Capital Requirements Regulation (CRR) is an EU law that aims to decrease the likelihood that banks go insolvent. Prudent valuation, incorporated under the CRR, requires diligent valuation of financial instruments to ensure that the solvency of a financial institution is not misrepresented.
Financial instruments that are traded frequently in high volumes have directly observable market prices. However, valuation gets challenging if the financial instruments are not traded on a regular basis or if they are illiquid. In such cases, valuation models are utilized, but depending on the assumptions of the model and quality of available data, the values derived may not paint a true picture of the actual value of the instrument. Positions that are recognized at fair value in the trading and banking book, are to be considered for prudent valuation.
However, if the prudent value is less than the fair value, the difference between the two is recorded as additional value adjustment (AVA) and is taken off common equity tier one capital. Components of AVA include market price uncertainty, close-out costs, model risk, unearned credit spreads, investing and funding costs, concentrated positions, future administrative costs, early termination and operational risk. To determine AVA, firms can use either the simplified or core approach.
The simplified approach can be used by institutions to calculate AVAs if their absolute value of on- and off-balance sheet fair valued assets and liabilities falls below €15bn. Alternatively, the core approach is intended to provide a consistent framework for determining prudent valuation. In this respect, the core approach gives a clear indication of the level of prudence that institutions should aim for when estimating AVAs.
Apart from the quantitative requirements for calculating AVA, there are regulatory requirements for the qualitative portion of the valuation process. This includes documentation of the prudent value calculation, and review of the appropriateness of the calculation.
SS&C GlobeOp helps fund managers, global asset managers and financial services firms meet worldwide regulatory requirements by providing data aggregation, expert analysis, reporting and transparency. Our product suite covers AIFMD – Annex IV, FormPF, Basel III, CPO/PQR, EMIR, Form 13F, OPERA, Solvency and TIC Reporting.