Prudence defined

New rules will set out exactly how must recommended that regulatory action be taken “to ensure that the capital of UK banks and building adjust valuations of their fair valued financial societies reflects a proper of their assets, a David Wigan. realistic assessment of future conduct costs and instruments, writes prudent calculation of weights.”

Discussion paper In the same month the European Banking Authority ne lesson of the financial crisis is that the (EBA) published a discussion paper on prudent value of financial instruments is not valuation, which led to a consultation and necessarily what the owner states it to be, quantitative impact study last year, and the even when it comes to relatively liquid publication of final draft regulatory technical markets such as government bonds. In standards in March of this year, under article 105 of Ofact, in many cases mismatches between assumed and the Capital Requirements Regulation. Approval by real value were extremely wide, and for some banks the European Parliament is expected in the coming poor valuation was a key element in their demise. weeks, with implementation soon after. One of the first regulators to recognise the damage “Historically the concept of prudence was central to caused by aggressive valuations was the UK Financial accounting, but what we found as regulators was that Services Authority (FSA). In 2008 it wrote a letter to both firms and auditors were often taking different firms outlining its concerns, which it followed up with stances on the interpretation of accounting standards visits to 10 banks to assess product control functions. that resulted in material valuation differences,” says In its 2011 report into the failure of RBS, the FSA uses Ragveer Brar, who leads the of England’s 2012 the word ‘valuation’ 114 times, for example saying that valuation and controls team. “For example, we saw In 2012 the UK Financial Policy Committee recommended regulatory the rival banks collateralised debt obligation valuations significant variances in approach (e.g. numbers of action on banks’ valuations of their were ‘significantly lower’ than those by RBS. yield curve risk buckets used to represent the full assets. In 2012 the UK Financial Policy Committee curve) for the calculation of the bid-offer reserves, and

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anomalies like collateral disputes running into looked at in detail, rather than a broader range of hundreds of millions of dollars with signed off positions. There was also over-reliance on accounts on both positions.” consensus data, without recourse to alternative The concept of prudent valuation relates to fair pricing sources such as traded prices, broker quotes value positions, defined by international accounting and collateral information. standards, (such as IFRS 13) as “the price that would The European rules aim to put an end to those be received to sell an asset or paid to transfer a doubts, setting out in detail how ‘prudent’ must be liability in an orderly transaction between market defined and laying out specific rules on the participants at the measurement date.” This is approaches banks must take to measure the value sometimes referred to as the ‘exit price’. Of course, in of their fair valued financial instruments. the case of many illiquid securities the exit price is not In simple terms the prudent valuation easy to guess, and in those circumstances the concept adjustment is the amount by which available of prudent valuation can be brought to bear. capital would need to be adjusted if the downside Prudent valuation is also, in effect, the migration of valuations were used instead of the fair values from regulatory oversight into accounting and is justified in a firm’s financial statements. that it aims to ensure that banks carry enough capital How firms reach those additional valuation to offset the risk of the positions, with a adjustments (AVAs), however, depends on the size of realistic level of accuracy. institutions, with firms whose fair value assets and “If a bank has a position valued at 50 and the liabilities are below the €15bn threshold are permitted market is liquid such that the range of plausible to use a simplified approach, under which the valuations is known to be somewhere between 49.9 calculation of the required AVA is based on a and 50.1 or if the position is complex and the market percentage of the aggregate absolute value of fair is illiquid such that the range of plausible valuations valued positions held by the institution which may be somewhere between 20 and 80, then the amounts to 0.1%. 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 The prudent valuation requirements at best estimates, the regulatory perspective is much more interested in downside risk.” pose considerable challenges to credit

European regulation institutions. Although UK authorities have been somewhat ahead of their continental European counterparts on requiring banks to consider prudent valuations, the Larger firms meanwhile must determine AVAs under new European regulations are set to be meat on the a core approach, with the following key features: bones of the UK approach, which was subject to l Each AVA shall be calculated as the excess of complaints by UK banks over what they saw as an valuation adjustments required to achieve the uneven playing field, in some cases leading to lively identified prudent value over any adjustments arguments with the regulator over the meaning of the applied in the institution’s fair value adjustment word ‘prudent’. that can be identified as addressing the same source The areas that were the biggest contributors to of valuation uncertainty as the AVA. valuation uncertainty were market prices, close-out l Where possible, the prudent value of a position is costs, and concentrated positions, and firms' linked to a range of plausible values and a specified current prudent valuation adjustments are between target level of certainty of 90%. In practical terms, 0.03% and 0.3% of the fair value balance sheet, this means that for market price uncertainty, close- according to the Bank of England. out costs and unearned credit spreads, institutions However, in completing their returns, some poor are required to calculate the prudent value using practices were observed among UK banks, with for market data and the 90% certainty level. example bid/offer spreads or historic Invoice Price l In all other cases, an expert-based approach is Variances used as a proxy for valuation uncertainty, specified, together with the key factors required to and only IFRS level 3 positions (unobservable inputs) 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 Banks now have a quantitative Core Equity Tier 1 of institutions in definition of prudent at the 90th absolute terms (on average €227m per institution), which is on average 0.07% percentile. of the value of fair valued positions on banks' balance sheets. Perhaps not surprisingly the mood “The prudent valuation requirements pose music emanating from the banking community in considerable challenges to credit institutions,” says Dr respect of prudent valuation has been less than Andreas Werner, a partner at Frankfurt based enthusiastic, implying as it does lower valuations (and consultancy d-fine, in a note. “The implementation is hence lower capital resources) through the challenging as new measurement methods and requirement to explicitly include early termination business processes have to be developed and new costs, investing and funding costs and administrative market data sources have to be identified. expenses. Also implied is increased operational Additionally, prudent valuation adjustments are pro- complexity and potentially a revaluation of fair value cyclical and may be significant with respect to tier one assets held in both the banking book and the trading capital, thus posing challenges to risk management.” book, both of which are covered by the rules. Less liquid markets Need for implementation One of the biggest challenges for market participants March Banks approached for the purposes of this article will be less liquid markets, and where firms are unable The European Banking Authority declined to comment. However, with the European to present a specific level of price uncertainty there is a published final draft regulatory rules set to come into force in the coming months the work out enabling them to explain to the regulator the technical standards on prudent time for debate has elapsed, and firms must now get approach they have adopted. valuation in March 2014. on with the serious business of implementation. “Banks now have a quantitative definition of prudent One of the key differences between prudent at the 90th percentile, with an element of qualitative valuation and other regulatory requirements is its assessment because we recognise that in some cases often subjective nature. While can be there will be insufficient data,” says the Bank’s Brar. calculated using a model, valuation is often a matter An example of the challenges facing banks is the of judgement within a prescribed framework, and that measurement of accounting for credit value judgement can change from one month to the next. adjustments, for which some firms currently value

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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 Ragveer Brar, head of valuation and controls team, assessments for their global entities because they Bank of England realise the advantage of having a better understanding of their valuation processes and the degree of valuation risk the firm is exposed to. counterparty risk based on historic data and others use Global regulators are watching the European market implied numbers from credit default swaps. example closely. “There have been discussions with Whereas this may be acceptable for accounting global regulators and some will be bringing in these standards, it also generates uncertainty, which is rules,” Brar says. “Two years ago it was the UK, and anathema to the regulator. However, it’s not only shortly it will be across Europe, so there is a trend. complex assets and liabilities that represent challenges There are clearly concerns at the highest levels around – finding firm prices can be just as challenging for valuation issues, and it would not be a surprise if vanilla securities such as bonds, particularly those that prudent valuation is adopted globally in due course.” are less liquid, e.g. emerging market bonds. Where models are used for valuation purposes, Measurement challenges institutions are required to estimate a model risk adjustment for each model. Compliance with prudential valuation obligations presents implementation challenges for banks that require new measurement methods, business processes and market “It’s incumbent on banks to demonstrate their data sources for hard to value and illiquid instruments. appreciation of the range of approaches available, so “Over the past year we met with over 40 banks and regulators in Europe and initially when it comes to modelling if there are 10 models in everyone seemed focused on the most complex assets on the balance sheet,” says the market then the theoretical ideal may be to build Leon Sinclair, director of evaluated pricing at Markit. “However, many underestimated each of the models and put your valuation through the challenges and capital impact to their institutions when undergoing additional valuation adjustment (AVA) analysis for more liquid assets. each and then reach the 90th percentile of certainty,” “We saw a sea change during the quantitative impact study in November, when says Brar. “However, in drafting regulatory policy we anecdotally banks took between six and 10 weeks to complete the core approach. have ensured sufficient balance in order to avoid an This was primarily due to the task of collecting data sets that hadn’t previously been unduly burdensome approach that may place too part of Independent Price Verification/ Risk workflows.” much pressure on resources. Therefore we have 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 pragmatically left open the option for an alternative the underlying raw data driving bond prices, customers can streamline the data approach based on an expert risk assessment of the collection process into their in-house methodologies while gaining access to statistics valuation models that firms use, including an from institutional market markers. assessment of factors such as liquidity, level of Banks will need to demonstrate full transparency in their methodologies and range of standardisation and size of position to determine an inputs fuelling the underlying pricing data, as well as liquidity metrics. Since the publication of the European Banking Authority Regulatory Technical appropriate prudent valuation adjustment.” 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 Standards vary they could result in an uneven playing field between institutions subject to the rules and Currently valuation standards vary considerably those outside the jurisdiction of the European regulators, says Sinclair. between and within banks, Brar says. Examples of

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