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Adjustments for fair value positions within the context of capital
determination under Basel III
Detailed provisions for their implementation
1. Introduction will be by specified by the European Banking
For the determination of tier one capital the Authority (EBA) which has released a
Capital Requirements Regulation (CRR) [3] consultation paper [6] on the corresponding
imposes the principle of prudence upon the technical standard in July 2013 and has
pricing of financial instruments recognized at conducted a quantitative impact study to
fair value. In particular, the prudent value of a further calibrate the prudent valuation regime
fair value position is obtained by subtracting [5]. The final technical standard has been
from its fair value several risk- and cost factors announced for the second quarter of 2014
which are not or only partially accounted for [10].
in its balance sheet value. The differences
between fair values and prudent values of all Capital Requirements Directive III &
of a banks fair value positions have to be Capital Requirements Regulation
subtracted from tier one capital. In a recent
According to CRD III banks have to evaluate,
article [1] we have discussed fundamental
for trading book positions, whether valuation
questions about the prudent requirements,
adjustments (formerly known as reserves) are
giving special consideration to dependencies
required to achieve a prudent valuation level.
between valuation, accounting, and capital
The factors set out in Section 3 have to be
requirements. In this white paper, we briefly
explicitly tested for relevance. If these
review the supervisory authorities
adjustments are material, the banks original
publications related to the topic and
own funds have to be reduced by the
summarize our insights and professional
adjustment insofar as it is unaccounted for in
opinions that we have gained in projects on
the balance sheet fair value.
prudent valuation over recent years.
The CRD III requirements are to a large extent
2. New regulatory requirements identical to those specified in the CRR in
for the valuation of financial article 105 (9 to 13). However, article 34 of
instruments CRR requires the application of prudent
Subsequent to the financial crisis, a adjustments to all fair value assets. This
conservative valuation of fair valued assets explicitly includes positions in the banking
became a requirement, as specified in book. Correspondingly, a reduction in the tier
November 2012 via the CRD III package [9]. one capital by the adjustment amounts that
(Implementation was provided at a national are unaccounted for in the balance sheet is
level. For example, in the UK by the FSAs Dear required for all assets recognized at fair value.
CEO letter [8] and in Germany by circular A threshold for the application of prudent
13/2011 issued by the supervisory authority, valuation adjustments is no longer foreseen.
BaFin[2]). The CRR directly enforces uniform
prudent valuation standards across Europe.
Market price
Early termination Operational risks
uncertainty
Concentration and
Close-out costs
illiquidity adjustments
Figure 1: Prudent Valuation adjustments according to the CRR [3] and the EBA consultation paper
management processes
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