Internal and regulatory oversight of the valuation process is essential to ensure that sources of prices are diverse and reliable, according to a recent report by the Bank for International Settlements (BIS). The BIS report suggests ways for financial institutions to assess the fair value of their assets, including promoting the need for independent verification of valuations.
“The application of fair value accounting to a wider range of financial instruments, together with experiences from the recent market turmoil, have emphasised the critical importance of robust risk management and control processes around fair value measurements,” the report states. “Moreover, given the significance of fair value measurements for regulatory capital adequacy and internal bank risk management it is equally important that supervisors assess the soundness of banks’ valuation practices through the Pillar 2 supervisory review process under the Basel II Framework.”
The Basel Committee on Banking Supervision in June this year published an assessment of fair value measurement and modelling challenges faced by banks during the market turmoil. The report builds on that documents and the committee’s guidance on the use of the fair value option in order to strengthen the valuation process in financial institutions suffering under the current market conditions.
This report applies to all financial instruments that are measured at fair value, both in normal market conditions and during periods of stress, and regardless of the financial reporting designation within a fair value hierarchy, says BIS.
The principles in the report therefore promote strong governance processes around valuations including the use of reliable inputs and diverse information sources. It also promotes the articulation and communication of valuation uncertainty to internal and external stakeholders, the allocation of sufficient banking and supervisory resources to the valuation process and independent verification and validation processes.
According to the BIS, there needs to be consistency in valuation practices for risk management and reporting purposes where possible and strong supervisory oversight around bank valuation practices. In terms of internal oversight of the valuations process, the report states that the valuation governance structures and related processes should be embedded in the overall governance structure of the bank. The board of an institution should first review and approve written policies related to fair valuations, then ensure that these are monitored and that adequate resources are devoted to the valuation process, says the report.
The board should articulate its tolerance for exposures subject to valuation uncertainty and monitor compliance with the board’s overall policy settings at an aggregate firm-wide level. There should also be independence between risk taking and control units, the report suggests. “Controls and procedures should be designed to ensure fair value measurements are reliable. They should further ensure clear and robust production, assignment and verification of financial instrument valuations,” it continues.
Independence in the valuations process is the key takeaway from the report, regarding both sourcing and controls. “A fundamental feature of adequate control processes is that the final approval of valuations should not be the responsibility of the risk taking units. There should be clear and independent reporting lines to ensure that valuations are independently determined. Banks should maintain functional separation between the front office, the risk taking units that typically provide the initial fair valuation estimates, and the measurement and control unit, the unit providing independent price verification (IPV), at all times. In addition, the unit responsible for IPV within the bank should source prices independently of the relevant trading desk,” it states.
Financial institutions must also stress test their valuations processes in order to make sure they can stand up in even the toughest market conditions, says BIS. Bank valuation methodologies are also expected to not place undue reliance on a single information source, especially when valuing complex or illiquid products. It recommends a “diversity of approaches and having in place a range of mechanisms to cross check valuations”.
Although it recommends the use of third party valuations, BIS stresses that there should be sufficient oversight: “Management must understand the basis of any measurement and valuation techniques used by outside parties so that it has a sufficient basis upon which to determine the appropriateness of the techniques used, the underlying assumptions and selection of inputs and the consistency of application.”
When assessing both internal and external pricing sources, a number of important factors must be considered, the report explains, including the frequency and availability of the prices, whether they are “relatively consistent” with available corroborating market information and whether they are transparent. Recent pricing data will tend to be more reliable than stale data, it continues. Institutions must also consider the maturity of the market, and in particular whether quotes will continue to be available for the foreseeable future.
“A bank has to be able to identify when active markets become inactive as this will affect the quality, transparency and reliability of inputs to a valuation,” the report states.
Overall, the key message from the BIS is to improve documentation and transparency around institutions’ valuations policies to engender better risk management. Given the news last week that BlueBay Asset Management had suffered a “valuations breach”, which is just one example of a growing problem, it seems appropriate that this should be a key issue for concern in today’s increasingly volatile markets. As fund managers come under greater pressure for performance, the controls around independent pricing must be tightened in order to prevent such policy breaches from happening.