RBS 2011 Annual Report Download - page 347

RBS Group 2011 345
11 Financial instruments - valuation
Valuation of financial instruments carried at fair value
Control environment
The Group's control environment for the determination of the fair value of
financial instruments includes formalised protocols for the review and
validation of fair values independent of the businesses entering into the
transactions. There are specific controls to ensure consistent pricing
policies and procedures, incorporating disciplined price verification. The
Group ensures that appropriate attention is given to bespoke
transactions, structured products, illiquid products and other instruments
which are difficult to price.
Akey element of the control environment is the independent price
verification (IPV) process. Valuations are first performed by the business
which entered into the transaction. Such valuations may be directly from
available prices, or may be derived using a model and variable model
inputs. These valuations are reviewed, and if necessary amended, by a
team independent of those trading the financial instruments, in light of
available pricing evidence.
IPV variances are classified as hard, soft or indicative. A variance is hard
where the independent information represents tradable or liquid prices
and soft where it does not. Variances are classed as indicative where the
independent evidence is so subjective or sparse that conclusions cannot
be formed with a sufficient degree of confidence. Adjustments are
required for all hard variances and for aggressive soft variances, with
conservative and indicative variances not requiring automatic adjustment.
IPV is performed at a frequency to match the availability of independent
data. For liquid instruments, the standard is to perform IPV daily. The
minimum frequency of review in the Group is monthly for exposures in
the regulatory trading book and six monthly for exposures in the
regulatory banking book. Monthly meetings are held between the
business and the support functions to discuss the results of the IPV and
reserves process in detail. The IPV control includes formalised reporting
and escalation of any valuation differences in breach of established
thresholds. The Global Pricing Unit (GPU) determines IPV policy,
monitors adherence to that policy and performs additional independent
reviews on highly subjective valuation issues for GBM and Non-Core.
During 2011, the Group made a significant and ongoing investment into
enhancing its already robust control environment. This included
continuing investment into a new global IPV and reserving tool, which
partly automates the process of carrying out IPV and consolidation of
reserves into a single central portal.
Valuation models are subject to a review process which requires different
levels of model documentation, testing and review, depending on the
complexity of the model and the size of the Group's exposure. A key
element of the control environment for model use is a Modelled Product
Review Committee, made up of valuations experts from several functions
within the Group. This committee sets the policy for model
documentation, testing and review, and prioritises models with significant
exposure for review by the Group's Quantitative Research Centre
(QuaRC). Potential valuation uncertainty is a key input in determining
model review priorities at these meetings. The QuaRC team within Group
Risk, which is independent of the trading businesses, assesses the
appropriateness of the application of the model to the product, the
mathematical robustness of the model, and where appropriate, considers
alternative modelling approaches.
Senior management valuation control committees meet formally on a
monthly basis to discuss independent pricing, reserving and valuation
issues relating to both GBM and Non-Core exposures. All material
methodology changes require review and ratification by these
committees. The committees include valuation specialists representing
several independent review functions which comprise market risk,
QuaRC and finance.
The Group Executive Valuation Committee discusses the issues
escalated by the Modelled Product Review Committee, GBM and Non-
Core senior management Valuations Control Committee and other
relevant issues, including the APS credit derivative valuation. This
committee covers key material and subjective valuation issues within the
trading business and provides a ratification to the appropriateness of
areas with high levels of residual valuation uncertainty. Committee
members include the Group Finance Director, the Group Chief
Accountant, Global Head of Market and Insurance Risk, GBM Chief
Financial Officer and Non-Core Chief Financial Officer, and
representation from front office trading and finance.
Valuation issues, adjustments and reserves are reported to GBM, Non-
Core and Group Audit Committees. Key judgmental issues are described
in reports submitted to these Audit Committees.
New products
The Group has formal review procedures owned by Group Operational
Risk to ensure that new products, asset classes and risk types are
appropriately reviewed to ensure, amongst other things, that valuation is
appropriate. The scope of this process includes new business, markets,
models, risks and structures.
Valuation hierarchy
There is a process to review and control the classification of financial
instruments into the three level hierarchy established by IFRS 7. Some
instruments may not easily fall into a level of the fair value hierarchy per
IFRS 7 (see page 350) and judgment may be required as to which level
the instrument is classified.
Initial classification of a financial instrument is carried out by the Business
Unit Control team following the principles in IFRS. The Business Unit
Control team base their judgment on information gathered during the IPV
process for instruments which include the sourcing of independent prices
and model inputs. The quality and completeness of the information
gathered in the IPV process gives an indication as to the liquidity and
valuation uncertainty of an instrument.
These initial classifications are challenged by GPU and are subject to
senior management review. Particular attention is paid during the review
processes upon instruments crossing from one level to another, new
instrument classes or products, instruments that are generating
significant profit and loss and instruments where valuation uncertainty is
high.