RBS 2011 Annual Report Download - page 356

354 RBS Group 2011
11 Financial instruments - valuation continued
Modelled products
For modelled products the market convention is to quote these trades
through the model inputs or parameters as opposed to a cash price
equivalent. A mark-to-market is derived from the use of the independent
market inputs calculated using the Group’s model.
The decision to classify a modelled asset as level 2 or 3 will be
dependent upon the product/model combination, the currency, the
maturity, the observability of input parameters and other factors. All these
need to be assessed to classify the asset.
An assessment is made of each input into a model. There may be
multiple inputs into a model and each is assessed in turn for observability
and quality. If an input fails the observability or quality tests then the
instrument is considered to be in level 3 unless the input can be shown to
have an insignificant effect on the overall valuation of the product.
The majority of derivative instruments are classified as level 2 as they are
vanilla products valued using observable inputs. The valuation
uncertainty on these is considered to be low and both input and output
testing may be available. Examples of these products would be vanilla
interest rate swaps, foreign exchange swaps and liquid single name
credit derivatives.
Non-modelled products
Non-modelled products are generally quoted on a price basis and can
therefore be considered for each of the 3 levels. This is determined by
the liquidity and valuation uncertainty of the instruments which is in turn
measured from the availability of independent data used by the IPV
process.
The availability and quality of independent pricing information is
considered during the classification process. An assessment is made
regarding the quality of the independent information. For example where
consensus prices are used for non-modelled products, a key assessment
of the quality of a price is the depth of the number of prices used to
provide the consensus price. If the depth of contributors falls below a set
hurdle rate, the instrument is considered to be level 3. This hurdle rate is
consistent with the rate used in the IPV process to determine whether or
not the data is of sufficient quality to adjust the instrument’s valuations.
However, where an instrument is generally considered to be illiquid, but
regular quotes from market participants exist, these instruments may be
classified as level 2 depending on frequency of quotes, other available
pricing and whether the quotes are used as part of the IPV process or
not.
For some instruments with a wide number of available price sources,
there may be differing quality of available information and there may be a
wide range of prices from different sources. In these situations an
assessment is made as to which source is the highest quality and this will
be used to determine the classification of the asset. For example, a
tradable quote would be considered a better source than a consensus
price.
Instruments that cross levels
Some instruments will predominantly be in one level or the other, but
others may cross between levels. For example, a cross currency swap
may be between very liquid currency pairs where pricing is readily
observed in the market and will therefore be classified as level 2. The
cross currency swap may also be between two illiquid currency pairs in
which case the swap would be placed into level 3. Defining the difference
between liquid and illiquid may be based upon the number of consensus
providers the consensus price is made up from and whether the
consensus price can be supplemented by other sources.
Level 3 portfolios and sensitivity methodologies
For each of the portfolio categories shown in the tables above, there
follows a description of the types of products that comprise the portfolio
and the valuation techniques that are applied in determining fair value,
including a description of valuation techniques used for levels 2 and 3
and inputs to those models and techniques. Where reasonably possible
alternative assumptions of unobservable inputs used in models would
change the fair value of the portfolio significantly, the alternative inputs
are indicated. Where there have been significant changes to valuation
techniques during the year a discussion of the reasons for this are also
included.
Loans and advances to customers
Loans in level 3 primarily comprise loans to emerging market
counterparties, structured loans and legacy commercial mortgages.
Commercial mortgages
These senior and mezzanine commercial mortgages are loans secured
on commercial land and buildings that were originated or acquired by the
Group for securitisation. Senior commercial mortgages carry a variable
interest rate and mezzanine or more junior commercial mortgages may
carry a fixed or variable interest rate. Factors affecting the value of these
loans may include, but are not limited to, loan type, underlying property
type and geographic location, loan interest rate, loan to value ratios, debt
service coverage ratios, prepayment rates, cumulative loan loss
information, yields, investor demand, market volatility since the last
securitisation andcredit enhancement. Where observable market prices
for a particular loan are not available, the fair value will typically be
determined with reference to observable market transactions in other
loans or credit related products including debt securities and credit
derivatives. Assumptions are made about the relationship between the
loan and the available benchmark data.
Notes on the consolidated accounts continued