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.
Current Market Developments
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:
- Decrease in market liquidity;
- Number of quotations decreased since December, particularly for credit instruments;
- Less consistency in pricing feeds from established pricing services;
- Bid/Offer spreads increased in all markets;
- Increase in credit risk;
- Credit spreads for investment grade and non-investment grade entities increased;
- Increase of market volatility and dividend cancellation;
- Equity volatility reached levels of the last financial crisis;
- Interest rates implied volatilities have spiked; and
- Companies have cancelled or postponed dividend payments.
Such developments impact the markets in different ways, as summarised below.
Impact on banks in current supervisory landscape
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:
- Do some instruments need to move from Level 2 to Level 3? There has been a reduction in quotation for market implied inputs which may lead to vanilla OTC products previously classified as Level 2 to level 3. Some equity derivatives could also need to be reclassified due to an increase in judgement in dividend projections.
- Do I need to revise policies or other supporting documentation? The current crisis may require changes in the existing IPV process, and any valuation methodology changes need to be reflected accordingly. This includes any transition from mark-to-market to mark-to-model approach that will impact levelling of investments.
- Have policies around observability been considered in the current context? Fair Value Hierarchy methodologies based on criteria such as number of market quotes and the dispersion among them would trigger a re-classification in this context due to reduced observability / consistency of market data. In addition, banks may need to consider closely significant intraday movements and decline in price quotations that create additional parameter uncertainty, which may affect the observability of valuation parameters and affect the Fair Value Hierarchy.
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.