Prudent valuation practices are becoming increasingly commonplace, prompted by edicts such as the European Union’s Capital Requirements Regulation. Rather than simply verifying the fair value of an asset (or accuracy of a model) by comparing it to an independent source, prudent valuation goes one step further and assumes the process of deriving fair value is sufficiently uncertain to warrant additional adjustments that reflect valuation risk.
Prudent valuation therefore introduces a ‘buffer’ that reduces the value of assets (or increases the value of liabilities) to reflect risks associated with their valuation. The difference between the ‘prudent value’ of an asset (or liability) and the fair value of that asset (or liability) accounted for on a bank’s balance sheet is known as the Additional Valuation Adjustment (AVA), which is deducted from Core Equity Tier 1 capital.
The AVA is itself split into a number of components, which include Market Price Uncertainty (MPU); Close Out Costs (CoCo); Model Risk (MoRi); Unearned Credit Spread (UCS); Investing and Funding Cost (IFC); Concentrated Positions (CoPo); Future Admin Costs (FAC); Early Termination (EaT) and Operational Risk.
The approach taken to derive a ‘prudent’ value follows more of a risk management methodology when compared to typical accounting or finance workflows. That is because it is more probabilistic: the goal is to find a value that can be achieved with 90% certainty, which means understanding the distribution profile with respect to each respective risk, while also looking to weigh risks taking into account diversification. This risk-based approach is data intensive and requires the ability to support complex time-series and statistical analysis.