that regulatory action be taken “to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets, a realistic assessment of future conduct costs and prudent calculation of risk weights.”

Discussion paperIn the same month the European Banking Authority (EBA) published a discussion paper on prudent valuation, which led to a consultation and quantitative impact study last year, and the publication of final draft regulatory technical standards in March of this year, under article 105 of the Capital Requirements Regulation. Approval by the European Parliament is expected in the coming weeks, with implementation soon after.

“Historically the concept of prudence was central to accounting, but what we found as regulators was that both firms and auditors were often taking different stances on the interpretation of accounting standards that resulted in material valuation differences,” says Ragveer Brar, who leads the Bank of England’s valuation and controls team. “For example, we saw significant variances in approach (e.g. numbers of yield curve risk buckets used to represent the full curve) for the calculation of the bid-offer reserves, and

New rules will set out exactly how banks must adjust valuations of their fair valued financial instruments, writes David Wigan.

Prudence defined

2012 In 2012 the UK Financial Policy Committee recommended regulatory action on banks’ valuations of their assets.

PRUDENT VALUATION

15 Autumn 2014

anomalies like collateral disputes running into hundreds of millions of dollars with signed off accounts on both positions.”

The concept of prudent valuation relates to fair value positions, defined by international accounting standards, (such as IFRS 13) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This is sometimes referred to as the ‘exit price’. Of course, in the case of many illiquid securities the exit price is not easy to guess, and in those circumstances the concept of prudent valuation can be brought to bear.

Prudent valuation is also, in effect, the migration of regulatory oversight into accounting and is justified in that it aims to ensure that banks carry enough capital to offset the risk of the fair value positions, with a realistic level of accuracy.

“If a bank has a position valued at 50 and the market is liquid such that the range of plausible valuations is known to be somewhere between 49.9 and 50.1 or if the position is complex and the market is illiquid such that the range of plausible valuations may be somewhere between 20 and 80, then the accounting representation of value is often largely the same,” says Brar. “However from a risk and capital adequacy perspective it makes an enormous difference. Whereas accounting standards are looking at best estimates, the regulatory perspective is much more interested in downside risk.”

European regulationAlthough UK authorities have been somewhat ahead of their continental European counterparts on requiring banks to consider prudent valuations, the new European regulations are set to be meat on the bones of the UK approach, which was subject to complaints by UK banks over what they saw as an uneven playing field, in some cases leading to lively arguments with the regulator over the meaning of the word ‘prudent’.

The areas that were the biggest contributors to valuation uncertainty were market prices, close-out costs, model risk and concentrated positions, and firms' current prudent valuation adjustments are between 0.03% and 0.3% of the fair value balance sheet, according to the Bank of England.

However, in completing their returns, some poor practices were observed among UK banks, with for example bid/offer spreads or historic Invoice Price Variances used as a proxy for valuation uncertainty, and only IFRS level 3 positions (unobservable inputs)

looked at in detail, rather than a broader range of positions. There was also over-reliance on consensus data, without recourse to alternative pricing sources such as traded prices, broker quotes and collateral information.

The European rules aim to put an end to those doubts, setting out in detail how ‘prudent’ must be defined and laying out specific rules on the approaches banks must take to measure the value of their fair valued financial instruments.

In simple terms the prudent valuation adjustment is the amount by which available capital would need to be adjusted if the downside valuations were used instead of the fair values from a firm’s financial statements.

How firms reach those additional valuation adjustments (AVAs), however, depends on the size of institutions, with firms whose fair value assets and liabilities are below the €15bn threshold are permitted to use a simplified approach, under which the calculation of the required AVA is based on a percentage of the aggregate absolute value of fair valued positions held by the institution which amounts to 0.1%.

Larger firms meanwhile must determine AVAs under a core approach, with the following key features:l Each AVA shall be calculated as the excess of

valuation adjustments required to achieve the identified prudent value over any adjustments applied in the institution’s fair value adjustment that can be identified as addressing the same source of valuation uncertainty as the AVA.

l Where possible, the prudent value of a position is linked to a range of plausible values and a specified target level of certainty of 90%. In practical terms, this means that for market price uncertainty, close-out costs and unearned credit spreads, institutions are required to calculate the prudent value using market data and the 90% certainty level.

l In all other cases, an expert-based approach is specified, together with the key factors required to be included in that approach. In these cases the

The prudent valuation requirements pose considerable challenges to credit institutions.

16 Autumn 2014

90% target level of certainty is set for the calibration of the AVAs.

Valuation uncertaintyThe EBA notes that for the majority of positions where there is valuation uncertainty, it is not possible to statistically achieve a specified level of certainty, but it says that specifying a target level is the most appropriate way to achieve greater consistency in the interpretation of a ‘prudent’ value.

Article 34 of the Capital Requirements Regulation requires institutions to deduct from Common Equity Tier 1 capital the aggregate AVA made for fair value assets and liabilities following the application of Article 105. A Quantitative Impact Study made in June 2013 by the EBA showed that on average the expected AVA would be equivalent to 1.5% of the Core Equity Tier 1 of institutions in absolute terms (on average €227m per institution), which is on average 0.07% of the value of fair valued positions on banks' balance sheets.

Perhaps not surprisingly the mood music emanating from the banking community in respect of prudent valuation has been less than enthusiastic, implying as it does lower valuations (and hence lower capital resources) through the requirement to explicitly include early termination costs, investing and funding costs and administrative expenses. Also implied is increased operational complexity and potentially a revaluation of fair value assets held in both the banking book and the trading book, both of which are covered by the rules.

Need for implementationBanks approached for the purposes of this article declined to comment. However, with the European rules set to come into force in the coming months the time for debate has elapsed, and firms must now get on with the serious business of implementation.

One of the key differences between prudent valuation and other regulatory requirements is its often subjective nature. While market risk can be calculated using a model, valuation is often a matter of judgement within a prescribed framework, and that judgement can change from one month to the next.

“The prudent valuation requirements pose considerable challenges to credit institutions,” says Dr Andreas Werner, a partner at Frankfurt based consultancy d-fine, in a note. “The implementation is challenging as new measurement methods and business processes have to be developed and new market data sources have to be identified. Additionally, prudent valuation adjustments are pro-cyclical and may be significant with respect to tier one capital, thus posing challenges to risk management.”

Less liquid marketsOne of the biggest challenges for market participants will be less liquid markets, and where firms are unable to present a specific level of price uncertainty there is a work out enabling them to explain to the regulator the approach they have adopted.

“Banks now have a quantitative definition of prudent at the 90th percentile, with an element of qualitative assessment because we recognise that in some cases there will be insufficient data,” says the Bank’s Brar.

An example of the challenges facing banks is the measurement of accounting for credit value adjustments, for which some firms currently value

Banks now have a quantitative definition of prudent at the 90th percentile.

March The European Banking Authority published final draft regulatory technical standards on prudent valuation in March 2014.

PRUDENT VALUATION

17 Autumn 2014

counterparty risk based on historic data and others use market implied numbers from credit default swaps. Whereas this may be acceptable for accounting standards, it also generates uncertainty, which is anathema to the regulator. However, it’s not only complex assets and liabilities that represent challenges – finding firm prices can be just as challenging for vanilla securities such as bonds, particularly those that are less liquid, e.g. emerging market bonds.

Where models are used for valuation purposes, institutions are required to estimate a model risk adjustment for each model.

“It’s incumbent on banks to demonstrate their appreciation of the range of approaches available, so when it comes to modelling if there are 10 models in the market then the theoretical ideal may be to build each of the models and put your valuation through each and then reach the 90th percentile of certainty,” says Brar. “However, in drafting regulatory policy we have ensured sufficient balance in order to avoid an unduly burdensome approach that may place too much pressure on resources. Therefore we have pragmatically left open the option for an alternative approach based on an expert risk assessment of the valuation models that firms use, including an assessment of factors such as liquidity, level of standardisation and size of position to determine an appropriate prudent valuation adjustment.”

Standards varyCurrently valuation standards vary considerably between and within banks, Brar says. Examples of

poor practice include firms relying unquestioningly on the same broker prices over a prolonged period, whereas at the other end of the spectrum some firms have developed systems that capture each market data point and reflect a hierarchy of sources. For the firms that have more work to do, operational changes may need to be accompanied by a change of culture, particularly in respect of the relationship between the front office and support functions.

“It is well known there have been concerns over front office dominance, and the ability at some banks of the control functions to challenge front office valuations. Now with firms having to report and justify their valuations to the regulator it is likely that the control functions will become more empowered to question the numbers coming from the front office and it is incumbent on firms to ensure that their control functions have the capacity and confidence to do that.”

US experience As European banks ponder the implications of the new prudent valuation rules, other financial institutions may be forgiven for looking on with a smile, having been spared similar rules in their own jurisdictions. There is, for example, no equivalent to prudent valuation for fair value in the US.

However, there are rumours that some large US banks are voluntarily producing prudent valuation assessments for their global entities because they realise the advantage of having a better understanding of their valuation processes and the degree of valuation risk the firm is exposed to.

Global regulators are watching the European example closely. “There have been discussions with global regulators and some will be bringing in these rules,” Brar says. “Two years ago it was the UK, and shortly it will be across Europe, so there is a trend. There are clearly concerns at the highest levels around valuation issues, and it would not be a surprise if prudent valuation is adopted globally in due course.”

Measurement challengesCompliance with prudential valuation obligations presents implementation challenges for banks that require new measurement methods, business processes and market data sources for hard to value and illiquid instruments.

“Over the past year we met with over 40 banks and regulators in Europe and initially everyone seemed focused on the most complex assets on the balance sheet,” says Leon Sinclair, director of evaluated pricing at Markit. “However, many underestimated the challenges and capital impact to their institutions when undergoing additional valuation adjustment (AVA) analysis for more liquid assets.

“We saw a sea change during the quantitative impact study in November, when anecdotally banks took between six and 10 weeks to complete the core approach. This was primarily due to the task of collecting data sets that hadn’t previously been part of Independent Price Verification/ Risk workflows.”

Banks must obtain all of the data they can access, both internal and external to satisfy the quantitative requirements of prudential valuation. For example, by acquiring the underlying raw data driving bond prices, customers can streamline the data collection process into their in-house methodologies while gaining access to statistics from institutional market markers.

Banks will need to demonstrate full transparency in their methodologies and range of inputs fuelling the underlying pricing data, as well as liquidity metrics.

Since the publication of the European Banking Authority Regulatory Technical Standards on prudential valuation in March some large European banks have lobbied over correlation and offset criteria, which they see as too punitive. The banks argue they could result in an uneven playing field between institutions subject to the rules and those outside the jurisdiction of the European regulators, says Sinclair.

Ragveer Brar, head of valuation and controls team, Bank of England