Continued from Part II.
A valuation-based approach may be the FSA’s preferred option for fixing banks’ trading books and fortifying them against future risk, but it’s difficult, to say the least. The very thing the FSA is trying to remedy — inconsistent valuations — seem endemic in the financial system:
Ensuring comparable valuations across firms can be just as important, if not more so, as applying comparable capital requirements – this is demonstrated in Box 3.1. Within the fair value category, we have identified several areas where the absence of specific accounting guidance has led to material variation in practice across firms . . .
There are some interesting examples given here.
The first is a range of values — between 20 and 80 per cent of their notional amount — produced by six big banks at the end of 2007 for those notorious super-senior tranches of CDOs. Since they sit at the very top of the CDO structure, all of them would have been expected to get triple-A ratings, but they are not all the same tranche of the same CDO. For every tranche, the maximum capital requirement is smaller than the variation in valuations of the super-seniors produced across the six financial firms.
A more salient example has to do with Credit Valuation Adjustments (CVAs) taken on monoline insurers, one of the big loss-drivers in the crisis. Monolines were paid to insure things like CDOs, but when the market collapsed en masse they too were hit. Here’s what the FSA says:
The analysis showed severe disparities in monoline CVA methodologies applied across firms. In the most extreme case, re-valuing one firm’s portfolio using the benchmark methodology50 would have led to a valuation adjustment of $4.7bn.
So, consistent valuation = historically infrequent and probably endemic. What to do?
Rather than fight it, the FSA is taking a much more interesting approach. It’s throwing its hands up, and saying valuation is inherently uncertain, so let’s deal with that:
Valuations always contain some uncertainty, stemming from the range of plausible assumptions that could be applied in determining the value of an instrument. The existing regulatory framework implies that valuation is known with certainty and that capital requirements should cover risk to that valuation arising from changes to external parameters (e.g. market variables or default). As shown in Chapter 3, this uncertainty can often be larger than the capital requirement . . . We believe that a better way to capture valuation uncertainty, and to bring together all of the aspects that affect it, would be the introduction of a new capital requirement based on a calculation of both methodological and supply/demand uncertainty inherent in instrument valuations. Capturing the uncertainty in a capital requirement would reflect the fact that the uncertainty represents a future risk to the firm.
In other words, building some sort of liquidity risk into the valuations.
However even this has a potential problem, and it’s name is pro-cyclicality:
One of the primary objectives of this charge should be to prevent the build up of leverage based on valuations that are uncertain or, at worst, implausible. Therefore it is important that the design of this charge is intended to dampen unrealisable profits in the upswing. There is a risk that any valuation uncertainty charge would be extremely pro-cyclical if regulators are unwilling to identify risks when market prices are freely available (even though robust liquidity might be absent) yet impose stringent requirements as valuations become more opaque and uncertain as market illiquidity becomes more obvious. A desire to avoid pro-cyclicality should be of primary importance when designing this charge.
Uh oh. “Dampen unrealisable profits” — hear that banks?
And remember this may be a discussion paper, but it is coming from the FSA, the organisation which, as the FT notes, also brought you the world’s first liquidity requirements and err, one of the first banker pay codes.
Related links:
Valuation ranges – Deus Ex Macchiato
Accounting is semi-officially exonerated from causing crisis – FT Alphaville