Prudent Valuation
The Capital Requirements Regulation (CRR) of the EU (Regulation No. 575/2013) contains under Article 105 some instructions on the “prudent valuation” of financial assets and liabilities. It is determined that valuation institution shall provide prudent and reliable valuation estimates to achieve an appropriate degree of certainty about their trading book positions.
What remains vague here, was now elaborated by the EBA to a detailled RTS. The final draft of this RTS was released in 2015, so banks can find out what they have to expect in near future.
The RTS of the EBA – a small Introduction
“Prudent Valuation” is one of the most important regulatory challenges today. That’s why a quick summary of the concrete requirements is worth it.
The RTS demands the calculation of so-called “Additional Valuation Adjustments” (AVAs) for all financial instruments or commodities measured with a fair value. There are two approaches to do so: The simplified and the Core Approach.
The Core Approach is meant to be the standard method to calculate AVAs. First the calculation is done for nine different categories (e.g. Model Risk, Future administrative costs, Operational Risks) separately. The resulting AVA is the sum of the nine category-level AVAs.
If one can document appropriately that a certain risk does not exist, a category-level AVA can go down to Zero. But if the method cannot be applied correctly, e.g. because of missing data, a fall-back method must be used. This fall-back method is much more expensive than the usual approach. In this case the AVA can definitely be about 25% of the Fair Value.
If the AVA calculation is treated carelessly, substantial extra costs are imminent.
The Simplified Approach is open just to institutions whose financial instruments do not exceed 15 bn € in the sum of their absolute Fair Value. If this approach is chosen the overall AVA is calculated simply as 0.1% of the absolute values of all Fair Values:
Whenever possible we recommend to choose this approach.
It is our philosophy to recommend our clients a good balance between effort and result. The Impact Analysis of the EBA has shown that the Core Approach results in AVAs of a similar dimension. The potential savings are therefor low, but the additional time and effort significant. Furthermore the Core Approach brings the danger of extra costs due to the fall-back methodology.