The Governance around the Valuation of Financial Instruments in Banks

This paper presents our analysis of the governance in banks regarding the valuation of financial instruments.

It reviews different frameworks that have been encountered in our discussions with risk managers and heads of valuation from several international banks. Topics addressed are data, valuation models, reserves for uncertainties, valuation adjustments (XVA) and regulatory additional valuation adjustments (AVA) that are computed for capital adequacy. The governance traditionally relies on the so-called Three Lines of Defence (3LOD) Model, in which the business line (Front Office) represents the first line and manages risks, while the second line oversees risks and is ensured by Finance/ Risk Department. The third line provides independent assurance and is held by Internal Audit. This schema has established itself as the dominant one despite critics pointing out several drawbacks, such as:

Our first finding is that governance frameworks as seen in banks may be classified into three categories. First, valuation tasks are mainly supported by Finance. The role of the Risk Department is limited to model validation. Secondly, the Risk Department has the main role that goes beyond the validation function and encompasses valuation methodology design and even data quality control. Lastly, a hybrid framework is encountered that differs from the two previous ones as it largely mixes valuation functions between Risk and Finance.

Our discussions clearly highlight that banks have serious concerns about the practical application of the 3LOD model, whichever of the above the frameworks is present.

Among these concerns:

• The fact that the F/O has undisputable knowledge regarding market data in comparison to other functions raises a problem which cannot be solved in a totally satisfactory manner. Indeed, it would be an illusion to think that the second line of defence can have the same level of market knowledge or insight as the first line. This difference of knowledge cannot be removed, whatever the choice of governance. However, some risk managers and valuation heads have made interesting suggestions, such as regularly recruiting front officers in the second line of defence.
• Two departments (Risk and Finance) may belong to the same line of defence (LOD2) with similar addressed issues. Attempts to split the roles between them may remove the ability of both departments to address and understand the whole spectrum of valuation issues. Besides, silos, when deeply rooted in the organisation, are generally perceived as a potential weakness in the valuation framework or even a source of additional risk. It would also be illusory to believe that dedicated committees (‘valuation committees’) combining the Front Office, Risk, and Finance Departments would be able to fully manage the risk of erroneous valuation.
• On the other hand, a too-close proximity may lead to blurred responsibilities. A target could be to set up an organisation based on a shared responsibility between Risk and Finance, with the goal of removing risk that either function considers not its responsibility, leading therefore to a false sense of security. A framework in which one department (Risk or Finance) would systematically challenge the other one also is attractive; it generalizes the validation process that has been put in place for models and, in some cases, for reserves. Such a framework would, however, imply significant redundancies of skills and would leave unresolved the question of who owns the ultimate responsibility in case of disagreement.

In addition, we found that some areas are not covered or insufficiently covered. Some actions should be taken in order to secure the valuation. This is the case for:

• the reserves’ methodologies which are not independently validated in some banks, although they form a significant part of the profit and loss account (P&L).
• the Day One P&L framework and the levelling (hierarchy of fair value) which are usually not reviewed.
  
• the Day One P&L framework and the levelling (hierarchy of fair value) which are usually not reviewed.
  
• the incorporation of long-term analysis to identify market tendencies over the long run (addressed by Risk or Finance). Although banks already carry out such tasks in some areas, they only partially complete these tasks. In this perspective, the frameworks in place might be questionable, as they are not designed to specifically address this issue. Indeed, teams who perform daily tasks are often those who realize long-term analyses.

Accordingly, the risk is that longterm questions are not sufficiently investigated because short-term problems always tend to be prioritized at the expense of long-term ones.

Lastly, we find that the business line is not actually or not sufficiently involved in some crucial components of the valuation (mainly reserves, XVA and AVA). Yet, they have the best knowledge of the market. Therefore, they should give a documented opinion on any components of the valuation, and not only for data or valuation models. Such a framework makes sense only if the Front Office P&L is impacted by these components; otherwise, they would have no incentive to perform these functions.

Silos, when deeply rooted in the organisation, are generally perceived as a potential weakness in the valuation framework or even a source of additional risk.