1 EBA Regulatory Technical Standards on prudent valuation: a framework for success Banking & Capital Markets May 2015. 01. The call to action EBA requirements necessitate Many institutions have not yet fully The European Banking control departments to change implemented a prudent valuation framework. Typical weaknesses Authority (EBA) first Capital Requirements Regulation observed across the market include (CRR) requires financial institutions to the following: published its consultation apply prudent valuation to all fair Policies and application guidelines value positions. The difference paper on draft Regulatory between the prudent value and the outlining quantification methods, fair value, called additional valuation valuation hierarchies and Technical Standards (RTS) on adjustment (AVA), is directly calculation premises have not yet deducted from the Common Equity been fully defined.
2 prudent valuation in July Tier 1 (CET1) capital. Documentation of expert EBA RTS on prudent valuation defined approaches applied is not 2013. Many banks still have . complete. new requirements for AVA. work to do to ensure they calculations as well as the valuation Governance frameworks and control framework supporting supporting prudent valuation have meet all the EBA calculations. not been defined or integrated into Organizations are adopting varied existing governance mechanisms. requirements and are ready to Periodic management reporting of approaches to addressing EBA RTS as . submit accurate returns by the guidance provides a framework AVA movements to provide and not a methodology. understanding of exposure to Q3 2015. valuation uncertainty has not been designed and implemented.
3 prudent valuation: a framework for success 1. Product inventories are not complete In January 2015, the EBA published and have not been validated with an amended version of the RTS on Business benefits front office or all relevant control prudent valuation. The EBA RTS are Banks that successfully deliver on departments. currently pending approval from the the EBA RTS on prudent valuation Internal audit has not been engaged European Commission and it is can expect to benefit. on a group-wide basis in relation to anticipated this will happen in Q3 Improved regulator confidence. proposed governance and policy for 2015. Thereafter, banks will be legally required to submit prudent Valuation Increased profitability will be AVA calculation processes. created by improved capital Returns in accordance with the new Model review processes are not management and incentivization.
4 Requirements. always adequate and thresholds for Improved valuation controls will determining when valuation models result in an enhanced control are no longer sufficiently robust are environment. not clearly defined. New product approval and new deal review policy and processes have not been revised in light of EBA. requirements. prudent valuation: a framework for success 2. 02 prudent valuation: ensuring success Regulators want to see that institutions have put a demonstrable framework A well-defined prudent in place to support new prudent valuation requirements and enable effective valuation framework is key to decision-making. ensuring regulator 1. Governance framework 2. Policy and application guidelines expectations are met. prudent valuation governance should be Policy on prudent valuation should Institutions should consider integrated into the existing valuation provide unambiguous interpretation of seven key areas.
5 Governance framework, which should be EBA RTS requirements and be aligned to clearly defined at the firm-wide level and existing fair value policy. linked to capital management Application guidelines should specify An external perspective is governance. product requirements and support There should be clarity in roles and accurate execution of policy. vital to ensure organizations responsibilities across divisions and Training sessions should be held to do not become an unintended functions, in particular for monitoring, ensure impacted staff understand the supervision and oversight activities. new prudent valuation policy and how it outlier within the market. Constructive challenge to AVA is to be applied in practice. calculation approaches and expert judgment methodologies applied must be embedded within governance mechanisms.
6 Organizations need to consider their overarching as well as the effectiveness of specific valuation governance framework valuation controls Valuation uncertainty appetite statement Front-office valuation Front-office policy, controls and cross- valuation functional management controls reporting Valuation and prudent valuation committee Product IPV, model & Product control, control policies, controls IPV and model and management reporting Valuation Oversight Escalation and Performance controls supporting the valuation policies and issue measurement framework supporting management (including policies management reporting &. Definition and KPIs) prudent implementation of new valuation controls required to controls support prudent valuation Internal audit and AVA calculations prudent valuation: a framework for success 3.
7 EBA requirements combined with organizational complexity demand that careful consideration is given to the operating model required to support prudent valuation. 3. Valuation controls Resource and skills requirements to 6. Documentation support business as usual (BAU). The EBA RTS make some broad and prudent valuation Institutions are required to document specific requirements in relation to prudent valuation methodology, as well systems and controls. In particular, they Performance measurement as methodology applied where an expert- prescribe that institutions must have framework to assess prudent based approach has been adopted. effective controls related to the valuation processes and outputs A standardized approach should be governance of all fair valued positions. Cross-functional and divisional developed for documentation, and Institutions should reassess existing fair collaboration is required to ensure a organizations should invest time up front value controls, ensure they are able to cohesive and consistent firm-wide to ensure documentation meets EBA.
8 Demonstrate compliance, and develop operating model is designed and requirements. Additionally, consideration remediation plans to address gaps within implemented to support prudent should be given to how organizations will appropriate time frames. valuation. maintain high-quality up-to-date Following the development of prudent Strong central coordination is required to documentation on an ongoing basis. policy and application guidelines, provide appropriate oversight and ensure institutions should design and implement complete and accurate EBA prudent 7. AVA optimization additional controls required to support Valuation Returns are produced within reporting deadlines. Institutions should also consider how prudent valuation. Control Standards they can move beyond prudent valuation should clearly describe control compliance toward optimization to requirements.
9 5. Management reporting manage the impact of capital deductions. Furthermore, institutions need to The EBA requires management reporting Key areas to be explored include: implement specific controls defined for senior management to provide an Refining current AVA calculation within the EBA RTS. These include a understanding of the level of valuation methodologies, tailoring approaches validated firm-wide product inventory, uncertainty to which the firm is exposed. to specific exposures across mapping valuation positions to product Management reporting should be categories definitions and valuation methodologies. designed to provide insight into AVA Increasing the number and quality of movements and rationale for drivers. It market data sources used to reduce 4. Operating model definition and should also provide transparency where reliance on proxies and application of implementation expert-based approaches have been expert-based judgment applied, and highlight AVA calculation Institutions should perform an Validating and enhancing the level of processes requiring management assessment to understand the changes netting applied when calculating AVAs attention or instances where policy or required to the operating model arising through implementation of a robust Regulatory requirements have not been from EBA prudent valuation process to perform the 100-day met.
10 Requirements. The following key areas netting test should be considered: In addition, where appropriate, management reporting should link the Reviewing the potential availability of Design of new processes, handoffs capital offsets that could be adopted fair value hierarchy, Level 3 disclosures and reporting outputs to reduce the final AVA number and fair value reserves. Revisions required to existing policies Management reporting should be used by and processes to support prudent senior management to incentivize the valuation right behavior and drive the optimal use Identification and implementation of of capital. To help achieve this, new market data sources, as well as consideration should be given to how improvement initiatives to enhance uncertainty results for AVA categories existing data such as operational risk could be IT solutions to automate apportioned to business lines.