Prudent Valuation (PRUVAL) and Valuation Risk Solution

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.

The Xenomorph platform meets all the data management requirements to support prudent valuation calculations.

Xenomorph enables firms to consolidate data from any number of sources – with pre-built adapters to all leading data providers, as well as a range of options for integrating data from risk management and other internal systems. All sources are then normalised into a consistent model, allowing for ease of aggregation, comparison and consolidation between different data sources.

Xenomorph is adept at all forms of analytical and statistical data management. The platform can be used to capture, derive and store any kind of risk measure. In addition, pre-built interfaces to leading financial analytics platforms such as FinCad, Numerix and Matlab, popular analytical programming languages such as Python, R and F#, and leading risk management applications, makes it easy to integrate a complete range of model inputs and outputs into your data management workflows. For prudent valuation, users can easily specify rules to use the bid price as the starting point for valuing long positions and the ask price for short positions.

Once prudent valuations have been derived across a firm’s assets and liabilities, all of those values can be run through validation rules. Rules can also be set to validate each individual input to the derived prudent value, to ensure the integrity of the process and flag any potential issues with calculations. Any corrections to the input data will automatically trigger re-calculation of the relevant dependent valuation to ensure consistency, accuracy and integrity of the valuations.

Deriving prudent values for assets and liabilities involves a complex series of calculations. With so many moving parts, the ability to maintain detailed insights (data lineage and process auditability) into how each component of AVA is calculated plays a crucial role in ensuring the accuracy and integrity of the process.