European Banking Authority on Prudential Valuations (PVA)

The current regulation, introduced in 2016, aimed to establish a standardised approach for valuing these assets for regulatory purposes. While it achieved a degree of convergence in valuation practices, the EBA recognises ongoing implementation issues, and remaining inconsistencies in applying the regulation. The consultation outlines targeted amendments designed to address these issues.

What is at stake

The prudent valuation of a financial instrument is calculated in such a way that its valuation corresponds to an exit price with a confidence level of at least 90%. This prudent value is estimated by means of additional valuation adjustments (AVAs), which reflect the uncertainty factors influencing the fair value. AVAs are defined and calculated in accordance with the guidelines of the RTS on Prudent Valuation introduced in 2016. AVAs are deduction to Common Equity Tier 1 capital; modification of their calculation can lead to material move in capital requirements.

What are the main proposed changes?

The main objectives of the future amendments, and their respective proposed actions, are:

Strengthen and clarify the rules for calculating AVAs to achieve a satisfactory level of conservatism and reduce the variability of AVAs under the core approach.

• Increase the frequency of AVA observations for specific institutions needing closer monitoring.
• Clarify the scope of application of Future Administrative Costs.
• Clarify the calculation of Unearned Credit Spread AVAs (capital deductions for potential future credit losses).
• More stringent constraints for parameters reduction, and more complexity for the Variance Ratio Test computation
• Change methodology for operational risk to be consistent with new CCR regulations.
• Extend the scope of the Fall-Back approach, 
• Standardise data sources and pricing models used for AVA calculation through new requirements.
• Consider liquidity horizons greater than 10 days in the calculation of Concentrated Positions

Modify AVAs' calculation methods and harmonise approaches for greater convergence between institutions.

• Define one aggregation method for Market Price Uncertainty, Close-out Costs and Model Risk AVAs
• Include back-to-back derivatives and SFTs in the computation of the threshold.
• Re-calibrate the fall-back approach, to be less conservative than before so that actors would be less reluctant to apply it.
• Change the diversification factor-alpha to be more conservative for “optimised” settings.
• Reduce AVAs values in exceptional circumstances.

Define conditions and extraordinary circumstances under which the calculation of AVAs goes beyond the framework of the previously defined regulation.

• ESG: Monitor on pricing approaches to identify potential new risk drivers.
• Define extraordinary circumstances involving a change in the calculation rules, and determine new diversification factors under these circumstances.

Foreseeable impacts

The amendments proposed by the EBA are likely to significantly impact banking institutions, depending on their exposure to the modifications that will be brought to the RTS.

In general, the following impacts are expected:

• An increase in AVAs due to the strengthening of calculation rules and the extension of the scope of the fall-back approach.
• An increase in operational costs due to more demanding calculation frequencies, more complex implementation methods or greater inspection and documentation work.
• An increase in the number of institutions concerned by the core approach following the inclusion of back-to-back derivatives and securities financing transactions (SFT) in the calculation of the threshold.

These elements constitute significant incentives for banking institutions to engage in a process of improving existing methodologies and tools and anticipating possible costs to comply with new regulatory requirements.

Although the timetable for the final text is not yet known, the expected impacts can be significant, and it is, therefore, essential for banking institutions to mobilise their resources and launch action plans that revolve around the priorities identified during the response to the consultation.

How we can support you

MQS has senior experts with previous leading roles within the industry on AVA, access to a wide industry benchmark thanks to our external audit and advisory G-SIBs mandates. We can provide you with assistance on:

• Gap assessment on proposed amendments
• Remediation plan & impacts
• Implementation of remediation plan

Get in touch