Prudent Valuation

See also

• Basel Framework, capital standard (CAP), which includes the prudent valuation guidance

• PRA Rulebook, for the UK rules

• EBA market risk, for the EU technical standards

Prudent valuation is the regulatory rule that makes a bank hold capital against the uncertainty in the fair value of its positions. Fair value under IFRS 13 is a best estimate of the exit price. A regulator, who is concerned with whether the bank can absorb losses, asks a different question: how much could the value be wrong, in the unfavourable direction, and is there capital to cover it?

The rule is simple in outline:

1. Take the positions that are measured at fair value.

2. For each of several sources of valuation uncertainty, calculate an additional valuation adjustment (AVA), the amount by which the fair value should be reduced to reach a prudent value.

3. Add up the AVAs, net of what the accounting valuation already includes, and deduct the total from CET1 capital.

The adjustment is a deduction from capital. It does not change the accounting value, the P&L or the balance sheet.

Where the rules come from

The requirement is in the Capital Requirements Regulation (Articles 34 and 105), with detailed technical standards written by the EBA. The UK took them over as retained law, and the PRA has been moving them into its own rulebook. The two sets of rules are very similar for now. In the US there is no direct equivalent, as US banks rely on their accounting valuation with the capital rules applying to it.

The prudent value is set at a high confidence level. For the main categories, the standards require the adjustment to be calibrated so that there is 90% confidence that the bank could exit the position at the prudent value or better.

The AVA categories

Categories of additional valuation adjustment

Category	What it covers
Market price uncertainty	The range of plausible prices for a position, for example from the dispersion of consensus data contributions.
Close-out costs	The cost of exiting a position, including the bid-offer spread, and the uncertainty in how wide it is.
Model risk	The valuation uncertainty from the choice of model, calibration or approach.
Unearned credit spreads	The part of the CVA on a derivative that is not yet earned, because the credit spread is uncertain.
Investing and funding costs	Uncertainty in the funding cost for a position, which relates to the FVA. See FVA: Funding Valuation Adjustment.
Concentrated positions	The cost of exiting a position that is large relative to the market, over a longer period.
Future administrative costs	The costs of running off a position that has to be hedged and managed, if it is not possible to close it.
Early termination	Losses from the early termination of trades by clients, if it is not covered by the contract.
Operational risk	Valuation losses from operational failures, where the position is valued with a model.

The categories for market price uncertainty, close-out costs and model risk tend to be the largest. In the core approach they are calculated for each valuation input or position, and a diversification benefit of 50% is allowed on the market price uncertainty, close-out cost and concentrated positions AVAs.

Simplified and core approaches

• Simplified approach: for a bank with fair-valued assets and liabilities of up to EUR 15 billion in total, the AVA is a fixed 0.1% of the sum of the absolute values of those fair-valued assets and liabilities.

• Core approach: for all other banks, the bank calculates each of the AVAs described above, by position or by valuation exposure, using the formulas in the technical standards.

The core approach needs a lot of evidence and calculation, because each AVA is built up from individual valuation inputs.

How it differs from the accounting valuation

Fair value reserves and prudent valuation

Feature	IFRS 13 fair value	Prudent valuation
Objective	Best estimate of the exit price.	A prudent value, with a high confidence of exit at that price or better.
Where it is booked	In the balance sheet and the income statement.	A deduction from CET1 only.
Confidence level	Not defined, but a central estimate.	About 90% for the main categories.
Overlap	Reserves such as bid-offer, model and close-out are already included in the fair value.	The AVA is reduced by the amount of the accounting reserves that cover the same risk, to avoid counting it twice.

Because the AVA is net of the accounting reserves, a bank with higher reserves in its fair value has lower AVAs. It is usual to look at them together, as a single set of valuation uncertainty measures.

UK, EU and US compared

• UK and EU: prudent valuation is a requirement for all institutions that have positions at fair value, and uses the simplified and core approaches. The rules are the same in substance. The UK may diverge as the PRA rewrites them.

• US: there is no AVA. US banks rely on the fair value of ASC 820, and the regulators use supervisory review and stress testing to challenge valuations.

A valuation control view

Prudent valuation is where independent price verification feeds directly into regulatory capital. Valuation control commonly provides, or reviews, the inputs to the calculation:

• Market price uncertainty: the data on the dispersion of consensus prices and on the number and quality of the contributors, which are also the results of IPV.

• Close-out costs: the bid-offer data and the evidence that the bid-offer reserves in the accounts are adequate.

• Model risk: the range of valuations from alternative models or calibrations, which links to model validation and to the model reserves.

• Reconciliation: the AVAs have to be consistent with the accounting reserves that they are netted against. See IFRS 13: Fair Value Measurement.

• Level 3 link: unobservable inputs have the widest ranges, so the Level 3 population from Fair-value hierarchy: Levels 1, 2 and 3 is typically where most AVA arises.

The AVA is also a useful management measure. A rising total, or a concentration in one product, tells you where valuation uncertainty is growing.