The Prudent Valuation of Financial Instruments - d

The Prudent Valuation of Financial
Instruments
Adjustments for fair value positions within the context of capital
determination under Basel III
1. Introduction
For the determination of tier one capital the
Capital Requirements Regulation (CRR) [3]
imposes the principle of prudence upon the
pricing of financial instruments recognized at
fair value. In particular, the prudent value of a
fair value position is obtained by subtracting
from its fair value several risk- and cost factors
which are not or only partially accounted for
in its balance sheet value. The differences
between fair values and prudent values of all
of a bank’s fair value positions have to be
subtracted from tier one capital. In a recent
article [1] we have discussed fundamental
questions about the prudent requirements,
giving special consideration to dependencies
between valuation, accounting, and capital
requirements. In this white paper, we briefly
review
the
supervisory
authorities’
publications related to the topic and
summarize our insights and professional
opinions that we have gained in projects on
prudent valuation over recent years.
2. New regulatory requirements
for the valuation of financial
instruments
Subsequent to the financial crisis, a
conservative valuation of fair valued assets
became a requirement, as specified in
November 2012 via the CRD III package [9].
(Implementation was provided at a national
level. For example, in the UK by the FSA’s Dear
CEO letter [8] and in Germany by circular
13/2011 issued by the supervisory authority,
BaFin[2]). The CRR directly enforces uniform
prudent valuation standards across Europe.
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Detailed provisions for their implementation
will be by specified by the European Banking
Authority (EBA) which has released a
consultation paper [6] on the corresponding
technical standard in July 2013 and has
conducted a quantitative impact study to
further calibrate the prudent valuation regime
[5]. The final technical standard has been
announced for the second quarter of 2014
[10].
Capital Requirements Directive III &
Capital Requirements Regulation
According to CRD III banks have to evaluate,
for trading book positions, whether valuation
adjustments (formerly known as reserves) are
required to achieve a prudent valuation level.
The factors set out in Section 3 have to be
explicitly tested for relevance. If these
adjustments are material, the bank’s original
own funds have to be reduced by the
adjustment insofar as it is unaccounted for in
the balance sheet fair value.
The CRD III requirements are to a large extent
identical to those specified in the CRR in
article 105 (9 to 13). However, article 34 of
CRR requires the application of prudent
adjustments to all fair value assets. This
explicitly includes positions in the banking
book. Correspondingly, a reduction in the tier
one capital by the adjustment amounts that
are unaccounted for in the balance sheet is
required for all assets recognized at fair value.
A threshold for the application of prudent
valuation adjustments is no longer foreseen.
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The new solvency reporting framework CoRep
also requires the disclosure of the tier one
capital reductions attributed to prudent
valuation adjustments.
EBA’s standardization effort
In Article 105 (14) the CRR mandates EBA to
submit a draft version of the technical
standards for the prudent valuation of
financial instruments. EBA’s first discussion
paper on these so called additional value
adjustments (AVA’s), published in 2012 [7],
received extensive criticism. On July 10th 2013
a markedly revised consultation paper was
published addressing most of the expressed
concerns. It is the view of EBA that the
prudent valuation regime, and consequently
the adjustments to tier one capital, will
encompass all fair value positions i.e. also
liabilities. EBA substitutes the minimum limit
by allowing a simplified approach to be
applied by institutions running smaller fair
value books.
3. Adjustment Categories
The CRR explicitly states numerous
circumstances where the market participants
are required to evaluate the necessity for
AVA’s.
As illustrated in Figure 1, the requirements
can be subdivided into valuation uncertainties
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arising at the calculation date, foreseeable
future costs and other adjustments. While
most of these categories were already
included in the updated CRD III [9], corrections
for market price uncertainties were only
amended in the CRR. Balance sheet
substantiation, which was a separate topic in
the initial draft version by the EBA, is now
treated within operational risk.
4. The Market’s Perception
In 2013 the CRR gave a new impetus to this
topic which has triggered numerous studies
and design projects. Implementation phases
for prudent valuation are foreseen for the last
quarter of 2013 and the first half of 2014.
We have conducted market surveys on the
implementation practice and have advised
several customers in various projects in this
context, where close out adjustments, market
liquidity, model risks and operational risks
received special attention. Furthermore, in
recent years we have successfully completed
numerous projects on balance sheet fair value
adjustments, which have a close relation to
the adjustment categories defined in the CRR.
These projects include adaption of pricing
models to new market practice (e.g. OIS
Discounting)
and
determination
of
downstream adjustments to model based fair
values (e.g. credit and debit valuation
adjustments).
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Uncertainties arising on
the calculation date
Foreseeable future costs
Other adjustments
Market price
uncertainty
Early termination
Operational risks
Model risk &
parameter
uncertainty
Investing and funding
costs
Balance sheet
substantiation
Unearned credit
spread
Future administrative
costs
Close-out costs
Concentration and
illiquidity adjustments
Figure 1: Prudent Valuation adjustments according to the CRR [3] and the EBA consultation paper
5. Challenges to Implementation
of Prudent Valuation
Regardless of the final specifications provided
by the EBA, the prudent valuation
requirements pose considerable challenges to
credit institutions. 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.
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The main aspects in our discussions with
market participants and in our conceptual and
implementation projects were:
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Design of efficient methods for adequate
quantification of the AVAs as well as
determination of exit-prices that are
realizable at the given probability required
by the EBA.
Determination of aggregation levels for
exposure netting for close-out costs and
for determining adjustments of less liquid
positions
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Adequate quantification of adjustments
for administrative costs taking into
consideration the existing systematics for
cost accounting
Appropriate
identification
and
measurement
of
adjustments
for
operational risks
Delineation of the different prudent
valuation adjustments and the avoidance
of double counting
Distinction
of
prudent
valuation
adjustments and balance sheet fair value
adjustment
Ensuring a consistent set-up for
determination of valuation adjustments,
reversal of accruals in the P&L and
integration of prudent valuation into
existing reserve processes
Setup and documentation of the required
data supply processes
Establishing and monitoring of consistent
management processes involving different
regulatory branches and functions.
Recognition
of
prudent
valuation
adjustments within risk management
processes
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In its consultation paper, EBA has further
specified
the
methodology
deemed
appropriate
for
determining
value
adjustments. With regard to scope and
technical specification the requirements have
been increased yet again. In particular,
requirements relating to the measurement of
market price uncertainties and the detailed
examination of error sources, as well as the
requirements on the use of aggregated risk
factors (reduced valuation inputs).
How may we assist you?
The d-fine team offers expertise and hands-on
experience in all aspects of the new regulatory
environment. Contact us …
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…to benefit from our market insight on
prudent valuation
…to receive updates on the debate
between regulatory authorities and
market participants and on the status of
implementation in the banking market
…to rank and prioritize the requirements
of your institution with respect to new
regulation and check their materiality for
your business model.
…to take advantage of the network of
experts within d-fine when selecting
suitable methodologies and let us assist
you with conception, implementation and
servicing of the required processes
...to help you implement valuation
adjustments and to benefit from our
experience in all aspects of valuation and
risk management of financial instruments
…to conduct prototypical calculations and
estimate the impact upon your capital
situation
…to discuss implications for your risk
management processes
important topic. We look forward to hearing
from you!
6. References
[1]
Dr. Hans Peter Wächter, Dr. Andreas Keese, Dr.
Tassilo Christ, Vorsichtige Bewertung – die
Ausgestaltung des Prudent Valuation Regimes durch
die Bankenaufsicht, Zeitschrift für das gesamte
Kreditwesen, June 2013, (German)
[2] Federal Financial Supervisory Authority, Circular
13/2011 (BA) - Bewertung von Positionen des
Handelsbuchs, November 30th 2011, (German)
[3] The European parliament and the European council,
Regulation (EU) No 575/2013 of the European
Parliament and of the Council of 26 June 2013 on
prudential requirements for credit institutions and
investment firms and amending Regulation (EU) No
648/2012 (Capital Requirements Regulation – CRR)
[4] European Banking Authority, Press Release – EBA
consults on draft technical standards on prudent
valuation,
July
10th
2013
(link:
http://www.eba.europa.eu/-/eba-consultson-drafttechnical-standards-on-prudent-valuation)
[5] European Banking Authority, Press Release – EBA
launches QIS exercise on prudent valuation, July 22nd
2013
(link:
http://www.eba.europa.eu/-/ebalaunches-qis-exercise-onprudent-valuation
[6] European Banking Authority, Consultation Paper –
Draft Regulatory Technical Standards (RTS) on
prudent valuation under Article 105(14) of
Regulation (EU) 575/2013 (Capital Requirements
Regulation - CRR), June 10th 2013
[7] European Banking Authority, Discussion Paper –
Relating to Draft Regulatory Technical Standards on
prudent valuation under Article 100 of the draft
Capital Requirements Regulation (CRR), November
30th
2012,
Response
under:
http://www.eba.europa.eu/regulation-andpolicy/marketrisk/draft-regulatory-technicalstandards-on-prudentvaluation/-/regulatoryactivity/discussionpaper/101749#responses_101749
[8] Financial Services Authority, Dear CEO Letter on
Valuation and Product Control, August 13nth, 2008
[9] The European parliament and the European council,
Directive 2010/76/EU of the European Parliament
and of the Council of 24 November 2010 amending
Directives 2006/48/EC and 2006/49/EC as regards
capital requirements for the trading book and for resecuritizations, and the supervisory review of
remuneration policies
[10] Revised deadlines for the delivery of EBA technical
standards
http://www.eba.europa.eu/-/reviseddeadlines-for-the-delivery-of-eba-technicalstandards
We would be pleased to arrange a meeting
with your in-house experts and discuss this
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7. Your Contacts at d-fine
For questions and discussions please contact
Dr. Andreas Werner, Partner
d-fine GmbH, Frankfurt
[email protected]
Dr. Mark Beinker, Partner
d-fine GmbH, Frankfurt
[email protected]
Dr. Andreas Keese, Senior Manager
d-fine GmbH, Frankfurt
[email protected]
Artur Steiner, Senior Manager
d-fine GmbH, Frankfurt
[email protected]
or
your direct contact at d-fine
You will find us on the web at: http://www.d-fine.com/PrudentValuation.
Or feel free to call us at +49 (0)69 90 737 0 specifying the keyword
„Prudent Valuation“.
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