Adjustment to the current valuation of less liquid positions for regulatory capital purposes
10. Authorised Persons should establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. The Regulator expects Authorised Persons to consider the need for an adjustment to a position's valuation to reflect current illiquidity whether the position is marked-to-market using market prices or observable inputs, third-party valuations or marked-to-model.
11. Bearing in mind that the assumptions made in relation to calculating VaR may not be consistent with the Authorised Person's ability to sell or hedge out less liquid positions, where appropriate, Authorised Persons should take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Reduced liquidity may have arisen from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing the adjustment.
12. Authorised Persons should consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in Guidance note 10.
13 For complex products including, but not limited to, securitisation Exposures and nth-to-default Credit Derivatives, Authorised Persons who are approved to use models to calculate Market Risk should explicitly assess the need for valuation adjustments to reflect two forms of model risk: the model risk associated with using a possibly incorrect valuation methodology; and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.
14. The adjustment to the current valuation of less liquid positions made under Guidance note 11 is likely to impact minimum Capital Requirements and may exceed those valuation adjustments made under the International Financial Reporting Standards and Guidance notes 8 and 9.