Letter on Fair Values under IFRS - Use of Valuation Models

[Logo: Banque Nationale de Belgique / National Bank of Belgium]

THE GOVERNOR

Brussels, 30 July 2013

Madam, Sir,

This letter concerns the use by Belgian financial institutions of "fair value" in their annual consolidated accounts prepared in accordance with IFRS standards, as well as in their IFRS reporting to the National Bank of Belgium (NBB). This letter is addressed to all relevant credit institutions and their approved auditors. It follows up on the analysis of a cross-sectional survey conducted on a sample of financial institutions regarding fair value assessments under IFRS for financial statements as of June 2012.

It is recalled that IFRS accounting standards provide that when markets are active, financial instruments are valued at market value (IAS 39.AG71 in fine: "The existence of published quotations in an active market constitutes the best indication of fair value; when they exist, they are used to value the financial asset or liability").

In a document from October 2008 titled Measuring and disclosing the fair value of financial instruments in markets that are no longer active, the IASB Expert Advisory Panel attributes the following characteristics to an inactive market (free translation of paragraphs 18 and 19):

• significant decrease in the volume and level of transactions;
• significant disparity in prices over time or among market participants, or the unavailability of current prices.

However, these factors taken in isolation do not necessarily mean that the market has become inactive. An active market is a market where transactions occur regularly between unrelated counterparties. The meaning to be given to the term "regularly" is a matter of judgment and depends on the facts and circumstances of the market for the relevant financial instrument. When a market is not active, fair value may be measured by using a valuation technique. This technique must take into account current market conditions. This is why fair value measurement must take into account a transaction price of an identical or similar instrument.

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It is also important to take into account the following text regarding the concept of "inactive market": "The issue to be addressed, therefore, is not about market activity per se, but about whether the transaction price observed represents fair value" (IASB Expert Advisory Panel, Measuring and disclosing the fair value of financial instruments in markets that are no longer active, paragraph 17 in fine).

The above considerations are detailed in IFRS 13, paragraphs 61-65 and Appendix B, paragraphs B37-47 (this standard, endorsed by the European Commission in December 2012, entered into force on 1 January 2013).

For the determination of fair value under IFRS, the following points should be considered as minimum requirements:

1. if the fair value adopted deviates significantly (based on a criterion to be defined by the institution) from the market value, the institution must convincingly demonstrate - for each position individually - that the relevant market is inactive, and that values observed in the market are not representative of fair value in light of IFRS. The use of a valuation model can only be justified in the absence of any relevant market value for the relevant position. It is also useful in this regard to develop decision-making rules for each distinct financial instrument;

2. a valuation model must use as input parameters relevant and specific market data (sub-indices, transactions on the primary/secondary market for similar issuers and collateral, data on credit spreads for similar collateral, broker quotations and pricing services, etc.) so that the resulting valuations are representative;

3. certain categories of products require particular attention due to their specific and/or complex pay-off function. The valuation model used must be adapted to the specifics of a complex financial instrument;

4. the management bodies of the financial institution ensure that the fair value assessment of financial instruments is subject to adequate control and reporting procedures. This notably implies:

• that the management committee establishes an official valuation policy and revises it at regular intervals; this policy describes acceptable valuation techniques and data sources and indicates when a valuation technique should be questioned; it is submitted periodically (at least annually) for the appreciation of the board of directors;
• that discrepancies between valuation for financial reporting purposes and that intended for risk management are identified and documented;
• that the valuation of financial instruments is determined using a structured process that provides for internal critical questioning (challenger), among other things, regarding the appropriateness of the market information used and the soundness of the resulting valuation;
• that the management committee allocates the necessary resources for the valuation of financial instruments;
• that internal audit includes the process of determining fair values in its audit universe.

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In the context of its prudential assessment of the adequacy of valuation models, the NBB applies the following principles:

a) a valuation model must present a suitable structure that includes logically explainable intermediate steps and results, clearly set out in the model documentation and covered by an internal validation cycle carried out by a party independent of the developers and users;

b) all tests performed (and notably sensitivity analyses and assumption verification) must be proportional to the complexity of the model;

c) the way in which the model exploits its input parameters (relevant and specific market data) must be consistent with market best practices in terms of modeling and calibration techniques. The selection of techniques takes into account their restrictions and scope of application;

d) values provided by a model are expected to align with market values of similar positions and to be consistent over time. The latter aspect implies that the evolution of valuations over time appears plausible relative to the evolution of market values of other relevant positions;

e) the internal critical questioning (challenge) mentioned above must provide management bodies with all the information enabling them to make an informed decision regarding fair value assessment, and to make appropriate adjustments to the results provided by a valuation model, if necessary.

Please note that a copy of this letter is sent to the approved auditor(s) of your institution.

Please accept, Madam, Sir, the assurance of my distinguished consideration.

[Signature: Luc Coene] Luc Coene