Prudent Valuation Guidelines and Sound Practices

The EU Capital Requirement Regulation (CRR) [8] and of EBA Regulatory Technical Standard for prudent valuation [15], published on Jan. 1st, 2014 and Jan. 28th, 2016, respectively, constitute the EU Prudent Valuation Framework. The CRR, art. 34, requires to Institutions a prudent valuation of positions measured at fair value and the deduction of the resulting Additional Valuation Adjustments (AVAs) from the Common Equity Tier One (CET1) capital. The art. 105 disciplines the AVAs intended to achieve an appropriate level of certainty in prudent value. The EBA RTS [15] allow two approaches to prudent valuation. The simplified approach, applicable by small financial institutions (with total absolute fair-valued assets and liabilities below EUR 15 billions), prescribes a very simple total AVA equal to 0.1% of the total fair value. The core approach, compulsory for institutions above the EUR 15 billion threshold, prescribes the calculation of 9 AVAs, referring to different sources of valuation uncertainty, as the excess of valuation adjustments required to achieve the prudent value with 90% level of confidence. Five out of nine AVAs include a 50% weight to take diversification into account and avoid double counting effects. Those positions for which a change in their fair value affects only partially the CET1 may be partially excluded from the AVAs calculation. The EU Prudent Valuation Framework represents a challenge for financial institutions, both from a methodological and practical point of view. In this work, we seek an ambitious fourfold result. First, we work out a practical realization of the regulatory requests, smoothing the difficulties arising from the detailed interpretation of the rules. Second, we give a comprehensive methodological analysis of the different sources of valuation risk (ambiguity, liquidity, correlation, concentration and model risks) that bring about the need of computing valuation adjustments. Third, we explore a wide range of possible individual AVA calculation approaches, providing many practical case studies mimicking the actual valuation scenarios that Institution might face. Finally, we design a comprehensive example of the entire Prudent Valuation process, covering both organizational and IT issues. In conclusion, this work provides a set of guidelines and sound practices that could be used as a starting point and, possibly, a benchmark for Prudent Valuation. On one side, Institutions will benefit of the rules explained and applied into a variety of case studies. On the other side, regulators will benefit to see how the rules are interpreted and applied by Institutions. These guidelines do not aim either to give any authentic interpretation of the regulations, which ultimately belongs to its corresponding owners (EU and EBA), or to question the principles behind the regulations, since real challenges may come only from practical applications of the principles to real financial portfolios, and comparisons across different financial institutions.