Basel Committee on Banking Supervision

Past experience has emphasised the critical importance of robust risk management and control processes around the measurement of fair values and their reliability.

The purpose of this chapter is to provide guidance to banks and banking supervisors to help strengthen their assessment of banks’ valuation processes for financial instruments and promote improvements in banks’ risk management and control processes.

This guidance applies to all financial instruments that are measured at fair value, both in normal market conditions and during periods of stress, and regardless of the financial reporting designation within a fair value hierarchy. This guidance does not set forth additional accounting requirements beyond those established by the accounting standard setters.

The supervisory expectations set forth in this guidance are applicable to all banks. However, the extent of application should be commensurate with the significance and complexity of banks’ fair valued exposures.

Principle 1: Supervisors expect a bank’s board to ensure adequate governance structures1 and control processes for all financial instruments that are measured at fair value for risk management and financial reporting purposes. These processes should be consistently applied across the bank and integrated with risk measurement and management processes.

The valuation governance structures, and related processes should be embedded in the overall governance structure of the bank, and consistent for both risk management and reporting purposes. The governance structures and processes are expected to explicitly cover the role of the board. The board might delegate some of these responsibilities to board committees or senior management but should continue to be ultimately responsible for the overall execution of governance. Specifically, the responsibilities for governance structures applicable to all financial instruments measured at fair value should include:

1. Reviewing and approving written policies related to fair valuations;
2. Ongoing review of significant valuation model performance for issues escalated for resolution and all significant changes to valuation policies;
3. Ensuring adequate resources are devoted to the valuation process;
4. Defining and monitoring tolerance for valuation uncertainty at a firm-wide level;
5. Ensuring the independence in the valuation process between risk taking and control units;
6. Ensuring the appropriate internal and external audit coverage of fair valuations and related processes and controls;
7. Ensuring the consistent application of accounting and disclosures with the applicable accounting framework; and
8. Ensuring the documentation and monitoring of significant differences, if any, between accounting and risk management measurements.

Controls

Controls and procedures should be designed to ensure all financial instruments that are measured at fair value are reliable and have clear and robust production, assignment and verification. Among other things the controls and procedures should:

1. Include well documented policies for all significant valuation methodologies, which would be approved by senior management and reported to the board as frequently as necessary and at least annually.
2. Detail the range of acceptable practices for the initial pricing, marking-to- market/model, valuation adjustments, observability and reliability of inputs, and periodic independent revaluation depending on the nature of the financial instruments and sources of independent prices; and
3. Establish the information feeds and thresholds to identify when a valuation model should be challenged. The valuation model may be challenged when valuations or valuation inputs are materially different from available external market information and that information is deemed to be reliable (eg objective thresholds that indicate when independent price verification (IPV2), test trades or other cross-checks indicate significant differences with model-based valuations).

For inactive markets, a bank needs to put more work into the valuation process to gain assurance that the transaction price provides evidence of fair value or determine necessary adjustments. Fair value should be measured using a valuation technique (eg a model), that reflects current market conditions. Transaction prices for the same or similar instruments should be considered in the assessment of fair value, as they likely reflect current market conditions., but they are not automatically determinative of fair value. If such transaction prices are used, they might require significant adjustment based on unobservable data. Determining fair value in a market that has become inactive depends on the facts and circumstances and may require the use of significant judgment. Banks should maintain sound controls over valuations involving inactive markets, including appropriate documentation to support valuations and adhere to relevant accounting standards and guidance. For risk management purposes, all valuation factors should be considered, with clear and approved documentation outlining the factors included in, or excluded from, the valuation technique.

Valuation controls should be applied consistently across similar instruments (risks) and across business lines (books). These controls should be subject to internal audit review with the resources and expertise required to identify and provide an effective review of practices.

A fundamental feature of adequate control processes is that the final approval of valuations should not be the responsibility of the risk-taking units. There should be clear and independent reporting lines to ensure that valuations are independently determined an assessed. Banks should maintain functional separation between the front office (the risk-taking units that typically provide the initial fair valuation estimates) and the measurement and control unit (the unit providing IPV) at all times. In addition, the unit responsible for IPV within the bank should source prices independently of the relevant trading desk.

New product approval processes should include all internal stakeholders relevant to risk measurement, risk control, financial reporting and the assignment and verification of valuations of financial instruments. Moreover, the process should be supported by a transparent, well-documented inventory of acceptable valuation methodologies that are specific and relevant to products and businesses.

Principle 2: Supervisors expect that a bank will have adequate capacity, including during periods of stress, to establish and verify valuations for instruments in which it engages.

A bank is expected to have adequate capacity and capability to produce valuations and assess third-party pricing services, aligned with the importance and riskiness of these exposures. This capacity should be resilient to periods of rapid business growth and market stress. Furthermore, senior management should ensure sufficient resources and capabilities to estimate appropriately the inherent risks and the value of financial instruments, including complex and illiquid instruments.

During stressed market conditions, market discontinuity or illiquidity can make valuation of many instruments particularly challenging. For exposures that represent material risk, banks should be able to use alternative methods when primary inputs and approaches become unreliable, unavailable or not relevant.

Valuation models should be tested and reviewed under stress conditions to understand their limitations. Banks should avoid overreliance on single information sources (eg external ratings) especially for complex or illiquid products. Bank processes should emphasise diverse valuation approaches and mechanisms to cross-check valuations.

The use of a third-party pricing service for fair valuations for financial instruments does not relieve the board of its oversight responsibility or senior management of its responsibility to ensure appropriate fair valuations and provide appropriate supervision, monitoring and management of risks. Management should conduct due diligence process to assess these services, ensuring the appropriateness of their techniques, underlying assumptions, input selection, and consistency in application.

Principle 3: Supervisors expect a bank’s senior management to ensure that policies for categorising financial instruments on the balance sheet are as consistent as possible across accounting, regulatory and risk management purposes. Additionally, these policies should align closely with the bank’s valuation capabilities.

Banks should categorise and report financial instruments in their financial reports in accordance with applicable accounting and regulatory reporting requirements. Senior management should ensure that the classification used for accounting, regulatory and risk management purposes are consistent wherever feasible. If there are significant differences in how financial instruments are categorised for risk measurement and management, these differences should be clearly documented, approved by senior management, and communicated to the relevant board level committees.

Banks’ strategy can evolve in response to changes in economic conditions, impacting the management of financial instruments. In that case, any reclassification of financial instruments should be made under the control of the bank’s senior management and appropriate board level committees, in compliance with accounting requirements. Classification and reclassification practices should not be used with the view to circumvent accounting requirements. It is especially important to disclose, in compliance with accounting rules, detailed information regarding reclassifications (eg reasons and impacts)

Senior management should ensure that appropriate control policies and practices are in place for the classification and any subsequent reclassification of financial instruments. Moreover, senior management should ensure that internal policies governing the classification and reclassification of financial instruments are applied consistently over time and across the group. The bank should, for instance, maintain documentation that substantiates the initial classification and any subsequent transfers between asset categories.

Principle 4: Supervisors expect a bank to have in place sound processes for the design and validation of methodologies used to produce valuations.

Key characteristics of such processes include:

1. independence of the validation from the design function;
2. rigorous validation;
3. integrated control processes; and (iv) sufficiently resourced internal and external audit programmes.

A valuation model, including any material changes to it, must be validated by an independent, suitably qualified group before use, with periodic reviews to ensure ongoing suitability. This group must have adequate resources to effectively challenge the model, and report independently from risk taking units.

Model validation processes should be systematically applied for both internally generated and, to the extent possible, vendor-provided models. Validation includes:

1. Evaluating the model’s theoretical soundness and mathematical integrity;
2. Assessing the appropriateness of model assumptions, including consistency with market practices and consistency with relevant contractual terms of transactions;
3. Conducting sensitivity analyses to assess the impact of variations in model parameters on fair value, including under stress conditions;
4. Benchmarking valuation results with the observed market price at the time of valuation or independent benchmark model; and
5. Conducting backtesting.

Banks must document the limitations to the performance of the model so as to understand the conditions under which valuations would not reasonably reflect an exit price. If performance is inadequate, appropriate actions – such as valuation adjustments for model limitations or risk, or model changes – must be taken.

Banks are expected to have in place policies defining a regular cycle for valuation model review that reflects the vulnerabilities of individual models. Policies should also identify specific triggers (eg indications of deterioration in model performance or quality) that would prompt an accelerated review of the valuation model.

Banks should establish explicit links between the results of the IPV process or indicators of performance of positions and the review process of models. Whenever possible, these links should be expressed in terms of explicit quantitative thresholds, the crossing of which should trigger a review of the valuation model and or valuation procedure. These triggers should be consistent with sound risk management practices.

Profit and loss (P&L) attribution processes are a key aspect of valuation control. For fair valuations where changes in fair value are reflected in the P&L statement, these processes should take place no less frequently than the risk management horizon and with a priority given to portfolios with significant valuation risk so that management understands the reliability and sources of P&L in a timely manner. The results of these processes can then feed back into periodic processes such as IPV and model validation.

Sound internal and external audit programmes play an important role in the bank’s validation process3.

Principle 5: Supervisors expect that banks will maximise the use of relevant and reliable inputs and incorporate all other important information so that fair value estimates are as reliable as possible.

The relevance and reliability of valuations depend on the inputs. Banks is expected to apply the accounting guidance provided to determine the relevant market information and other factors likely to have a material effect on an instrument's fair value when selecting the appropriate inputs to use in the valuation process. This process requires judgement, considering all facts and circumstances. Where values are determined to be in an active market, a bank should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. However, where a market is deemed inactive, 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 accounting fair value guidance provides assistance on what should be considered, but is not always definitive.

In assessing whether a source is reliable and relevant, the following factors should be considered:

1. The frequency and availability of the prices/quotes and whether those prices represent actual regularly occurring transactions on an arm's length basis. Whether the price/quote is an indicative price or a binding offer.
2. Consistency of prices with corroborating market information and variations across market participants.
3. Transparency and generally availability of prices to market participants.
4. Timeliness of pricing data relative to valuation frequency, with recent pricing data tending to be more reliable than stale data.
5. The number of independent sources that produce the quotes/prices and the dispersion of available prices/quotes, which can indicate data quality.
6. The maturity of the market.
7. The similarity between the financial instrument sold in a transaction and the instrument held by the institution.
8. The nature of a transaction, especially in inactive markets, and whether it reflected a forced or distressed sale (which are not relevant) or otherwise involved a seller that needed to sell and one or very few buyers (which may require consideration of other information and management judgement in determining the implications for the estimate of fair value).

Banks have to be able to identify when active markets become inactive as this will affect the quality, transparency and reliability of inputs to a valuation. They should have in place appropriate procedures for valuing financial instruments when markets are inactive. These procedures should be well documented and approved by senior management.

Principle 6: Supervisors expect banks to have a rigorous and consistent process to determine valuation adjustments for risk management, regulatory and financial reporting purposes, where appropriate.

A fair value estimate should comply with applicable standards and guidance (eg accounting, risk management, or prudential requirements or guidelines). In some circumstances, adjustments may be necessary to result in a valuation estimate that meets the applicable valuation definition. Accordingly, the overall governance and control framework for valuations should include a policy to identify the types of valuation adjustments that could affect the valuation estimate and valuation processes. These processes should ensure an appropriate segregation of duties and ensure an appropriate level of management review. Furthermore, procedures for the resolution and escalation of valuation issues and exceptions to the board of directors or a committee thereof (such as the audit or risk committee) should be defined and documented.

Valuation adjustments should be initially authorised and monitored subsequently by an independent control group (eg IPV or financial control unit, and/or independent model validation unit). Valuation adjustments should be supported by appropriate and regularly maintained documentation. Senior management, including the Chief Risk Officer and/or the Chief Financial Officer (or equivalent positions) should ensure that the control and oversight process incorporates the valuation adjustment process. Accordingly, significant valuation adjustments and differences between fair values included in financial reporting, risk management or regulatory reporting, if any, should be reported to and agreed on by senior management. A clear process should exist to timely resolve significant disagreements on valuation adjustments and to escalate material valuation issues to the board of directors or appropriate governance committee. Routine reporting to the board or committee should occur regularly, with material valuation issues, presented in an aggregated and understandable format.

For financial reporting purposes, banks must include appropriate risk factors that market participants would consider in determining fair value. Risk factors include risk related to model uncertainty, liquidity, credit or other risks (such as a risk premium for complex financial instrument). If these risks are not fully incorporated in the valuation estimate or model, supervisors expect banks to make adjustments to fair value estimates to ensure the valuation properly reflects all appropriate risks, consistent with a market participant view, in accordance with applicable standards and guidance. When market conditions and associated risks are not captured in a model valuation, adjustments to the model or to the valuation may be necessary under accounting standards to reflect what the transaction price would have been on the measurement date for a financial instrument. These adjustments should be made consistently with the assessment of risk and uncertainty surrounding the valuation and should only be made if they improve the estimate of fair value. Banks should follow the relevant accounting guidance for such valuations and related adjustments.

Banks should be aware that some regulatory adjustments required by prudential filters or used for risk management purposes may not be appropriate for financial reporting purposes. For example, discount adjustments for a large block of market observable (ie level 1) instruments are not permitted in fair valuations for financial reporting purposes, but may be considered under prudent valuation guidance for risk management purposes. However, supervisors expect banks to have rigorous governance and control processes for all valuation adjustments, regardless of their purposes – be it risk management, regulatory or financial reporting. Any significant differences between fair values used for financial reporting purposes and those used for risk management and regulatory purposes should be well understood by senior management, appropriately documented, and reported to the board or appropriate governance committee.

Principle 7: Supervisors expect that a bank will have valuation and risk management processes that explicitly assess valuation uncertainty and that assessments of all material valuation uncertainty are included in the information communicated to the board and senior management.

Outside of actual transactions, uncertainty about the current value of a financial instrument should be viewed as an inherent characteristic of the valuation process. Uncertainty is specific to the instrument and to the point in time the valuation is done and is not exclusive to any specific valuation methodology.

Supervisors expect banks to systematically recognise and account for valuation uncertainty. In particular, valuation processes and methodologies should produce an explicit assessment of uncertainty related to the assignment of value for all instruments or portfolios. Where appropriate, this may simply be a statement that uncertainty for a particular set of exposures is very small. While qualitative assessments are a useful starting point, it is desirable that banks develop methodologies that provide, quantitative assessments, wherever possible. These methodologies may gauge the sensitivity of value to the use of alternative models and modelling assumptions (when applicable), to the use of alternative values for key input parameters to the pricing process, and to alternative scenarios to the presumed availability of counterparties. The extent of this analysis should be commensurate to the importance of the specific exposure for the overall solvency of the institution.

Assessments of valuation uncertainty are expected to be fully integrated in banks’ internal decision-making processes. Quantitative and qualitative assessments of uncertainty should accompany all internal reports of valuation information and risk reports. This information should be shared with all relevant bodies in the institution where investment and risk management decisions are made, including senior management and the board. Additionally, it should be communicated with the same frequency and timeliness as information on position values and associated risks.

Principle 8: Supervisors expect that a bank’s external reporting will promote transparency by providing timely, relevant, reliable and decision-useful information.

Key information for users of financial statements includes descriptions of valuation techniques used to determine fair value and the instruments to which they are applied4. Disclosures explaining the inputs and assumptions used in the fair value measurements help users understand the judgments made in determining fair value. In addition, disclosures about the sensitivity of fair value measurements to alternative assumptions that would significantly impact valuation are particularly important. A description of the bank’s valuation governance and controls processes can improve understanding of the quality of its fair valuations and the robustness of its risk management processes. These disclosures are especially important in times of market stress and uncertainty. Accordingly, senior management should consider making valuation uncertainty disclosures more meaningful. Moreover, appropriate disclosures should also be provided with respect to financial asset reclassifications.

A bank should regularly review its disclosure policies to ensure that the information remains relevant to its business model and products and to current market conditions.

Principle 9: Supervisors may require banks to provide supplemental information to help them assess valuation and governance processes.

Banks are expected to disclose information about fair values, including corporate governance, controls, and methodologies, and on the use of the fair value option required by their relevant accounting framework (eg International Financial Reporting Standards (IFRS) 7 disclosures). Beyond publicly available information, supervisors may periodically request supplemental information on fair values and related internal processes. This information, which banks typically developed for internal purposes, can help supervisors to assess the quality of valuations and better understand the risks associated with instruments measured at fair value, as well as their impact on earnings and capital adequacy. When a bank has made significant transfers between asset categories involving assets reported at their fair values, the supervisor may also seek additional information about these transfers.

To assess senior management’s engagement in valuation issues, supervisors may request valuation reports presented to the board or assessments conducted by external auditors, internal auditors or independent risk management teams.

In case of material uncertainty surrounding valuation practices and where feasible, supervisors may consider undertaking test portfolio exercises. However, they should ensure that such exercises are not mistaken for model validation.

Principle 10: Supervisors should evaluate a bank’s valuation practices including governance, risk management and control practices; and incorporate their evaluation when assessing capital adequacy.

Supervisors expect banks to promptly address any deficiencies identified by internal and external auditors with respect to their valuations and related corporate governance, controls, risk management and disclosure policies and practices. When supervisors identify deficiencies, they should use the full range of supervisory tools to ensure that management addresses and corrects these issues in a timely manner. Supervisory responses may include:

1. Regularly communicating concerns to senior management and escalating significant concerns to the board, while evaluating their responses as to these concerns.
2. Considering concerns about fair value practices in supervisory ratings such as prudential risk management or capital adequacy assessments.
3. Taking informal or formal supervisory actions (either public or non-public) requiring management and the board to address deficiencies in a defined timeframe and provide periodic written progress reports.

While strong processes and controls are expected, there may be situations where deficiencies require adjustments to regulatory capital. For example:

1. A reclassification of financial instruments may be necessary for capital adequacy or regulatory reporting purposes if a bank shows weaknesses in valuation processes or controls relating to trading book positions or if fair value reporting is inconsistent with the way the bank measures and manages risk.
2. Significant weaknesses in valuation-related risk management policies, systems and controls may lead supervisors to require the bank to hold additional capital to cover overall risk exposure (eg under Pillar 2 of the Basel Framework). If such weaknesses undermine the reliability of fair values, supervisors may exclude unrealised gains (or non-impairment losses) from Tier 1 capital, or require other prudential adjustments, such as addressing potential fair value overstatements based on third party valuations).