| (13) | As a minimum, and without derogating from the relevant requirements specified in regulations 3 and 14 of these Regulations, a bank that invests or trades in instruments, contracts or positions that are measured at fair value shall implement robust governance structures and control processes as part of its risk-management framework for the prudent valuation of the said instruments, contracts or positions, which structures, control processes and risk-management framework shall include the key elements specified below: |
| (a) | Structures, processes, systems and controls |
A bank shall establish and maintain adequate structures, processes, systems and controls in respect of instruments, contracts or positions measured at fair value, which structures, processes, systems and controls—
| (i) | shall explicitly cover the role of the board of directors and the senior management of the bank; |
| (ii) | shall ensure that the board receives regular reports from senior management regarding matters related to the valuation oversight and valuation model performance that were brought to the attention of the senior management for resolution, and all significant changes to valuation policies; |
| (iii) | shall ensure the robust production, assignment and verification of all relevant valuations; |
| (iv) | shall be sufficiently robust— |
| (A) | to ensure and promote the quality, integrity and reliability of all relevant input that affects the valuation of instruments, contracts or positions, in respect of which input the bank shall duly consider— |
| (i) | the frequency and availability of the relevant prices or quotes; |
| (ii) | whether or not the relevant prices represent actual regularly occurring transactions on an arm's length basis; |
| (iii) | the breadth of the distribution of the data and whether it is generally available to all relevant participants in the market; |
| (iv) | the timeliness of the information relative to the frequency of valuations; |
| (v) | the number of independent sources that produce the relevant quotes or prices; |
| (vi) | whether or not the relevant quotes or prices are supported by actual transactions; |
| (vii) | the maturity of the market; and |
| (viii) | the similarity between the instrument, contract or position sold in a transaction and the instrument, contract or position held by the bank; |
| (B) | to appropriately consider and apply all relevant international standards or guidance that may affect the valuation of instruments, contracts or positions, including all relevant financial or accounting standards or statements; |
| (C) | to ultimately ensure that the bank's valuation estimates provide the bank's board of directors, senior management and the Registrar with sufficient certainty that the said valuation estimates are prudent and reliable; |
[Item (C) of subregulation (13)(a)(iv) substituted by regulation 8(a) of Notice No. R. 261 dated 27 March 2015]
| (v) | shall ensure that all relevant new product approval processes include all internal stakeholders relevant to risk measurement, risk control, and the assignment and verification of valuations; |
| (vi) | shall ensure that the bank's control processes for the measurement and reporting of valuations are consistently applied— |
| (B) | across similar instruments or risks; and |
| (C) | across all relevant business lines; |
| (vii) | shall be duly integrated with other risk management structures, policies, procedures, processes and systems, such as credit analysis, within the bank; |
| (viii) | shall be based on duly documented policies and procedures for the process of valuation, which documented policies and procedures, among other things— |
| (A) | shall ensure that all relevant approvals of valuation methodologies are duly documented; |
| (B) | shall duly specify the range of acceptable practices for the initial pricing, marking-to-market or model, valuation adjustments and periodic independent revaluation; |
| (C) | shall include duly defined responsibilities of the various areas involved in the determination of valuations; |
| (D) | shall include the sources of market information to be used and the review of their appropriateness; |
| (E) | shall include appropriate guidelines for the use of unobservable inputs, reflecting the bank's assumptions of what market participants may use when pricing the relevant position; |
| (F) | shall include the frequency of independent valuation; |
| (G) | shall include the timing of closing prices; |
| (H) | shall include all relevant matters related to verification. |
| (ix) | shall ensure that the performance of the bank's relevant models is subject to robust testing and review, particularly under stressed conditions, in order to ensure that the board of directors and senior management of the bank understand any potential limitations of the models; |
| (x) | shall ensure that the bank has in place— |
| (A) | adequate capacity to determine or establish and verify all relevant valuations, particularly during periods of stress; |
| (B) | a board-approved external reporting or disclosure policy— |
| (i) | that complies with the relevant requirements specified in regulation 43; |
| (ii) | that ensures that the bank provides timely, relevant and reliable information; |
| (iii) | that ensures that the bank provides meaningful information relating to— |
| (aa) | the bank's respective modelling techniques and the instruments to which they apply; |
| (bb) | the sensitivity of fair values to modelling inputs and assumptions; |
| (cc) | the impact of stress scenarios on valuations; |
| (iv) | that promotes transparency; |
| (v) | that is subject to regular review to ensure that the information disclosed continues to be relevant and current; |
| (C) | documented policies and procedures for the process of valuation, including procedures for adjusting valuations, end-of-the-month and ad hoc verification procedures; |
[Regulation 39(13)(a)(iv)(C) inserted by regulation 8(b) of Notice No. R. 261 dated 27 March 2015]
| (xi) | shall be subject to clear and independent reporting lines, that is, independent from the front office, which reporting line ultimately shall be to an executive director of the bank; |
| (xii) | shall be subject to internal audit. |
| (b) | Valuation methodologies |
Based on readily available close out prices, which close out prices shall be sourced independently, a bank shall mark to market all positions accounted for at fair value as often as possible, but not less frequently than at the close of business of every day or when the closing price of a particular position or market is published, provided that—
| (A) | unless the bank is a significant market maker in a particular instrument or position, and the bank is in a position to close positions out at mid-market prices, the bank shall use the more prudent side of bid/offer prices; |
| (B) | when estimating fair value the bank shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs; |
| (C) | when observable inputs or transactions are deemed by the bank not to be relevant, such as in a forced liquidation or distressed sale situation, or transactions may not be observable, such as when markets are inactive, the bank shall duly consider any observable data in accordance with its board-approved policies, in order to determine the extent to which such inputs should be regarded as determinative. |
Only when a bank is unable to mark to market positions accounted for at fair value, the bank may use a mark-to-model approach, that is, valuations that are benchmarked, extrapolated or otherwise calculated from a market input, provided that—
| (A) | the senior management of the bank shall be aware of the elements of the trading book or other instruments, contracts or positions that are accounted for at fair value and that are subject to mark-to-model valuations, and shall understand the uncertainty that may exist in the reporting of the risk or performance of the bank; |
| (i) | shall demonstrate to the satisfaction of the Registrar that its mark-to-model approach is prudent; |
| (ii) | shall source market input as frequently as possible; |
| (iii) | shall use generally accepted valuation methodologies relating to particular products as frequently as possible; |
| (iv) | shall have in place formal change control procedures and a secure copy of the model, which copy of the model shall be maintained and periodically used to check all relevant valuations; |
| (C) | when the model was developed internally by the bank, the model— |
| (i) | shall be based on appropriate assumptions, which assumptions shall be assessed by duly qualified persons who shall be independent from the development process; |
| (ii) | shall be approved independently from the front office; |
| (iii) | shall be independently tested. |
| D) | the model shall be subject to periodic review to determine the accuracy of its performance, including an analysis of profit and loss against the risk factors and a comparison of actual close out values to model outputs. |
| (iii) | Independent price verification |
By way of independent price verification, a bank shall regularly but not less frequently than once a month, verify market prices and model inputs for accuracy, which independent price verification in respect of market prices or model inputs—
| (A) | shall be performed by a unit independent from the dealing room; |
| (i) | to identify any errors or biases in pricing; |
| (ii) | to eliminate any inaccurate adjustments to valuations. |
Due to, for example, the uncertainty associated with liquidity in markets, instruments or products accounted for at fair value, that may result in a bank being unable to sell or hedge the said instruments, products or positions in a desired short period of time, a bank shall establish and maintain procedures for considering relevant valuation adjustments, as part of the bank’s risk management framework and mark-to-market or mark-to-model procedure, provided that—
[Words preceding regulation 39(13)(c)(i) substituted by regulation 23(b) of Notice No. 297, GG 40002, dated 20 May 2016]
| (i) | as a minimum, the bank shall duly consider— |
| (A) | valuation adjustments to instruments, products or positions that may be subject to reduced liquidity; |
| (B) | relevant close-out prices for concentrated positions and/or stale positions; |
| (C) | all relevant factors when determining the appropriateness of valuation adjustments or reserves for less liquid positions, including, for example— |
| (i) | the time required to hedge out the position or risks associated with the position; |
| (ii) | the average volatility of bid/offer spreads; |
| (iii) | the availability of independent market quotes; |
| (iv) | the number and identity of market makers; |
| (v) | the average and volatility of trading volumes, including trading volumes during periods of market stress; |
| (vi) | market concentrations; |
| (vii) | the aging of positions; |
| (viii) | the extent to which valuation relies on marking-to-model, and the impact of model risk; |
| (D) | the valuation adjustments or reserves specified below: |
| (i) | unearned credit spreads; |
| (v) | investing and funding costs; |
| (vi) | future administrative costs; and |
| (vii) | where appropriate, model risk; |
[Regulation 39(13)(c)(i)(D) inserted by regulation 8(c) of Notice No. R. 261 dated 27 March 2015]
| (ii) | for complex products, including securitization or resecuritisation exposures and n-th-to-default credit derivative instruments, the bank shall explicitly and continuously assess the need for any relevant valuation adjustment to reflect at least two forms of model risk, namely |
| (A) | the model risk associated with using a possibly incorrect valuation methodology; and |
| (B) | the risk associated with using unobservable and possibly incorrect calibration parameters in the bank's valuation model. |
| (iii) | the bank shall ensure that any relevant adjustment to the current valuation of less liquid positions is duly reflected in the bank’s common equity tier 1 capital and reserve funds, which adjustment may exceed the valuation adjustments made under any relevant financial reporting standard issued from time to time. |
[Regulation 39(13)(c)(iii) substituted by regulation 23(c) of Notice No. 297, GG 40002, dated 20 May 2016]
