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The valuation imperative: Part II

Martijn Groot

In our previous blog, we examined the changing IPV landscape and the additional market data requirements that have resulted from changes to accounting practices, buy-side and the banking book.

Here, we look in depth at the resulting operational impact…

Further regulatory developments: risk meets finance

In addition to the natural evolution within valuation, the IPV process has been the focal point of a number of recent regulatory changes. Regulation such as Prudent Valuation and FRTB will significantly impact the IPV operating model and increases the function’s importance within an organization.

Prudent Valuation addresses significant flaws in traditional fair value pricing. During the 2008 credit crisis significant volatility and the drying up of liquidity led to firms overvaluing the book value of the assets they held when in practice there was no real active buyer at that price.

To account for this, Prudent Valuation rules augment the process of determining fair value by applying risk management considerations to what has traditionally been a pure pricing function. This is done by calculating and applying Additional Valuation Adjustments to the fair value[1]. Additional Valuation Adjustments are buffers that are subtracted from the fair value to take into consideration all costs that can be attributed to holding or liquidating a position, including liquidity, cost of collateral, cost of funding and cost of regulatory capital.

The major upgrade in capabilities needed to comply with these regulations requires the introduction of best practices in operations as well as the infrastructure to support that.

IPV projects and IPV departments

IPV is one important stakeholder in market data management. Market data management is a foundational capability: it is a prerequisite to support many if not most financial services departments and applications.

Yet, the current state of a valuation process often comes down to significant data integration, cleansing and calculation efforts in Excel. Spreadsheets which are meant for reporting and to be the end state in a data processing chain are often misused as an intermediate step in a data management process. Many prices are manually sourced from trading terminals. This introduces operational risks, prevents an operation to scale and lacks a record of decisions required for regulators.

What is needed is a cost-efficient process that keeps the costs of change (new input data, new reports, new rules, higher volumes) as low as possible and that satisfies regulatory scrutiny.

To achieve IPV, the organization, procedures and systems need to be adapted which often requires an IPV project. The objective of such projects is the definition and implementation of operating processes, market data sourcing, models and governance around these processes and any change.

The daily process of independent verification of prices and market data (IPV Process) guarantees that:

  • The daily revaluation is compliant with accounting standards, regulatory requirements and indications, internal policy and governance documents.
  • The IPV rules are consistent with the degree of complexity of the evaluated portfolio and the coherent sources are identified for the control and validation of price and market data as fixed by the Front Office.
  • A solid and integrated control system on accurate and consistent control measures and rules is defined.

An IPV solution should include dashboards that present summary information to help the different stakeholders across the business. It requires a solid exceptions handling process to help analysts with speedy and accurate resolution of issues, support timely intervention, set rules to minimise the number of false positives, catch all suspects, allow them to (re)set and tweak business rules, onboard new rules, sources and asset classes to lower cycle time for the business and reduce cost of change. It demands that all changes and interventions are documented.

Best practices in IPV

The changing valuation landscape has arguably evolved silently, yet significantly, as a result of the raft of regulation the financial services industry has endured over the last decade. However, IPV is now set to firmly establish itself as a fundamental capability of a financial services firms, not just for regulatory purposes but also to integrate risk, finance, product control and collateral management processes.

A common market data source for finance, risk, scenario management, stress testing, product control, quant group is a major step forward to lower the cost of change and makes for faster cycle time in developing and deploying valuation and risk models.

[1] See under the definition of market price uncertainty.