RBS 2012 Annual Report Download - page 405

RBS GROUP 2012
403
The level 3 sensitivities above are calculated at a trade or low level
portfolio basis. They are not calculated on an overall portfolio basis and
therefore do not reflect the likely overall potential uncertainty on the
whole portfolio. The figures are aggregated and do not reflect the
correlated nature of some of the sensitivities. In particular, for some of the
portfolios the sensitivities may be negatively correlated where a
downwards movement in one asset would produce an upwards
movement in another, but due to the additive presentation of the above
figures this correlation cannot be observed. The actual potential
downside sensitivity of the total portfolio may be less than the non-
correlated sum of the additive figures as shown in the above table.
Judgmental issues
The diverse range of products traded by the Group results in a wide
range of instruments that are classified into the three level hierarchy.
Whilst the majority of these instruments naturally fall into a particular
level, for some products an element of judgment is required. The majority
of the Group’s financial instruments carried at fair value are classified as
level 2: inputs are observable either directly (i.e. as a price) or indirectly
(i.e. derived from prices).
Active and inactive markets
A key input in the decision making process for the allocation of assets to
a particular level is liquidity. In general, the degree of valuation
uncertainty depends on the degree of liquidity of an input. For example, a
derivative can be placed into level 2 or level 3 dependent upon its
liquidity.
Where markets are liquid or very liquid, little judgment is required.
However, when the information regarding the liquidity in a particular
market is not clear, a judgment may need to be made. This can be made
more difficult as assessing the liquidity of a market may not always be
straightforward. For an equity traded on an exchange, daily volumes of
trading can be seen, but for an over-the counter (OTC) derivative
assessing the liquidity of the market with no central exchange can be
more difficult.
A key related issue is where a market moves from liquid to illiquid or vice
versa. Where this change is considered to be temporary, the
classification is not changed. For example, if there is little market trading
in a product on a reporting date but at the previous reporting date and
during the intervening period the market has been considered to be
liquid, the instrument will continue to be classified in the same level in the
hierarchy. This is to provide consistency so that transfers between levels
are driven by genuine changes in market liquidity and do not reflect short
term or seasonal effects.
Interaction with the IPV process
The determination of an instrument’s level cannot be made at a global
product level as a single product type can be in more than one level. For
example, a single name corporate credit default swap could be in level 2
or level 3 depending on whether the reference counterparty is liquid or
illiquid.
As part of the Group’s IPV process, data is gathered at a trade level from
market trading activity, trading systems, pricing services, consensus
pricing providers, brokers and research material amongst other sources.
The breadth and depth of this data allows a good assessment to be made
of liquidity and pricing uncertainty, which assists with the process of
allocation to an appropriate level. Where suitable independent pricing
information is not readily available the instrument will be considered to be
level 3.
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.