Focus Article – Prudent Valuation 

The financial market stresses seen during March highlighted important aspects relating to a core regulatory requirement – prudent valuation. Financial institutions are required to report additional valuation adjustments to their assets and liabilities to account for transactional liquidity and costs, which impacts their reported Tier 1 capital. Hamish Darbyshire dives into the topic:

The scope of the regulation allows banks to develop their own internal framework to assess these values. This permits the advantage of designing a framework suitably accurate for the variety of items on their balance sheet, but disadvantageously requires the framework to be thoroughly assessed to avoid both error and risk.

The impacts to most banks’ prudent valuation assessments at March quarter end were significant, indicating either a lack of robustness or too few degrees of freedom in their frameworks. After March, EBA rapidly deployed new regulation to provide temporary relief to many of those banks affected, by increasing their allowed diversification parameter from 50% to 66% effective from Jun quarter end (see link here). In combination with retracing financial markets we have seen some stability (see the chart of selected Nordic banks below).

Source: Official quarterly financial reports of each mentioned institution

FCG has been working with Nordic institutions to develop their frameworks with three key objectives:

• Develop automated mechanisms for all classes of assets/liabilities, accounting for the nuances of each class. This allows more frequent monitoring of the balances and more proactive, rather than reactive, decision making.
• Review and structure models that provide accurate and reliable prudential AVAs with enough flexibility and fallback documentation such that appropriate values are maintained even when data availability becomes sparse in periods of stress.
• Include sensitivity analysis that provides useful metrics for analysis and which feeds into the proactive response mechanism.

 My personal opinion is that the recent focus from senior management and executive committees on this topic will likely free up resources to develop these frameworks; especially at more progressive institutions. One issue we also hope to address and feel will be particularly impactful is to bring some consensus thinking to certain balance sheet items. For example the XVA (valuation adjustments) components of the prudent valuation framework are currently treated very differently from bank to bank. As consensus develops it will allow EBA to adopt clearer guidelines allowing less progressive institutions the opportunity to revise and improve their frameworks. We should not forget that the prudent valuation regulation is only relatively young, since 2015 and potentially subject to greater granularity. FCG, with its central insight into the treatment at different banks, is ideally positioned to steer the discussion and positive developments across the Nordics.