Watch Out, There’s a Regulator About
Anyone involved in providing valuation advice will put great store on their freedom to come to an independent opinion. To a large extent this is surely only right and proper. Not only is independence of mind necessary to achieve objectivity, it also mirrors the actions of market participants, who will price assets in a free market according to their own view of supply and demand, not according to a prescribed formula or the diktat of a central authority. However, like many freedoms, independence in valuation needs to be exercised responsibly if it is not to be threatened. And there have been enough examples of egregious valuation for the financial regulators to get involved, bringing the threat of regulation that may compromise the freedom that is essential for effective valuation.
The European Supervisory Authorities (ESAs) for securities (ESMA), banking (EBA), and insurance and occupational pensions (EIOPA) have just issued their latest joint report on Risks and Vulnerabilities in the EU financial system. The report highlights a number of potential threats to financial stability in the EU. Unsurprisingly, the risks associated with possible financial outcomes of the political and economic situations in China and Greece feature prominently. However, the ESAs are also increasingly concerned at the impact of low interest rates, which affect not only the continuing profitability of financial institutions but also are leading to yield compression as institutions chase better returns. And their concern is amplified by the fact that the pricing of some of the assets that are in vogue is not adequately reflecting their relative lack of liquidity.
All of these concerns will not come as a surprise to observers of the financial markets, but what action are the ESAs intending to take? These joint reports are indicative of current agenda priorities for the three supervisory authorities, but are also intended to influence the competent national authorities of EU member states, which in many cases are responsible for the supervision of financial institutions within their jurisdiction.
So when the joint report calls for “rigorous action” on asset quality and in particular valuation risk associated with illiquid markets, those involved in commissioning or preparing valuations need to pay attention. Banks, fund managers, insurers and pension providers can all expect greater scrutiny of the values of their assets and liabilities and pressure for adequate disclosure of risks and uncertainties. Indeed, the report could hardly use more forthright language, saying that “rigorous valuation of assets and liabilities and transparency in the disclosure of valuation risk is essential to discourage mis-valuation tendencies.”
Valuation uncertainty was of course identified by the predecessor body of the Financial Stability Board as one of the prime causes of the 2008 crisis, and clearly there is concern that the lessons from eight years ago are not only learned but applied. The International Valuation Standards Council (IVSC) has recently produced useful guidance on the identification and disclosure of valuation uncertainty and awareness of this would be helpful to all those involved in the process of preparing, approving or analysing valuations.
The report also champions the need for consistency across member states in the disclosure of risk exposures which it identifies as a key supervisory concern. While banks are still subject to immense scrutiny as the supervisors look for consistency in implementing valuation and risk disclosures under the Capital Requirements Regulation and Directive, the report expresses particular concern over the insurance industry. This is perhaps because the banking industry now has had a few years of experience implementing the CRR and CRD, but with Solvency II only coming into operation in 2016, many insurers will be coming to this for the first time.
The report confirms that the EBA is to embark on a transparency exercise later in the year to publish detailed data on all EU banks' balance sheets, including their “risk weighted assets” categorised by sovereign risk, credit risk, market risk and securitisation exposures. It does not require a huge leap of imagination to anticipate EIOPA following suite once Solvency II starts to be implemented in earnest.
All these concerns about valuation consistency and disclosure are not particularly new, but the sense of urgency in this latest report suggests that supervisory bodies are moving them up the list of priorities. This in turn puts the pressure on the financial industry to meet the expectations of “rigour” and consistency, and to ensure that the concerns about liquidity and yield compression, as well as the macroeconomic threats mentioned, are not only factored in but can be shown to be factored into valuations.
And if the industry does not respond adequately? The report contains the following statement:
“…any adequate policy action should target the resolution of frictions detected in the valuation of assets and the functioning of markets in which those assets are traded, thereby improving liquidity conditions and pricing efficiency.”
Some will see irony in this statement as it can be cogently argued that “policy action” has been a major factor in reducing the liquidity of the bond markets. Relaxing the capital adequacy requirements that have resulted in loss of liquidity could be one way of improving the function of the market and "pricing efficiency", but I somehow doubt this is what the ESAs have in mind. It is more likely that they believe more regulation around the valuation process itself can achieve these objectives. Could this work?
Requiring valuations to be undertaken and reported in accordance with recognised valuation standards would help improve confidence those valuations by those who rely on them. To the extent that increased confidence in any market will increase the propensity to transact then better valuation practice can assist market efficiency. Providing it stops there then regulatory action could have a positive impact. However, any move to introduce regulatory prescription around the methods or models used in the valuation process would surely have the opposite effect. If valuations had to be prepared according to a regulator's recipe rather than current market practice a credibility gap could quickly open, resulting in confusion and reductions in confidence and market efficiency.
One way of reducing the threat of further regulatory intervention in the valuation process is for the industry to set its own house in order. If all institutions heed the warnings explicit in the ESAs' report and ensure that they are adopting best practice in the undertaking and reporting of valuations, the regulatory spotlight would move away to the next problem. Surely an industry led solution has to be preferable to a sub optimal regulatory regime being imposed sometime in the future?