Firms’ valuation processes are becoming increasingly stretched and in some cases are “materially flawed or inadequate”, according to the UK Financial Services Authority (FSA). In an open letter to the CEOs of banks and investment firms, FSA chief executive Hector Sants has criticised the lack of due care and attention being given to the area of valuation within these firms.
The letter notes concern about the “large number” of material mis-marking incidents over the last 12 months and recommends that firms look to the FSA’s “prudent valuation principles” as a benchmark to meet. Sants also warns against snap decisions on headcount reduction in this area as a result of the difficult economic climate. “We recommend that you consider carefully any headcount reduction exercises that will affect valuation control functions at this sensitive time,” the letter states.
The regulator also indicates that it will be stepping up its hands on policing of this particular area by initiating a series of “visits” to market participants in the first half of next year. These visits will include a review of whether the firms are adequately applying the FSA’s valuation principles, both from a high level strategic level and a practical level within systems and processes.
Sants concedes that the recommendations are not prescriptive or mandatory but warns that the FSA will be making sure its principles-based regulation is enforced. He goes as far as to threaten that communications such as the FSA’s valuation principles may be “relevant” to the regulator’s “approach in individual enforcement cases”. As such, although firms are only required to comply with the overarching rules and principles, the FSA has the teeth to rule that a company is disregarding the prudent valuation principles in individual cases and take action accordingly.
The letter also includes the details of these valuation principles and details of how mis-marking incidents can be avoided and dealt with in the future. It highlights the underlying causes behind the valuation process and control failures and indicates that though these processes may have been adequate before the second half of 2007, they should now be reviewed in light of “increased market illiquidity and valuation uncertainty”.
The FSA has displayed concern that firms’ senior management teams are not sufficiently monitoring their trading activities for some time and the letter reiterates that worry. It points to the fact that these mis-marking incidents were able to continue undetected for “extended periods of time” as proof of this fact.
It highlights a need for adequate training of product control staff in order to allow them to challenge and monitor front office staff more appropriately. The letter also indicates that the manual and opaque nature of these valuation processes has exacerbated the problem and that firms should look to upgrade these systems appropriately.
“We believe that by developing better frameworks for the measurement of residual valuation and model risks after the application of independent price verification (IPV), model validation and other processes, firms would be better placed to evaluate and manage the valuation risks that they face and firms will also be better placed to deliver a control framework consistent with the prudent valuation principles,” the letter concludes.
Given that the FSA appears to be taking the matter very seriously and is not shy of fining those involved in these mis-marking incidents (see Credit Suisse’s recent fine of £5.6 million for evidence), it seems likely that there will be a boom in spending on this area before the end of the year.
Regardless of the regulator’s statement, spending on risk management and valuation systems overall does not seen to have dwindled in 2008 despite the economic downturn. However, the impact of this statement by the FSA is expected to be that this spending will be driven to even higher levels. And that spells good news for the vendor community.