Prudent Valuation Guidelines and Sound Practices

148 Pages Posted: 16 Jun 2016 Last revised: 26 Aug 2018

See all articles by Marco Bianchetti

Marco Bianchetti

Intesa Sanpaolo - Financial and Market Risk Management; University of Bologna; AIFIRM - Associazione Italiana Financial Industry Risk Manager

Umberto Cherubini

University of Bologna - Department of Economics

Date Written: March 1, 2016

Abstract

The EU Capital Requirement Regulation (CRR) and the EBA Regulatory Technical Standard for prudent valuation, published on Jan. 1st, 2014 and Jan. 28th, 2016, respectively, constitute the EU Prudent Valuation Framework, which represents a challenge for financial institutions both from a methodological and practical point of view.

In this work we seek an ambitious fourfold result. First, we work out a practical realization of the regulatory requests, smoothing the difficulties arising from the detailed interpretation of the rules. Second, we give a comprehensive methodological analysis of the different sources of valuation risk (ambiguity, liquidity, correlation, concentration and model risks) that bring about the need of computing valuation adjustments. Third, we explore a wide range of possible individual AVA calculation approaches, providing many practical case studies mimicking the actual valuation scenarios that institutions might face. Finally, we design a comprehensive example of the entire Prudent Valuation process, covering both organizational and IT issues.

This work provides a set of guidelines and sound practices that could be used as a starting point and, possibly, a benchmark for prudent valuation. On the one side, institutions will benefit of the rules explained and applied into a variety of case studies. On the other side, regulators will benefit to see how the rules are interpreted and applied by institutions. We do not aim either to give any authentic interpretation of the regulations, which ultimately belongs to its owners, or to question the principles behind the regulations, since real challenges may come out only from practical applications of the principles to real financial portfolios, and comparisons across different financial institutions.

This work is the result of the joint effort of the Market Risk Committee of AIFIRM - Italian Association of Financial Industry Risk Managers.

Keywords: AIFIRM, CRR, EBA, AVA, Additional Valuation Adjustments, prudent valuation, fair valuation, valuation uncertainty, valuation risk, ambiguity, liquidity, correlation, market price uncertainty, close out cost, model risks, unearned credit spread, investing and funding cost, concentrated position

JEL Classification: G12, G13

Suggested Citation

Bianchetti, Marco and Cherubini, Umberto, Prudent Valuation Guidelines and Sound Practices (March 1, 2016). Available at SSRN: https://ssrn.com/abstract=2790629 or http://dx.doi.org/10.2139/ssrn.2790629

Marco Bianchetti (Contact Author)

Intesa Sanpaolo - Financial and Market Risk Management ( email )

Piazza P. Ferrari 10
Milan, 20121
Italy

University of Bologna ( email )

Piazza Scaravilli 2
Bologna, 40100
Italy

AIFIRM - Associazione Italiana Financial Industry Risk Manager ( email )

www.aifirm.it
Italy

Umberto Cherubini

University of Bologna - Department of Economics ( email )

Strada Maggore, 45
Bologna, FI 40125
Italy
+ +39 051 2092615 (Phone)

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