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Notes on the consolidated accounts
412
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.
A key 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 the light of
available pricing evidence.
A new IPV quality hierarchy was implemented with detailed classifications
linked to the fair value hierarchy principles as laid out in IFRS 13 ‘Fair
value measurement’. The new hierarchy classifies IPV differences into
fair value levels 1, 2 and 3 with the valuation uncertainty risk increasing
as the levels rise from 1 to 3. These differences are then further classified
into high, medium, low and indicative depending on the quality of the
independent data available to validate the prices. Valuations are revised
if they are outside agreed thresholds for each of the levels.
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 quarterly 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. 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 Markets and Non-Core.
In 2013, the Group made a significant and ongoing investment into
further enhancing its control environment. This included continuing
investment in global IPV and reserving tools which partly automated the
IPV and reserves process into a single central portal. System
developments included implementing a rules based approach which
ensures consistency across portfolios and the use of hierarchy of
independent data inputs.
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.
The Management Valuation Control Committees meet formally on a
monthly basis to discuss independent pricing, reserving and valuation
issues relating to both Markets and Non-Core exposures. All material
methodology changes require review and ratification by these
committees. The committees, which include valuation specialists
representing several independent review functions, comprise Market
Risk, QuaRC, Finance and senior business representatives.
The Group Executive Valuation Committee discusses the issues
escalated by the Modelled Product Review Committee, Markets and Non-
Core Management Valuations Control Committees and other relevant
issues. This committee covers key material and subjective valuation
issues within the trading businesses 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, the Group Head of Market Risk, the Markets
Chief Financial Officer, the Non-Core Chief Financial Officer, the Head of
QuaRC, the Head of GPU and representation from Front Office Trading
and Finance.
Valuation issue, adjustments and reserves are reported to Markets, Non-
Core and Group audit committees. Key judgmental issues are described
in the reports submitted to these Audit Committees.
Market risk metrics such as value-at-risk (VaR) and stressed value-at-risk
(SVaR) cover financial instruments in Markets and Non-Core. The Group
has a framework to quantify those market risks not adequately captured
by standard market risk framework such as VaR and SVaR - Risks not in
VaR. Refer to pages 323 to 329 for details.
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.