Trading Book (CRR)

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Application Provision

1.1

This Part applies to:

  1. (a) a firm that is a CRR firm; and
  2. (b) a CRR consolidation entity.

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2

Level of Application

2.1

Title II of Part One (Level of application) of the CRR applies to Chapters 3 and 4 of this Part as that Title applies to Part Three (Capital Requirements) of the CRR.

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3

Trading Book (Part Three Title I Chapter 1, and Article 94, CRR)

[Note: Articles 92 to 93 remain in the CRR]

Article 94 Derogation for Small Trading Book

1.

By way of derogation from point (b) of Article 92(3), institutions may calculate the own funds requirement for their trading book business in accordance with paragraph 2 of this Article, provided that the size of the institutions' on- and off-balance-sheet trading book business is equal to or less than both of the following thresholds on the basis of an assessment carried out on a monthly basis using the data as of the last day of the month:

  1. (a) 5% of the institution's total assets;
  2. (b) GBP 44 million.

2.

Where both conditions set out in points (a) and (b) of paragraph 1 are met, institutions may calculate the own funds requirement for their trading book business as follows:

  1. (a) for the contracts listed in point 1 of Annex II of the CRR, contracts relating to equities which are referred to in point 3 of that Annex and credit derivatives, institutions may exempt those positions from the own funds requirement referred to in point (b) of Article 92(3);
  2. (b) for trading book positions other than those referred to in point (a) of this paragraph, institutions may replace the own funds requirement referred to in point (b) of Article 92(3) with the requirement calculated in accordance with point (a) of Article 92(3).

3.

Institutions shall calculate the size of their on- and off-balance-sheet trading book business on the basis of data as of the last day of each month for the purposes of paragraph 1 in accordance with the following requirements:

  1. (a) all the positions assigned to the trading book in accordance with Article 104 shall be included in the calculation except for the following:
    1. (i) positions concerning foreign exchange and commodities;
    2. (ii) positions in credit derivatives that are recognised as internal hedges against non- trading book credit risk exposures or counterparty risk exposures and the credit derivative transactions that perfectly offset the market risk of those internal hedges as referred to in Article 106(3);
  2. (b) all positions included in the calculation in accordance with point (a) shall be valued at their market value on that given date; where the market value of a position is not available on a given date, institutions shall take a fair value for the position on that date; where the market value and fair value of a position are not available on a given date, institutions shall take the most recent of the market value or fair value for that position;
  3. (c) the absolute value of long positions shall be summed with the absolute value of short positions.

4.

Where both conditions set out in points (a) and (b) of paragraph 1 of this Article are met, irrespective of the obligations set out in provisions implementing Articles 74 and 83 of Directive 2013/36/EU, Article 102(3) and Articles 103 of this Chapter 3 of the Trading Book (CRR) Part of the PRA Rulebook shall not apply to an institution.

5.

Institutions shall notify the competent authorities when they calculate, or cease to calculate, the own funds requirements of their trading-book business in accordance with paragraph 2.

6.

An institution that no longer meets one or more of the conditions set out in paragraph 1 shall immediately notify the competent authority thereof.

7.

An institution shall cease to calculate the own funds requirements of its trading book business in accordance with paragraph 2 within three months of one of the following occurring:

  1. (a) the institution does not meet the conditions set out in point (a) or (b) of paragraph 1 for three consecutive months;
  2. (b) the institution does not meet the conditions set out in point (a) or (b) of paragraph 1 during more than 6 out of the last 12 months.

8.

Where an institution has ceased to calculate the own funds requirements of its trading book business in accordance with this Article, it shall only be permitted to calculate the own funds requirements of its trading book business in accordance with this Article where it demonstrates to the competent authority that all the conditions set out in paragraph 1 have been met for an uninterrupted full-year period.

[Note: This is a permission under section 144G and 192XC of FSMA to which Part 8 of the Capital Requirements Regulations applies]

9.

Institutions shall not enter into, buy or sell a trading book position for the sole purpose of complying with any of the conditions set out in paragraph 1 during the monthly assessment.

[Note: This rule corresponds to Article 94 of the CRR as it applied immediately before revocation by the Treasury.]

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Article 102 Requirements for the Trading Book

1.

Institutions shall ensure that positions in the trading book shall be either free of restrictions on their tradability or able to be hedged.

2.

Institutions shall ensure that trading intent shall be evidenced on the basis of the strategies, policies and procedures set up by the institution to manage the position or portfolio in accordance with Articles 103, and 104.

3.

Institutions shall establish and maintain systems and controls to manage their trading book in accordance with Article 103.

4.

[Note: Provision left blank]

5.

Institutions shall ensure that positions in the trading book shall be subject to the requirements for prudent valuation specified in Article 105.

6.

Institutions shall treat internal hedges in accordance with Article 106.

[Note: This rule corresponds to Article 102 of the CRR as it applied immediately before revocation by the Treasury.]

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Article 103 Management of the Trading Book

1.

Institutions shall have in place clearly defined policies and procedures for the overall management of the trading book. Those policies and procedures shall at least address:

  1. (a) the activities which the institution considers to be trading business and as constituting part of the trading book for own funds requirement purposes;
  2. (b) the extent to which a position can be marked-to-market daily by reference to an active, liquid two-way market;
  3. (c) for positions that are marked-to-model, the extent to which the institution can:
    1. (i) identify all material risks of the position;
    2. (ii) hedge all material risks of the position with instruments for which an active, liquid two-way market exists;
    3. (iii) derive reliable estimates for the key assumptions and parameters used in the model;
  4. (d) the extent to which the institution can, and is required to, generate valuations for the position that can be validated externally in a consistent manner;
  5. (e) the extent to which legal restrictions or other operational requirements would impede the institution's ability to effect a liquidation or hedge of the position in the short term;
  6. (f) the extent to which the institution can, and is required to, actively manage the risks of positions within its trading operation.
  7. (g) [Note: Provision left blank]

2.

In managing its positions or portfolios of positions in the trading book, the institution shall comply with all the following requirements:

  1. (a) the institution shall have in place a clearly documented trading strategy for the position or portfolios in the trading book, which shall be approved by senior management and include the expected holding period;
  2. (b) the institution shall have in place clearly defined policies and procedures for the active management of positions or portfolios in the trading book; those policies and procedures shall include the following:
    1. (i) which positions or portfolios of positions may be entered into by each trading desk or, as the case may be, by designated dealers;
    2. (ii) the setting of position limits and monitoring them for appropriateness;
    3. (iii) ensuring that dealers have the autonomy to enter into and manage the position within agreed limits and according to the approved strategy;
    4. (iv) ensuring that positions are reported to senior management as an integral part of the institution's risk management process;
    5. (v) ensuring that positions are actively monitored with reference to market information sources and an assessment is made of the marketability or hedgeability of the position or its component risks, including the assessment, the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market;
    6. (vi) active anti-fraud procedures and controls;
  3. (c) the institution shall have in place clearly defined policies and procedures to monitor the positions against the institution's trading strategy, including the monitoring of turnover and positions for which the originally intended holding period has been exceeded.

[Note: This rule corresponds to Article 103 of the CRR as it applied immediately before revocation by the Treasury.]

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Article 104 Inclusion in the Trading Book

1.

Institutions shall have in place clearly defined policies and procedures for determining which position to include in the trading book for the purposes of calculating their capital requirements, in accordance with the requirements set out in Article 102 and the definition of trading book in accordance with point (86) of Article 4(1), taking into account the institution's risk management capabilities and practices. The institution shall fully document its compliance with these policies and procedures and shall subject them to periodic internal audit.

2.

[Note: Provision left blank]

[Note: This rule corresponds to Article 104 of the CRR as it applied immediately before revocation by the Treasury.]

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Article 105 Requirements for Prudent Valuation

1.

Institutions shall ensure that all trading book positions and non-trading book positions measured at fair value shall be subject to the standards for prudent valuation specified in this Article and in Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook. Institutions shall in particular ensure that the prudent valuation of their trading book positions achieves an appropriate degree of certainty having regard to the dynamic nature of trading book positions and non-trading book positions measured at fair value, the demands of prudential soundness and the mode of operation and purpose of capital requirements in respect of trading book positions and non-trading book positions measured at fair value.

2.

Institutions shall establish and maintain systems and controls sufficient to provide prudent and reliable valuation estimates. Institutions shall ensure that those systems and controls shall include at least the following elements:

  1. (a) documented policies and procedures for the process of valuation, including clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the institution's assumptions of what market participants would use in pricing the position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, month end and ad-hoc verification procedures;
  2. (b) reporting lines for the department accountable for the valuation process that are clear and independent of the front office, which shall ultimately be to the management body.

3.

Institutions shall revalue trading book positions at fair value at least on a daily basis. Institutions shall report changes in the value of those positions in the profit and loss account of the institution.

4.

Institutions shall mark their trading book positions and non-trading book positions measured at fair value to market whenever possible, including when applying the relevant capital treatment to those positions.

5.

When marking to market, an institution shall use the more prudent side of bid and offer unless the institution can close out at mid-market. Where institutions make use of this derogation, they shall every six months inform their competent authorities of the positions concerned and furnish evidence that they can close out at mid-market.

6.

Where marking to market is not possible, institutions shall conservatively mark to model their positions and portfolios, including when calculating own funds requirements for positions in the trading book and positions measured at fair value in the non-trading book.

7.

Institutions shall comply with the following requirements when marking to model:

  1. (a) senior management shall be aware of the elements of the trading book or of other fair-valued positions which are subject to mark to model and shall understand the materiality of the uncertainty thereby created in the reporting of the risk/performance of the business;
  2. (b) institutions shall source market inputs, where possible, in line with market prices, and shall assess the appropriateness of the market inputs of the particular position being valued and the parameters of the model on a frequent basis;
  3. (c) where available, institutions shall use valuation methodologies which are accepted market practice for particular financial instruments or commodities;
  4. (d) where the model is developed by the institution itself, the institution shall ensure that it is based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process;
  5. (e) institutions shall have in place formal change control procedures and shall hold a secure copy of the model and use it periodically to check valuations;
  6. (f) risk management shall be aware of the weaknesses of the models used and how best to reflect those in the valuation output; and
  7. (g) institutions shall subject their models to periodic review to determine the accuracy of their performance, which shall include assessing the continued appropriateness of assumptions, analysis of profit and loss versus risk factors, and comparison of actual close out values to model outputs.

For the purposes of point (d) of the first subparagraph, institutions shall ensure that the model is developed or approved independently of the trading desks and is independently tested, including validation of the mathematics, assumptions and software implementation.

8.

Institutions shall perform independent price verification in addition to daily marking to market or marking to model. Institutions shall ensure that verification of market prices and model inputs shall be performed by a person or unit independent from persons or units that benefit from the trading book, at least monthly, or more frequently depending on the nature of the market or trading activity. Where independent pricing sources are not available or pricing sources are more subjective, institutions shall take into account that prudent measures such as valuation adjustments may be appropriate.

9.

Institutions shall establish and maintain procedures for considering valuation adjustments.

10.

Institutions shall formally consider the following valuation adjustments: unearned credit spreads, close-out costs, operational risks, market price uncertainty, early termination, investing and funding costs, future administrative costs and, where relevant, model risk.

11.

Institutions shall establish and maintain procedures for calculating an adjustment to the current valuation of any less liquid positions, which can in particular arise from market events or institution-related situations such as concentrated positions and/or positions for which the originally intended holding period has been exceeded. Institutions shall, where necessary, make such adjustments in addition to any changes to the value of the position required for financial reporting purposes and shall design such adjustments to reflect the illiquidity of the position. Under those procedures, institutions shall consider several factors when determining whether a valuation adjustment is necessary for less liquid positions. Those factors include the following:

  1. (a) the amount of time it would take to hedge out the position or the risks within the position beyond the liquidity horizons;
  2. (b) the volatility and average of bid/offer spreads;
  3. (c) the availability of market quotes (number and identity of market makers) and the volatility and average of trading volumes including trading volumes during periods of market stress;
  4. (d) market concentrations;
  5. (e) the ageing of positions;
  6. (f) the extent to which valuation relies on marking-to-model;
  7. (g) the impact of other model risks.

12.

When using third party valuations or marking to model, institutions shall consider whether to apply a valuation adjustment. In addition, institutions shall consider the need to establish adjustments for less liquid positions and on an ongoing basis review their continued suitability. Institutions shall also explicitly assess the need for valuation adjustments relating to the uncertainty of parameter inputs used by models.

13.

With regard to complex products, including securitisation exposures and n-th-to-default credit derivatives, institutions shall explicitly assess the need for valuation adjustments to reflect the model risk associated with using a possibly incorrect valuation methodology and the model risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.

14.

[Note: Provision left blank]

[Note: This rule corresponds to Article 105 of the CRR as it applied immediately before revocation by the Treasury.]

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Article 106 Internal Hedges

1.

Institutions shall ensure that an internal hedge shall in particular meet the following requirements:

  1. (a) it shall not be primarily intended to avoid or reduce own funds requirements;
  2. (b) it shall be properly documented and subject to particular internal approval and audit procedures;
  3. (c) it shall be dealt with at market conditions;
  4. (d) the market risk that is generated by the internal hedge shall be dynamically managed in the trading book within the authorised limits;
  5. (e) it shall be carefully monitored in accordance with adequate procedures.

2.

The requirements of paragraph 1 apply without prejudice to the requirements applicable to the hedged position in the non-trading book.

3.

By way of derogation from paragraphs 1 and 2, when an institution hedges a non-trading book credit risk exposure or counterparty risk exposure using a credit derivative booked in its trading book using an internal hedge, institutions shall ensure that the non-trading book exposure or counterparty risk exposure shall not be deemed to be hedged for the purposes of calculating risk-weighted exposure amounts unless the institution purchases from an eligible third party protection provider a corresponding credit derivative meeting the requirements for unfunded credit protection in the non-trading book. Without prejudice to point (h) of Article 299(2), where such third party protection is purchased and recognised as a hedge of a non-trading book exposure for the purposes of calculating capital requirements, institutions shall ensure that neither the internal nor external credit derivative hedge shall be included in the trading book for the purposes of calculating capital requirements.

[Note: This rule corresponds to Article 106 of the CRR as it applied immediately before revocation by the Treasury.]

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4

Rules Supplementing Article 105 on Standards for Prudential Valuation (previously Regulation (EU) No 2016/101)

Chapter I General Provisions

Article 1 Methodology for Calculating Additional Valuation Adjustments (AVAs)

Institutions shall calculate the total additional valuation adjustments ('AVAs') necessary to adjust the fair values to the prudent value and shall calculate those AVAs quarterly according to the method provided in Chapter 3 of this Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook, unless they meet the conditions for applying the method provided in Chapter 2 of this Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook.

[Note: This rule corresponds to Article 1 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 2 Definitions

For the purpose of this Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook the following definitions shall apply:

  1. (a) 'valuation position' means a financial instrument or commodity or portfolio of financial instruments or commodities held in both trading and non-trading books, which are measured at fair value;
  2. (b) 'valuation input' means a market observable or non-observable parameter or matrix of parameters that influences the fair value of a valuation position;
  3. (c) 'valuation exposure' means the amount of a valuation position which is sensitive to the movement in a valuation input.

[Note: This rule corresponds to Article 2 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 3 Sources of Market Data

1.

Where institutions calculate AVAs based on market data, they shall consider the same range of market data as the data used in the independent price verification ('IPV') process referred to in Article 105(8) of the CRR, as relevant, subject to the adjustments described in this Article.

2.

Institutions shall consider a full range of available and reliable market data sources to determine a prudent value including each of the following, where relevant:

  1. (a) exchange prices in a liquid market;
  2. (b) trades in the exact same or very similar instrument, either from the institution's own records or, where available, trades from across the market;
  3. (c) tradable quotes from brokers and other market participants;
  4. (d) consensus service data;
  5. (e) indicative broker quotes;
  6. (f) counterparty collateral valuations.

3.

For cases where an expert-based approach is applied for the purpose of Articles 9, 10 and 11, alternative methods and sources of information shall be considered, including each of the following, where relevant:

  1. (a) the use of proxy data based on similar instruments for which sufficient data is available;
  2. (b) the application of prudent shifts to valuation inputs;
  3. (c) the identification of natural bounds to the value of an instrument.

[Note: This rule corresponds to Article 3 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Chapter II Simplified Approach for the Determination of AVAs

Article 4 Conditions for use of the Simplified Approach

1.

Institutions may apply the simplified approach described in this Chapter 2 of this Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook only if the sum of the absolute value of fair-valued assets and liabilities, as stated in the institution's financial statements under the applicable accounting framework, is less than GBP 13 billion.

2.

Exactly matching, offsetting fair-valued assets and liabilities shall be excluded from the calculation of paragraph 1. For fair-valued assets and liabilities for which a change in accounting valuation has a partial or zero impact on Common Equity Tier 1 ('CET1') capital, their values shall only be included in proportion to the impact of the relevant valuation change on CET1 capital.

3.

The threshold referred to in paragraph 1 shall apply on an individual and consolidated basis. Where the threshold is breached on a consolidated basis, the core approach shall be applied to all entities included in the consolidation.

4.

Where institutions applying the simplified approach fail to meet the condition of paragraph 1 for two consecutive quarters, they shall immediately notify the relevant competent authority and shall agree on a plan to implement the approach referred to in Chapter 3 of this Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook within the following two quarters.

[Note: This rule corresponds to Article 4 of Part 2 Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 5 Determination of AVAs Under the Simplified Approach

Institutions shall calculate AVAs under the simplified approach as 0.1% of the sum of the absolute value of fair-valued assets and liabilities which are included within the threshold calculation laid down in Article 4.

[Note: This rule corresponds to Article 5 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 6 Determination of Total AVAs Calculated Under the Simplified Approach

For institutions applying the simplified approach, the total AVAs for the purpose of Article 1 shall be the AVA resulting from the calculation of Article 5.

[Note: This rule corresponds to Article 6 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Chapter III Core Approach for the Determination of AVAs

Article 7 Overview of the Core Approach

1.

Institutions shall calculate AVAs under the core approach, by applying the following two-step approach:

  1. (a) they shall calculate AVAs for each of the categories described in paragraphs 10 and 11 of Article 105 of the CRR ('category level AVAs') according to paragraph 2 of this Article;
  2. (b) they shall sum the amounts resulting from point (a) for each of the category level AVAs to provide the total AVAs for the purposes of Article 1.

2.

For the purposes of point (a) of paragraph 1, institutions shall calculate category level AVAs in one of the following ways:

  1. (a) according to Articles 9 to 17;
  2. (b) where the application of Articles 9 to 17 is not possible for certain positions, according to a 'fall-back approach', whereby they shall identify the related financial instruments and calculate an AVA as the sum of the following:
    1. (i) 100% of the net unrealised profit on the related financial instruments;
    2. (ii) 10% of the notional value of the related financial instruments in the case of derivatives;
    3. (iii) 25% of the absolute value of the difference between the fair value and the unrealised profit, as determined in point (i), of the related financial instruments in the case of non-derivatives.

For the purposes of point (b)(i) of the first paragraph, 'unrealised profit' shall mean the change, where positive, in fair value since trade inception, determined on a first-in-first-out basis.

[Note: This rule corresponds to Article 7 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 8 General Provisions for the Calculations of AVAs under the Core Approach

1.

For fair-valued assets and liabilities for which a change in accounting valuation has a partial or zero impact on CET1 capital, AVAs shall only be calculated based on the proportion of the accounting valuation change that impacts CET1 capital.

2.

In relation to the category level AVAs described in Articles 14 to 17, institutions shall aim to achieve a level of certainty in the prudent value that is equivalent to that set out in Articles 9 to 13.

3.

AVAs shall be considered to be the excess of valuation adjustments required to achieve the identified prudent value, over any adjustment applied in the institution's fair value that can be identified as addressing the same source of valuation uncertainty as the AVA. Where an adjustment applied in the institution's fair value cannot be identified as addressing a specific AVA category at the level at which the relevant AVAs are calculated, that adjustment shall not be included in the calculation of AVAs.

4.

AVAs shall always be positive, including at valuation exposure level, category level, both pre and post aggregation.

[Note: This rule corresponds to Article 8 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 9 Calculation of Market Price Uncertainty AVA

1.

Market price uncertainty AVAs shall be calculated at valuation exposure level (‘individual market price uncertainty AVAs’).

2.

The market price uncertainty AVA shall only be assessed to have zero value where both of the following conditions are met:

  1. (a) the institution has firm evidence of a tradable price for a valuation exposure or a price can be determined from reliable data based on a liquid two-way market as described in the second subparagraph of Article 338(1) of the CRR;
  2. (b) the sources of market data set out in Article 3(2) do not indicate any material valuation uncertainty.

3.

Where a valuation exposure cannot be shown to have a zero AVA, when assessing the market price uncertainty AVA institutions shall use the data sources defined in Article 3. In this case the calculation of the market price uncertainty AVA shall be performed as described in paragraphs 4 and 5.

4.

Institutions shall calculate AVAs on valuation exposures related to each valuation input used in the relevant valuation model.

  1. (a) The granularity at which those AVAs shall be assessed shall be one of the following:
    1. (i) where decomposed, all the valuation inputs required to calculate an exit price for the valuation position;
    2. (ii) the price of the instrument.
  2. (b) Each of the valuation inputs referred to in point (a)(i) shall be treated separately. Where a valuation input consists of a matrix of parameters, AVAs shall be calculated based on the valuation exposures related to each parameter within that matrix. Where a valuation input does not refer to tradable instruments, institutions shall map the valuation input and the related valuation exposure to a set of market tradable instruments. Institutions may reduce the number of parameters of the valuation input for the purpose of calculating AVAs using any appropriate methodology provided the reduced parameters satisfy all of the following requirements:
    1. (i) the total value of the reduced valuation exposure is the same as the total value of the original valuation exposure;
    2. (ii) the reduced set of parameters can be mapped to a set of market tradable instruments;
    3. (iii) the ratio of variance measure 2 defined below over variance measure 1 defined below, based on historical data from the most recent 100 trading days, is less than 0.1. For the purposes of this paragraph, 'variance measure 1' shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input and 'variance measure 2' shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input minus the valuation exposure based on the reduced valuation input.
  3. (c) Where a reduced number of parameters is used for the purpose of calculating AVAs, the determination that the criteria set out in point (b) are met shall be subject to independent control function review of the netting methodology and internal validation on at least an annual basis.

5.

Market price uncertainty AVAs shall be determined as follows:

  1. (a) where sufficient data exists to construct a range of plausible values for a valuation input:
    1. (i) for a valuation input where the range of plausible values is based on exit prices, institutions shall estimate a point within the range where they are 90% confident they could exit the valuation exposure at that price or better;
    2. (ii) for a valuation input where the range of plausible values is created from mid prices, institutions shall estimate a point within the range where they are 90% confident that the mid value they could achieve in exiting the valuation exposure would be at that price or better;
  3. (b) where insufficient data exists to construct a plausible range of values for a valuation input, institutions shall use an expert-based approach using qualitative and quantitative information available to achieve a level of certainty in the prudent value of the valuation input that is equivalent to that targeted under point (a). Institutions shall notify competent authorities of the valuation exposures for which this approach is applied, and the methodology used to determine the AVA;
  4. (c) institutions shall calculate the market price uncertainty AVA based on one of the following approaches:
    1. (i) they shall apply the difference between the valuation input values estimated according to either point (a) or point (b), and the valuation input values used for calculating fair value to the valuation exposure of each valuation position;
    2. (ii) they shall combine the valuation input values estimated according to either point (a) or point (b) and they shall revalue valuation positions based on those values. Institutions shall then take the difference between the revalued positions and fair-valued positions.

6.

Institutions shall calculate the total category level AVA for market price uncertainty by applying to individual market price uncertainty AVAs the formulae for either Method 1 or Method 2 laid down in, “Formulae to be used for the purpose of aggregating AVAs under Article 9(6), Article 10(7) and Article 11(7) in the Annex to this Part”.

[Note: This rule corresponds to Article 9 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 10 Calculation of Close-Out Costs AVA

1.

Close-out costs AVAs shall be calculated at valuation exposure level (‘individual close-out costs AVAs’).

2.

When an institution has calculated a market price uncertainty AVA for a valuation exposure based on an exit price, the close-out cost AVA may be assessed to have zero value.

3.

Where an institution applies the derogation referred to in paragraph 5 of Article 105 of the CRR, the close-out costs AVA may be assessed to have zero value, on the condition that the institution provides evidence that it is 90% confident that sufficient liquidity exists to support the exit of the related valuation exposures at mid-price.

4.

Where a valuation exposure cannot be shown to have a zero close-out costs AVA, institutions shall use the data sources defined in Article 3. In this case the calculation of the close-out costs AVA shall be performed as described in paragraphs 5 and 6 of this Article.

5.

Institutions shall calculate close-out costs AVAs on valuation exposures related to each valuation input used in the relevant valuation model.

  1. (a) The granularity at which those close-out costs AVAs shall be assessed shall be one of the following:
    1. (i) where decomposed, all valuation inputs required to calculate an exit price for the valuation position;
    2. (ii) the price of the instrument.
  2. (b) Each of the valuation inputs referred to in point (a)(i) shall be treated separately. Where a valuation input consists of a matrix of parameters, institutions shall assess the close-out cost AVA based on the valuation exposures related to each parameter within that matrix. Where a valuation input does not refer to tradable instruments, institutions shall explicitly map the valuation input and the related valuation exposure to a set of market tradable instruments. Institutions may reduce the number of parameters of the valuation input for the purpose of calculating AVAs using any appropriate methodology provided the reduced parameters satisfy all of the following requirements:
    1. (i) the total value of the reduced valuation exposure is the same as the total value of the original valuation exposure;
    2. (ii) the reduced set of parameters can be mapped to a set of market tradable instruments;
    3. (iii) the ratio of variance measure 2 over variance measure 1, based on historical data from the most recent 100 trading days, is less than 0.1.
  3. For the purposes of this paragraph, 'variance measure 1' shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input and 'variance measure 2' shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input minus the valuation exposure based on the reduced valuation input.
  4. (c) Where a reduced number of parameters is used for the purpose of calculating AVAs, the determination that the criteria set out in point (b) are met shall be subject to independent control function review and internal validation on at least an annual basis.

6.

Close-out costs AVAs shall be determined as follows:

  1. (a) where sufficient data exists to construct a range of plausible bid-offer spreads for a valuation input, institutions shall estimate a point within the range where they are 90% confident that the spread they could achieve in exiting the valuation exposure would be at that price or better;
  2. (b) where insufficient data exists to construct a plausible range of bid-offer spreads, institutions shall use an expert-based approach using qualitative and quantitative information available to achieve a level of certainty in the prudent value that is equivalent to that targeted where a range of plausible values is available. Institutions shall notify competent authorities of the valuation exposures for which this approach is applied, and the methodology used to determine the AVA;
  3. (c) institutions shall calculate the close-out costs AVA by applying 50% of the estimated bid-offer spread calculated in accordance with either point (a) or point (b) to the valuation exposures related to the valuation inputs defined in paragraph 5.

7.

Institutions shall calculate the total category level AVA for close-out costs by applying to the individual close-out costs AVAs the formulae for either Method 1 or Method 2 laid down in the “Formulae to be used for the purpose of aggregating AVAs under Article 9(6), Article 10(7) and Article 11(7)” in the Annex to this Part.

[Note: This rule corresponds to Article 10 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 11 Calculation of Model Risk AVA

1.

Institutions shall estimate a model risk AVA for each valuation model ('individual model risk AVA') by considering valuation model risk which arises due to the potential existence of a range of different models or model calibrations, which are used by market participants, and the lack of a firm exit price for the specific product being valued. Institutions shall not consider valuation model risk which arises due to calibrations from market derived parameters, which shall be captured according to Article 9.

2.

The model risk AVA shall be calculated using one of the approaches defined in paragraphs 3 and 4.

3.

Where possible, institutions shall calculate the model risk AVA by determining a range of plausible valuations produced from alternative appropriate modelling and calibration approaches. In this case, institutions shall estimate a point within the resulting range of valuations where they are 90% confident they could exit the valuation exposure at that price or better.

4.

Where institutions are unable to use the approach defined in paragraph 3, they shall apply an expert-based approach to estimate the model risk AVA.

5.

The expert-based approach shall consider all of the following:

  1. (a) complexity of products relevant to the model;
  2. (b) diversity of possible mathematical approaches and model parameters, where those model parameters are not related to market variables;
  3. (c) the degree to which the market for relevant products is 'one way';
  4. (d) the existence of unhedgeable risks in relevant products;
  5. (e) the adequacy of the model in capturing the behaviour of the pay-off of the products in the portfolio.

Institutions shall notify competent authorities of the models for which this approach is applied, and the methodology used to determine the AVA.

6.

Where institutions use the method described in paragraph 4, the prudence of the method shall be confirmed annually by comparing the following:

  1. (a) the AVAs calculated using the method described in paragraph 4, if it were applied to a material sample of the valuation models for which the institution applies the method in paragraph 3; and
  2. (b) the AVAs produced by the method in paragraph 3 for the same sample of valuation models.

7.

Institutions shall calculate the total category level AVA for model risk by applying to individual model risk AVAs the formulae for either Method 1 or Method 2 laid down in “Formulae to be used for the purpose of aggregating AVAs under Article 9(6), Article 10(7) and Article 11(7)” in the Annex to this Part.

[Note: This rule corresponds to Article 11 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 12 Calculation of Unearned Credit Spreads AVA

1.

Institutions shall calculate the unearned credit spreads AVA to reflect the valuation uncertainty in the adjustment necessary according to the applicable accounting framework to include the current value of expected losses due to counterparty default on derivative positions.

2.

Institutions shall include the element of the AVA relating to market price uncertainty within the market price uncertainty AVA category. The element of the AVA relating to close-out cost uncertainty shall be included within the close-out costs AVA category. The element of the AVA relating to model risk shall be included within the model risk AVA category.

[Note: This rule corresponds to Article 12 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 13 Calculation of Investing and Funding Costs AVA

1.

Institutions shall calculate the investing and funding costs AVA to reflect the valuation uncertainty in the funding costs used when assessing the exit price according to the applicable accounting framework.

2.

Institutions shall include the element of the AVA relating to market price uncertainty within the market price uncertainty AVA category. The element of the AVA relating to close-out cost uncertainty shall be included within the close-out costs AVA category. The element of the AVA relating to model risk shall be included within the model risk AVA category.

[Note: This rule corresponds to Article 13 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 14 Calculation of Concentrated Positions AVA

1.

Institutions shall estimate a concentrated position AVA for concentrated valuation positions ('individual concentrated positions AVA') by applying the following three-step approach:

  1. (a) they shall identify concentrated valuation positions;
  2. (b) for each identified concentrated valuation position, where a market price applicable for the size of the valuation position is unavailable, they shall estimate a prudent exit period;
  3. (c) where the prudent exit period exceeds 10 days, they shall estimate an AVA taking into account the volatility of the valuation input, the volatility of the bid offer spread and the impact of the hypothetical exit strategy on market prices.

2.

For the purposes of point (a) of paragraph 1, the identification of concentrated valuation positions shall consider all of the following:

  1. (a) the size of all valuation positions relative to the liquidity of the related market;
  2. (b) the institution's ability to trade in that market;
  3. (c) the average daily market volume and typical daily trading volume of the institution.

Institutions shall establish and document the methodology applied to determine concentrated valuation positions for which a concentrated positions AVA shall be calculated.

3.

Institutions shall calculate the total category level AVA for concentrated positions AVA as the sum of individual concentrated positions AVAs.

[Note: This rule corresponds to Article 14 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 15 Calculation of Future Administrative Costs AVA

1.

Where an institution calculates market price uncertainty and close-out cost AVAs for a valuation exposure, which imply fully exiting the exposure, the institution may assess a zero AVA for future administrative costs.

2.

Where a valuation exposure cannot be shown to have a zero AVA according to paragraph 1, institutions shall calculate the future administrative cost AVA ('individual future administrative costs AVA') considering the administrative costs and future hedging costs over the expected life of the valuation exposures for which a direct exit price is not applied for the close-out costs AVA, discounted using a rate which approximates the risk free rate.

3.

For the purposes of paragraph 2, future administrative costs shall include all incremental staffing and fixed costs that are likely to be incurred in managing the portfolio but a reduction in these costs may be assumed as the size of the portfolio reduces.

4.

Institutions shall calculate the total category level AVA for future administrative costs AVA as the sum of individual future administrative costs AVAs.

[Note: This rule corresponds to Article 15 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 16 Calculation of Early Termination AVA

Institutions shall estimate an early termination AVA considering the potential losses arising from non- contractual early terminations of client trades. The early termination AVA shall be calculated taking into account the percentage of client trades that have historically terminated early and the losses that arise in those cases.

[Note: This rule corresponds to Article 16 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 17 Calculation of Operational Risk AVA

1.

Institutions shall estimate an operational risk AVA by assessing the potential losses that may be incurred as a result of operational risk related to valuation processes. This estimate shall include an assessment of valuation positions judged to be at-risk during the balance sheet substantiation process, including those due to legal disputes.

2.

Where an institution applies the Advanced Measurement Approach for Operational Risk as specified in Part Three, Title III, Chapter 4 of the CRR, it may report a zero operational risk AVA on condition that it provides evidence that the operational risk relating to valuation processes, as determined in accordance with paragraph 1, is fully accounted for by the Advanced Measurement Approach calculation.

3.

In other cases than those referred to in paragraph 2, the institution shall calculate an operational risk AVA of 10% of the sum of the aggregated category level AVAs for market price uncertainty and close-out costs.

[Note: This rule corresponds to Article 17 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 18 Documentation Requirements

1.

Institutions shall document appropriately the prudent valuation methodology. This documentation shall include internal policies providing guidance on all of the following points:

  1. (a) the range of methodologies for quantifying AVAs for each valuation position;
  2. (b) the hierarchy of methodologies for each asset class, product, or valuation position;
  3. (c) the hierarchy of market data sources used in the AVA methodology;
  4. (d) the required characteristics of market data to justify a zero AVA for each asset class, product, or valuation position;
  5. (e) the methodology applied where an expert based approach is used to determine an AVA;
  6. (f) the methodology for determining whether a valuation position requires a concentrated position AVA;
  7. (g) the assumed exit horizon for the purpose of calculating AVAs for concentrated positions, where relevant;
  8. (h) the fair-valued assets and liabilities for which a change in accounting valuation has a partial or zero impact on CET1 capital according to Article 4(2) and Article 8(1).

2.

Institutions shall also maintain records to allow the calculation of AVAs at valuation exposure level to be analysed, and information from the AVA calculation process shall be provided to senior management to allow an understanding of the level of valuation uncertainty on the institution's portfolio of fair-valued positions.

3.

The documentation specified in paragraph 1 shall be reviewed at least annually and approved by senior management.

[Note: This rule corresponds to Article 18 of Part 2 Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Article 19 Systems and Controls Requirements

1.

AVAs shall be authorised initially, and monitored subsequently, by an independent control unit.

2.

Institutions shall have effective controls related to the governance of all fair-valued positions, and adequate resources to implement those controls and ensure robust valuation processes even during a stressed period. These shall include all of the following:

  1. (a) at least an annual review of valuation model performance;
  2. (b) management sign-off on all significant changes to valuation policies;
  3. (c) a clear statement of the institution's risk appetite for exposure to positions subject to valuation uncertainty which is monitored at an aggregate institution-wide level;
  4. (d) independence in the valuation process between risk taking and control units;
  5. (e) a comprehensive internal audit process related to valuation processes and controls.

3.

Institutions shall ensure there are effective and consistently applied controls related to the valuation process for fair-valued positions. These controls shall be subject to regular internal audit review. The controls shall include all of the following:

  1. (a) a precisely defined institution-wide product inventory, ensuring that every valuation position is uniquely mapped to a product definition;
  2. (b) valuation methodologies, for each product in the inventory covering choice and calibration of model, fair value adjustments, AVAs, independent price verification methodologies applicable to the product, and the measurement of valuation uncertainty;
  3. (c) validation process ensuring that, for each product, both the risk-taking and relevant control departments approve the product-level methodologies described in point (b) and certify that they reflect the actual practice for every valuation position mapped to the product;
  4. (d) defined thresholds based on observed market data for determining when valuation models are no longer sufficiently robust;
  5. (e) a formal IPV process based on prices independent from the relevant trading desk;
  6. (f) a new product approval processes referencing the product inventory and involving all internal stakeholders relevant to risk measurement, risk control, financial reporting and the assignment and verification of valuations of financial instruments;
  7. (g) a new deal review process to ensure that pricing data from new trades are used to assess whether valuations of similar valuation exposures remain appropriately prudent.

[Note: This rule corresponds to Article 19 of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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Chapter IV Final Provisions

Annex Formulae to be used for the purpose of Aggregating AVAs under Article 9(6), Article 10(7) and Article 11(7)

Formula for Method 1

APVA = (FV – PV) – α . (FV – PV)
= (1 – α) . (FV – PV)
AVA = Σ APVA

Formula for Method 2

APVA = max {0, (FV – PV) – α . (EV – PV)}
= max {0, FV – α . EV – (1 – α) . PV}
AVA = Σ APVA

Where:

FV = The valuation exposure-level fair value after any accounting adjustment applied in the institution's fair value that can be identified as addressing the same source of valuation uncertainty as the relevant AVA,

PV = The valuation exposure-level prudent value determined in accordance with this Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook,

EV = The expected value at a valuation exposure level taken from a range of possible values,

α = The aggregation factor,

APVA = The valuation exposure-level AVA after adjusting for aggregation,

AVA = The total category-level AVA after adjusting for aggregation.

Institutions shall set the aggregation factor 'α' at 50%.

[Note: This rule corresponds to the annex of Part 2 of Regulation (EU) No 2016/101 as it applied immediately before revocation by the Treasury.]

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