Prudent valuation practices discussed

Representatives from PricewaterhouseCoopers and Prytania Solutions recently discussed how IPV and prudent valuation practices are adjusting to new European regulatory requirements during a live webinar hosted by SCI (view the webinar here). Topics included the definition of a prudent valuation and investment bank key requirements, as well as the role of the risk management function. This Q&A article highlights the main talking points from the session.

Q: The EBA is expected to finalise its regulatory technical standards (RTS) related to prudent valuation adjustments of fair valued positions in the coming months. How has the provision of valuation services changed in response to such regulatory reporting requirements?
Fraser Malcolm, head of Prytania Solutions: The prudent valuation directive is the latest in a long line of regulatory initiatives designed to facilitate transparency and accountability around the valuations process, specifically in connection with banks. It follows on the heels of IFRS 13 and includes some elements of the Basel 3 and Solvency 2 standards.

The prudent valuation adjustment is essentially a way of conveying the uncertainty around valuations on a bank's balance sheet. Such uncertainty is being driven by a number of factors: the prudent valuation directive focuses on model uncertainty and uncertainty around the realisation of profit and loss, as well as close-out uncertainty - which can be directly linked to a lack of liquidity for certain instruments.

Over the last 12 to 18 months, clients have begun requiring much more than just a price in connection with their valuation activity. They now require all sorts of information around that price and how it was derived, as well as transparency around the model inputs and market observables used to derive the price.

This is symptomatic within the context of additional valuation adjustment (AVA), as defined by the prudent valuation directive, which is proving to be a significant data challenge. Essentially, more than just a price is required in order to adhere to the new regulations.

Q: How would you define what constitutes a prudent valuation under the EBA directive?
Neil Douglas, director at PricewaterhouseCoopers: It's important to bear in mind that ultimately demonstrating an appropriate prudent valuation is actually a matter of demonstrating to the regulator how you comply with the rules. The standard was borne out of the regulator's concern that fair value (FV) was no longer representing what is required from a capital perspective.

Consequently, the first component of what constitutes a prudent valuation is to address the concern that FV does not adequately cover prudence and leading to more aggressive marks than the regulators desired for capital purposes. The market price uncertainty AVA, close-out costs AVA and model risk AVA lead on from this, with the emphasis on revisiting a valuation and working out what needs to be done to reach the 90% confidence level required in terms of prudence and conservatism.

The second component of what constitutes a prudent valuation is additional adjustments, which the regulator considers important for capital purposes, but may not be allowed for fair value purposes. This leads to adjustments, such as concentration risk AVA, future admin costs AVA and operational risk AVA.

Q: Are there any other differences between a prudent valuation and fair value?
ND: The major difference is clearly that additional prudence is explicitly incorporated in the prudent valuation in order to produce a value considered by the regulators to be more appropriate for capital purposes. Another concern of the regulators is that firms across different jurisdictions were perhaps applying the FV standard in an inconsistent manner - depending on GAAP and so on - and, through the RTS, they've established a consistent standard across the EU. Obviously, how consistently that standard will be interpreted and applied is a different question.

Q: When implementing a prudent valuation framework, what are the key requirements for the sell-side and how do they translate to the buy-side?
ND: Most sell-side firms have been able to establish an approach to calculating prudent valuations and they are now performing that calculation. But this has taken a fairly significant amount of effort - and that's for investment banks that already have established independent price verification (IPV) functions and model approval processes, into which prudent valuation items can be integrated.

However, this is only part-way to the final solution. The problem is that although sell-side approaches are generally in agreement at a very high level as to how prudent valuation calculations ought to be approached, differences remain in the details of how banks have implemented them. For example, there are methodological differences in how to treat netting, how to aggregate the various AVA and what offsets are permissible with a prudent valuation.

This methodological disparity and the subjective nature of the calculation mean that every decision must be very well documented. One of the issues that banks are finding is that there is a lot of work to be done on the documentation side to ensure that every step in the process is appropriately justified.

The other side of the equation is controls and governance. The key requirements here are to build a methodology that complies with the rules, then document everything that has been done and ensure that the governance around it is appropriate. There's probably a fair amount of disparity around how well prepared banks are for the final implementation of the prudent valuation directive.

FM: Certainly investment banks seem to be more advanced in their approaches to prudent valuation and in terms of the information that they require than those on the buy-side. There also seems to be better connections between the different regulatory requirements on the sell-side.

Q: Could you provide more detail on the controls and infrastructure that should be in place under a prudent valuation framework?
ND: The first aspect is documentation. There is a fair amount of disparity across the industry as to how the regulations are being implemented and there is a significant level of subjectivity that needs to be applied in working out the prudent valuation rules, especially for illiquid assets.

So documenting this is a prerequisite: firms need to be able to demonstrate not only what they've done, but also why they did it. Without that last step, it's considered as bad as not having done anything at all.

On the sell-side, such documentation varies considerably - from thousands of pages of information to much smaller documents. Ideally, firms start with the high level generic guidance of the RTS and map it to the specifics of their business to produce an overall policy and then document each application of that policy by area to the positions that are on their books, detailing the assumptions made. The key is to document the expert judgments made and that boils down to getting the appropriate expertise together, with as much data as possible.

If a firm has documented everything at this level of detail, the conversation with the regulator can become more about the reasoning leading to a given valuation, as opposed to simply an argument about the valuation itself.

In terms of governance, it's important to demonstrate adequate senior management involvement, with their sign-off on the key assumptions and limitations. Another area of focus is on how the approach should be integrated with a firm's other valuation teams because there are important overlaps with risk management and the broader finance function, as well as how communications should function between them.

Q: Are institutions already making allowances for valuation risk?
ND: There are two parts to this: in fair value, some institutions are making allowances for valuation risk to a limited extent. Some parts of the accounting standards explicitly allow adjustments to be made for valuation uncertainty.

Others are making allowances for model risk within their FV frameworks; it often depends on their attitude and the local GAAP. But no-one's making allowances across the board with respect to prudent valuation.

There is also a capital question: whether firms are taking AVA calculations to capital or not. The larger banks are, although the degree to which the calculations comply with the standards varies. It also varies significantly outside of the UK; generally they're not yet being taken in Europe.

FM: Some of the institutions we speak to are looking at model risk uncertainty. They want information on how a price was derived and where the vectors came from and so on, and this is being used to some extent to adjust the FV. But many institutions still only require a price at the moment.

Especially at the more illiquid end of the fixed income spectrum, firms will need a management information system to organise the data in an effective manner. That is a significant challenge for many institutions.

Q: Are there any other issues that investors should be aware of regarding the roll-out of the prudent valuation regulations?
FM: Different institutions are taking different approaches, so the quest for standardisation isn't necessarily being resolved by the prudent valuation rules, although they bring the market closer to this goal. The challenge for institutions that aren't yet in a position to deal with this extra information burden is that it's a huge data issue. It's a question of not only collecting the data, but also being able to understand and use it effectively.

Q: Market data will be a crucial component of the prudent valuation infrastructure. Do you have any advice on the sourcing of data and how it should be used?
FM: We've been rolling out our pricing and valuation framework, which collects market data, cleans and sorts it, and creates a hierarchy of usefulness. But this information is not always readily available, given the illiquid nature of the product - and where it is available, it can be very patchy and thin.

So it's incumbent on any organisation to create a data framework that allows for an ordered use of pricing data. This is something that can be provided as a service, while the bigger investment banks have their own sophisticated systems in-house.

As a standard requirement, firms need market observable data, model inputs and information about how many other proxy positions were used to derive a price.

ND: The full range of reliable data sources should be considered. Whereas many investment banks have historically relied on consensus prices, the trend recently has been towards persuading them to consider a broader range of market data sources to do a proper data scrub - looking at all the data sources that could be relevant for the positions, including market prices, evaluated and consensus data.

The next step is to rank them in terms of trust and then come up with an overall measure, rather than relying on a single source. Then firms need to demonstrate that the sources used have the maximum reliability and that every attempt has been made to capture trade data and consider it in a price assessment.

Q: Can you provide a practical example of how to approach the modelling of a prudent valuation?
ND: The broad sell-side industry consensus as to how modelling ought to be approached is as follows. Generally the calculation of market price uncertainty is linked in some way to the IPV approach - including certain thresholds, which trigger adjustments when breached. How those thresholds are calculated varies significantly; often they're consensus-based for many assets.

There is fairly significant divergence in terms of how netting requirements are interpreted within prudent valuations. Two articles - 9.4 and 9.5 - in the final standard outline how the final numbers can be netted up for market price uncertainty. This is important because if valuation uncertainty is grossed up across each instrument on a book, the final number will be a very large number, whereas it will be much smaller if everything is netted out.

The EBA has tried to normalise this situation with a hedging efficiency test, where variances can be compared. You can either approach the test on a sample basis or take a whole curve approach.

For close-out cost adjustments, there is also a netting challenge, but generally here firms are scaling up their bid/offer adjustments. The scaling factor generally comes from the variance in broker quotes over time and by applying a consistent methodology to come up with a FV multiplier.

These two items - market price uncertainty and close-out cost adjustments - represent a good portion (around 40%-50%) of the final number for most firms, although there is some overlap with model risk.

The next component is model risk. The better firms are looking at the different sources of model risk for each item and working out ways of quantifying those sources in the most material areas. We're also seeing score card-based approaches, where a model is scored on a range of different factors driven by the RTS and assign numerical values to those factors.

It's important to think carefully about how model risk overlaps with market price uncertainty risk because, depending on what your parameters are for each, you get very different results for how each risk should be considered. For example, firms should ensure that where they're performing output price testing, their model risk number takes account of the reduced uncertainty in that scenario.

Meanwhile, funding and unearned credit spread adjustments are generally wrapped up into market price uncertainty and close-out costs, so institutions will consider their FVA, CVA and collateralised funding models as part of those processes.

One remaining item is concentration, and there are a number of models for this, which vary considerably depending on whether a firm is based in the US (where they are somewhat allowed to include concentration in FV) or Europe (where they aren't). For cash positions, the concentration approach is fairly well understood - most firms calculate the standard market size and number of days to divest; then come up with a liquidity adjustment depending on the volatility of the price. For derivatives, the approach varies considerably and an industry consensus has yet to emerge.

There has been some confusion about what future admin costs are, but the general approach is to take some kind of cost base for your firm, scale it down to reflect the fact that you've wound down and multiply it by an average maturity. The regulators have indicated that they don't expect this to be a very big number. The main challenge has been to help banks square this with their recovery and resolution numbers for what would happen in a wind-down situation, which tend to be much larger.

The early termination adjustment is very small (often zero). Here, banks generally identify their historical profile of non-contractual terminations and situations where they've lost money.

So far, we've only seen a few cases of early termination AVA. There are some markets where it's accepted practice for firms to buy back assets from clients, even if that would cause them to incur a P&L loss. This is often already reflected in FV.

Finally, the EBA has provided a formula for the operational risk calculation, so the approach tends to be a fairly simple application of that formula.

Q: Industry consensus on the risk management function is yet to emerge. How do you view the role of the risk manager?
ND: Both the market risk functions and risk management functions need to be involved in a prudent valuation, partly because they have some level of involvement on the model risk side and partly because these calculations can overlap with the calculations used for VaR.

An equally interesting question is what the role of the front office should be. What we've seen on the sell-side is that the front office hasn't been involved in this as much as might be expected. Its role has been limited to being informed and being asked, rather than coming up with the calculations, whereas the regulator would like to see this front and centre of the front office's thinking when they're trading.

Maybe this will begin to happen when the capital hit becomes more real and the capital starts to be distributed back to desks. There is a divergence at present between the role of the front office within investment banks and where the regulators would like to see it because the whole point of the prudent valuation standard is to engender behavioural change in those making investment decisions.

FM: Our dialogue with risk management functions is increasing, specifically with regard to model risk. Some institutions have a risk management function that sits alongside the IPV function, reporting up the cfo line. The risk management function at other institutions reports directly into the business.

The risk management function is important in the context of prudent valuations. With these types of initiatives, typically the front office is either not informed or doesn't want to be informed so it can concentrate on doing business. But the reality is that prudent valuation has significant implications for business - there's obviously a capital implication, plus the valuation adjustment hit.

Model risk in illiquid assets is a hugely important aspect of front office activity, especially in structured finance. For instance, with respect to close-out costs for illiquid assets, the front office is putting on the risk and should really know what the valuation uncertainty associated with a position is. The smart organisations will therefore have the front office suitably involved in this process.

Q: Ideally, where should the prudent valuation group sit within an organisation?
FM: I believe that it should sit within or adjunct to the IPV group - assuming the IPV group is set up and sophisticated enough to carry out prudent valuation processes. While most investment banks are organised in this way, smaller banks may have some major resource and organisational weaknesses in this regard.

Q: Is an independent review of a valuation ultimately likely to be necessary?
ND: The standards make it clear that an independent review is required, but what isn't clear is whether that is independent of the risk-taking units or independent of the person who's performing the calculation. Where there's ambiguity, regulators have a tendency to follow the more stringent version and so most firms are opting for the latter interpretation.

For example, if the IPV person is performing the calculation, someone else within the firm has to review it. There are a variety of ways to approach this: some firms are adopting a peer review; some have a model risk function that reviews it; while others have an internal audit.

There is also a question of how external audit should be involved - to which the answer seems to be 'not very'. However, uncertainty remains over how best to conduct such a review because often the expertise isn't available within the organisation, so it's unclear how an independent review should be achieved. One trend is to outsource much of the IPV operations to lower-cost locations and there are questions around whether this is feasible for prudent valuation and what the resourcing model should look like.

Q: How should institutions be positioning themselves for the future from a prudent valuations perspective?
ND: Having a methodology in place and performing a calculation is only half the battle; it's the documentation and controls around this that take up significant time and resources to achieve the standard that regulators expect. While there is a methodological consensus, key areas of disagreement remain - including the approach to netting, what can be offset against a prudent valuation and how it should be integrated into the rest of the capital framework.

The EBA considers that its job is done, so we're unlikely to see additional guidance with respect to the application of the standard. Interpretation appears to be up to the individual supervisors now.

FM: The AVA is ultimately a capital expense. These adjustments may actually deter firms from becoming involved in the more illiquid markets because the organisational implications of adhering to the directive could have a real cost, which obviously impacts a firm's bottom line. However, based on polls conducted during the webinar, it appears that the majority of the audience feels they are somewhat or fully prepared for the introduction of the prudent valuation requirements.

For more information on the EBA's draft RTS on prudent valuation adjustments and the complete webinar poll results, download SCI's prudent valuations paper here.

CS