120.In order to enhance the supervisory assessment of banks’ valuation practices, the Basel Committee published Supervisory guidance for assessing banks’ financial instrument fair value practices in April 2009. This guidance applies to all positions that are measured at fair value and at all times, not only during times of stress.

121.The characteristics of complex structured products as well as simple but illiquid products, including securitisation transactions, make their valuation inherently difficult due, in part, to the absence of active and liquid markets, the complexity and uniqueness of the cash waterfalls, and the links between valuations and underlying risk factors. The absence of a transparent price from a liquid market means that the valuation must rely on models or proxy-pricing methodologies, as well as on expert judgment. The outputs of such models and processes are highly sensitive to the inputs and parameter assumptions adopted, which may themselves be subject to estimation error and uncertainty. Moreover, calibration of the valuation methodologies is often complicated by the lack of readily available benchmarks.

122.Therefore, a bank is expected to have adequate governance structures and control processes for fair valuing exposures for risk management and financial reporting purposes. The valuation governance structures and related processes must be embedded in the overall governance structure of the bank, and consistent for both risk management and reporting purposes. The governance structures and processes are expected to explicitly cover the role of the board and senior management. In addition, the board must receive reports from senior management on the valuation oversight and valuation model performance issues that are brought to senior management for resolution, as well as all significant changes to valuation policies.

123.A bank must also have clear and robust governance structures for the production, assignment and verification of financial instrument valuations. Policies must ensure that the approvals of all valuation methodologies are well documented. In addition, policies and procedures must set forth the range of acceptable practices for the initial pricing, marking-to-market/model, valuation adjustments and periodic independent revaluation. New product approval processes (which has to be established in the first place) must include all internal stakeholders relevant to risk measurement, risk management, and the assignment and verification of valuations of financial instruments.

124.A bank’s control processes for testing and reporting valuations must be consistently applied across the firm and integrated with risk measurement and management processes. In particular, valuation controls must be applied consistently across similar instruments (risks) and consistent across business lines (books). These controls must be subject to internal audit. Regardless of the booking location of a new product, reviews and approval of valuation methodologies must be guided by a minimum set of considerations. Furthermore, the valuation/new product approval process must be supported by a transparent, well-documented inventory of acceptable valuation methodologies that are specific to products and businesses. The Board must be familiar with and approve the basic assumptions behind these methodologies.

125.In order to establish and verify valuations for instruments and transactions in which it engages, a bank must have adequate capacity, including during periods of stress. This capacity must be commensurate with the importance, riskiness and size of these exposures in the context of the business profile of the bank. In addition, for those exposures that represent material risk, a bank is expected to have the capacity to produce valuations using alternative methods that cannot just solely rely on the valuations provided by its counterparts in the event that primary inputs and approaches become unreliable, unavailable or not relevant due to market discontinuities or illiquidity. A bank must test and review the performance of its models under stress conditions so that it understands the limitations of the models under stress conditions.

126.The relevance and reliability of valuations is directly related to the quality and reliability of the inputs. Where values are determined to be in an active market, a bank must maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. However, where a market is deemed inactive, observable inputs or transactions may not be relevant, such as in a forced liquidation or distress sale, or transactions may not be observable, such as when markets are inactive. In such cases, accounting fair value guidance provides assistance on what must be considered, but may not be determinative. In assessing whether a source is reliable and relevant, a bank must consider, among other things:

1. i.The frequency and availability of the prices/quotes;
2. ii.Whether those prices represent actual regularly occurring transactions on an arm's length basis;
3. iii.The breadth of the distribution of the data and whether it is generally available to the relevant participants in the market;
4. iv.The timeliness of the information relative to the frequency of valuations;
5. v.The number of independent sources that produce the quotes/prices;
6. vi.The maturity of the market; and
7. vii.The similarity between the financial instrument sold in a transaction and the instrument held by the bank.