1.Marking to market

97.Marking to market is the at-least-daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

98.Banks must mark to market as much as possible. The more prudent side of a bid/offer spread should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Banks should maximize the use of relevant observable inputs and minimize the use of unobservable inputs when estimating fair value using a valuation technique. However, some 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 should be considered, but may not be determinative.

2.Marking to model

99.Only where marking to market is not possible should banks mark to model, but this must be demonstrated to be prudent. Marking to model is defined as any valuation that has to be benchmarked, extrapolated, or otherwise calculated from a market input. 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:

• •Senior management should be aware of the elements of the trading book or of other fair-valued positions that are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business.
• •Market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly.
• •Where available, generally accepted valuation methodologies for particular products should be used as far as possible.
• •Where the institution itself develops the model, it should be based on appropriate assumptions that have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. The model should be independently tested, including validation of the mathematics, the assumptions, and the software implementation.
• •There should be formal change control procedures in place, and a secure copy of the model should be held and periodically used to check valuations.
• •Risk management should be aware of the weaknesses or limitations of the models used, and should account for those model weaknesses or limitations when using the valuation output.
• •The model should be subject to periodic review to assess its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs).
• •Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation.

3.Independent price verification

100.Independent price verification is distinct from daily marking to market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking to market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily marking to market, since independent marking of positions should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks.

101.Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting. For independent price verification, where pricing sources are more subjective, for example where there is only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

4.Valuation adjustments

102.As part of their procedures for marking to market, banks must establish and maintain procedures for considering valuation adjustments. The Central Bank expects banks using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking to model.

103.The Central Bank expects the following valuation adjustments/reserves to be formally considered at a minimum: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk.

104.Banks must establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. Banks should consider the need for an adjustment to a position’s valuation to reflect current illiquidity whether the position is marked to market using market prices or observable inputs, valued using third-party valuations, or marked to model. Such adjustments to the current valuation of less liquid positions should impact Tier 1 regulatory capital, and may exceed valuation adjustments made under financial reporting standards.

105.Bearing in mind that the assumptions made about liquidity in the market risk capital charge may not be consistent with the bank’s ability to sell or hedge out less liquid positions, where appropriate, banks must take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Closeout prices for concentrated positions and/or stale positions should be considered in establishing the adjustment. Banks must consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking to model, and the impact of other model risks.

106.For complex products such as securitisation exposures and nth-to-default credit derivatives, banks must explicitly assess the need for valuation adjustments to reflect both the model risk associated with using a possibly incorrect valuation methodology, and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.