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PIB A2.5 Guidance

1. This following guidance sets out the DFSA's expectations for prudent valuation practices, including adequate systems and controls and valuation methodologies, for the purpose of PIB section 2.4 of PIB.

Systems and controls

2. Authorised Firms should establish and maintain adequate systems and controls sufficient to give management and the DFSA the confidence that their valuation estimates are prudent and reliable. These systems should be integrated with other risk management systems within the organisation (such as credit analysis). Such systems are expected to include:
a. documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the Authorised Firm's assumptions of what market participants would use in pricing the position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of the month and ad-hoc verification procedures; and
b. clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main board executive director or equivalent.

Valuation methodologies

Marking-to-market

3. Marking-to-market is at least the daily valuation of positions at readily available close out prices in orderly transactions that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.
4. Authorised Firms should mark-to-market as much as possible. The more prudent side of bid/offer should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Authorised Firms should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. However, observable inputs or transactions may not be relevant, such as in a forced liquidation or distressed sale, or transactions may not be observable, such as when markets are inactive. In such cases, the observable data should be considered, but may not be determinative.

Marking-to-Model

5. Only where marking-to-market is not possible should Authorised Firms mark-to-model, but in such cases, the Authorised Firm should be able to demonstrate to the DFSA that the approach is prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. When marking-to-model, an extra degree of conservatism is appropriate. The DFSA will consider the following in assessing whether a mark-to-model valuation is prudent:
a. senior management should be aware of the elements of the trading book or of other fair-valued positions which are subject to mark-to-model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business;
b. market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly;
c. where available, generally accepted valuation methodologies for particular products should be used as far as possible;
d. where the model is developed by the Authorised Firm itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation;
e. there should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations;
f. risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output;
g. the model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of profit and loss versus risk factors, comparison of actual close out values to model outputs); and
h. valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation (see also valuation adjustments in Guidance notes 6 to 14.)

Independent price verification

6. Independent price verification is distinct from daily mark-to-market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily mark-to-market, since the objective, i.e. independent, marking of positions should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks.
7. Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting in between reporting dates. For independent price verification, where pricing sources are more subjective, e.g. only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

Valuation adjustments

8. As part of their procedures for marking-to-market, Authorised Firms should establish and maintain procedures for considering valuation adjustments. The DFSA expects Authorised Firms using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking-to-model.
9. The DFSA expects the following valuation adjustments to be formally considered at a minimum: unearned credit spreads, close-out costs, Operational Risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk.

Adjustment to the current valuation of less liquid positions for regulatory capital purposes

10. Authorised Firms should establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. The DFSA expects Authorised Firms to consider the need for an adjustment to a position's valuation to reflect current illiquidity whether the position is marked-to-market using market prices or observable inputs, third-party valuations or marked-to-model.
11. Bearing in mind that the assumptions made in relation to calculating VaR may not be consistent with the Authorised Firm's ability to sell or hedge out less liquid positions, where appropriate, Authorised Firms should take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Reduced liquidity may have arisen from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing the adjustment.
12. Authorised Firms should consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in Guidance note 10.
13. For complex products including, but not limited to, securitisation Exposures and n-th-to-default Credit Derivatives, Authorised Firms who are approved to use models to calculate Market Risk should explicitly assess the need for valuation adjustments to reflect two forms of model risk: the model risk associated with using a possibly incorrect valuation methodology; and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.
14. The adjustment to the current valuation of less liquid positions made under Guidance note 11 is likely to impact minimum Capital Requirements and may exceed those valuation adjustments made under the International Financial Reporting Standards and Guidance notes 8 and 9.
Derived from RM111/2012 (Made 15th October 2012). [VER20/12-12]