Prudence defined
New rules will set out exactly how banks must
adjust valuations of their fair valued financial
instruments, writes David Wigan.
O
2012
In 2012 the UK Financial Policy
Committee recommended regulatory
action on banks’ valuations of their
assets.
14
Autumn 2014
ne 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 paper
In 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
PRUDENT VALUATION
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 regulation
Although 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%.
The prudent valuation requirements
pose considerable challenges to credit
institutions.
Larger firms meanwhile must determine AVAs under
a core approach, with the following key features:
lE ach 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
W here 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, closeout 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
Autumn 2014
15
90% target level of certainty is set for the
calibration of the AVAs.
Valuation uncertainty
The 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.
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.
16
Autumn 2014
Need for implementation
Banks 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 procyclical and may be significant with respect to tier one
capital, thus posing challenges to risk management.”
Less liquid markets
One 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
PRUDENT VALUATION
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
Ragveer Brar, head of
valuation and controls team,
Bank of England
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 vary
Currently valuation standards vary considerably
between and within banks, Brar says. Examples of
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 challenges
Compliance 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.
Autumn 2014
17