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  • Article 4: Valuation

    1. 1. A Bank must mark-to-market at least on a daily basis its market risk positions. The more prudent side of bid/offer must be used, unless the Bank is a significant market maker in a particular position type and it can close-out at mid-market. A Bank must maximize the use of relevant observable inputs and minimize 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 must be considered, but may not be determinative.
    2. 2. A Bank may use mark-to-model only where marking-to-market is not possible, but it must be able to demonstrate to the Central Bank that this approach is prudent. When marking-to-model, an extra degree of conservatism is appropriate. The Central Bank will consider the following in assessing whether a mark-to-model valuation is prudent:
      1. a. Senior Management must be aware of the elements of the trading book or of other fair-valued positions which are subject to mark-to-model and must understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business;
      2. b. Market inputs must be sourced, to the extent possible, which show satisfactory track record of the actual position held. The appropriateness of the market inputs for the particular position being valued must be reviewed regularly;
      3. c. Where available, generally accepted valuation methodologies for particular products must be used as far as possible;
      4. d. A Bank’s model must be based on appropriate assumptions which have been assessed and challenged by suitably qualified parties independent of the development process. This can take the form of a Technical Committee. The model must be developed or approved independently of the risk-taking functions and must be independently tested;
      5. e. There must be formal change control procedures in place and a secure copy of the model must be held and periodically used to check valuations;
      6. f. The independent risk management function must be aware of the weaknesses of the models used and how best to reflect those in the valuation output;
      7. g. The model must 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
      8. h. Valuation adjustments must be made as appropriate (for example, to cover the uncertainty of the model valuation).
    3. 3. As part of its procedures for marking-to-market, a Bank must establish and maintain procedures for considering valuation adjustments. A Bank using third-party valuations must consider whether valuation adjustments are necessary. Such considerations are also necessary when marking-to-model.
    4. 4. A Bank must, at a minimum, formally consider credit valuation adjustments, unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, future administrative costs and, where appropriate, model risk.
    5. 5. The Board-approved polices must provide for independent verification of market prices or model inputs by a unit independent of the risk taking functions, at least monthly and depending on the nature of the market/trading activity, more frequently. Senior Management must take appropriate action to ensure the elimination of inaccurate daily marks.
    6. 6. Where pricing sources are more subjective, such as when only one available broker quote is provided, prudent measures, such as valuation adjustments must be taken as appropriate.

    • Back-Testing

      1. 7. The independent risk management function must conduct a regular back-testing program and profit and loss attribution program including but not limited to comparison of the risk measure and profit or loss values generated by the model against actual daily changes in portfolio value, as well as hypothetical changes based on static positions.
      2. 8. A Bank’s back-testing program must cover a minimum period of 250 business days.
      3. 9. A Bank’s back-testing program must include a formal evaluation of instances where trading outcomes are not covered by the risk measures (termed ‘exceptions’) on at least a quarterly basis, using the most recent twelve months modelled results and profit data. The Bank must document all exceptions generated from its ongoing back-testing program, including an explanation for the exceptions. A Bank must have the capacity to perform back-testing analysis both at the level of the whole portfolio and at the level of sub-portfolios or books that contain material risk.
      4. 10. A Bank must perform back-tests using both actual trading outcomes and hypothetical trading outcomes. Hypothetical trading outcomes are calculated by applying the day’s price movements to the previous day’s end-of-day portfolio. When performing back-tests using actual trading outcomes, a Bank must use clean trading outcomes, i.e. actual trading outcomes adjusted to remove the impact of income arising from factors other than market movements alone, such as fees and commissions, brokerage, additions to and releases from reserves which are not directly related to market risk (such as administration reserves).