The COVID-19 pandemic and subsequent uncertainty surrounding both its severity and potential duration continues to present multiple challenges for banks. For those banks that report fair values for complex and illiquid financial instruments, the ongoing market disruption adds another layer of complexity when it comes to the matter of appropriate valuation and disclosure. As the name implies, fair value measurement is a market-based measurement: assumptions should be used that market participants would use, reflecting market conditions as of the measurement date, without the use of hindsight of adjusting for depressed pricing. Since this measurement is based upon assumptions and inputs, any period of financial disruptions presents challenges for banks, to ensure that their fair value measurements accurately reflect current market conditions, and it can be assume that the fair value of assets and liabilities will have changed significantly.
In this section we explore a short summary of current market developments that we have noted in the industry, how they affect various products, and what impact this might have on banks under the current supervisory landscape.
Volatility in prices in the markets can affect fair values essentially in two main ways, either direct (e.g. if fair value is determined based on market prices such as debt securities traded on the active market), or indirectly if valuation is performed using inputs derived from volatile markets.
For this reason, the main observations from our KPMG iRadar group that are affecting fair value are:
Such developments impact the markets in different ways, as summarised below.
As we have noted previously, supervisors have over the last years increased their attention on the topic of fair value measurement, and via onsite inspections (OSIs) have focused from the inception of transactions (including new product approvals, the effectiveness of controls and governance over policies in the valuation framework), the Independent Price Verification (IPV) process right up until fair value hierarchy disclosure (including the observability of market data sources, and its review, documentation to ensure correct classification at either Level 2 or 3).
At a time when all of these elements of a banks’ operations are under stress via remote working or decreased FTE capacity, combined with a volatile market that is the basis for the valuation of most of these instruments, banks should expect continued scrutiny from the supervisor as was indeed confirmed by Andrea Enria in a recent letter (PDF 43.7 KB) to Marco Zanni, member of the EU Parliament.
Therefore, as banks approach half year reporting, key aspects that banks may wish to consider include:
The list of course is not exhaustive, and fair value measurement is a pervasive and judgemental issue. Banks should continue to revisit their governance framework, policy documentation and policies surrounding key supervisory issues such as observability to ensure that they are capturing the ongoing volatility and market uncertainty in a compliant manner.