RBS 2012 Annual Report Download - page 406

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Notes on the consolidated accounts continued
11 Financial instruments - valuation continued
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.
Overview of sensitivity methodologies
Reasonably possible alternative assumptions of unobservable inputs are
determined based on a 95% confidence interval. The assessments
recognise different favourable and unfavourable valuation movements
where appropriate. Each unobservable input within a product is
considered separately and sensitivity is reported on an additive basis.
Alternative assumptions are determined with reference to all available
evidence including consideration of the following: quality of independent
pricing information taking into account consistency between different
sources, variation over time, perceived tradability or otherwise of
available quotes; consensus service dispersion ranges; volume of trading
activity and market bias (e.g. one-way inventory); day 1 P&L arising on
new trades; number and nature of market participants; market conditions;
modelling consistency in the market; size and nature of risk; length of
holding of position; and market intelligence.
Loans and advances to customers
Loans in level 3 primarily comprise loans to emerging market
counterparties and, legacy commercial and residential mortgages.
Loans to emerging market counterparties
The trades in each loan structure are valued using curves using a proxy
methodology. Each curve consists of the independent proxy value and
various basis adjustments, such as those relating to loan-CDS basis,
credit basis, tenor and liquidity. For the low and high valuation scenarios
for the structures, these different bases are flexed up and down within the
range that each one is deemed to span. The resultant maximum and
minimum scenario curves are used to value the assets and liabilities in
the structure separately. The low valuation scenario is the one that
minimises the assets and maximises the liabilities. The high valuation
scenario is the converse.
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 and credit 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.
Residential mortgages
These pools of residential mortgages were mostly acquired for
securitisation before the 2008 financial crisis. Factors that affect the
value, or liquidation level, of these loans are geographic location, current
loan-to-value, condition of the home, and availability of eligible buyers.
The loans are serviced by various mortgage servicers. Operations and
the Front Office monitor the performance of these loans and the
valuations are tested against an estimated recovery level as part of the
IPV process. The market for non-agency securitisation remains extremely
weak and is restricted to new issue prime loans.
Debt securities
Level 3 debt securities principally comprise asset-backed securities.
Residential mortgage-backed securities (RMBS)
RMBS where the underlying assets are US agency-backed mortgages
and there is regular trading are generally classified as level 2 in the fair
value hierarchy. RMBS are also classified as level 2 when regular trading
is not prevalent in the market, but similar executed trades or third-party
data including indices, broker quotes and pricing services can be used to
substantiate the fair value. RMBS are classified as level 3 when trading
activity is not available and a model with significant unobservable data is
utilised.