Basel Guidance Links Sound Corporate Governance to Proper Fair Value Accounting

In the wake of FASB’s recent guidance on fair value accounting, the Basel Committee for Banking Supervision has issued guidance to financial institutions and their regulators designed to strengthen their valuation processes for financial instruments. The principles promote strong governance and risk management around valuations and the allocation of sufficient resources to create an independent valuation process.

The application of fair value accounting to a wider range of financial instruments, together with experiences from the recent market turmoil, have emphasized the critical importance of robust risk management and governance control processes around fair value measurements. Moreover, given the significance of fair value measurements for regulatory capital adequacy and internal risk management it is equally important that regulators assess the soundness of valuation practices through the Pillar 2 process under the Basel II Accord.

The guidance is intended for both two-tier and one-tier governance structures. Some countries, such as the Netherlands, use a two-tier structure, where the supervisory function of the board of directors is performed by a separate entity known as a supervisory board, which has no executive functions. Other countries, by contrast, such as the US, use a one-tier structure in which the board has a broader role. Basel refers to both approaches as corporate governance structures, which indeed they are.

A broad theme of the Basel guidance is that regulators should factor in governance and risk management when evaluating a firm’s valuation practices. In addition to communicating their concerns to firms about governance deficiencies, regulators can take informal or formal actions requiring management and the board to remedy the deficiencies in a specified timeframe and provide periodic written progress reports.

Stronger action may be needed if a firm exhibits significant weaknesses in its risk management policies, systems and controls related to valuations. For example, the regulator could determine that the firm needs to hold more capital in relation to its overall risk exposure under Pillar 2 of the Basel II Accord. Further, if such weaknesses call into question the reliability of the fair values, it is appropriate in certain circumstances to exclude from or make adjustments to Tier 1 capital for the associated unrealized gains or require other prudential adjustments for capital purposes such as for potential overstatement of fair value based on a third party valuation.

As part of sound governance, senior management should ensure that appropriate control policies are in place regarding the classification and any subsequent reclassification of financial instruments. Moreover, senior management should ensure that internal policies related to classification and reclassification of financial instruments are applied consistently over time and within a group. There must also be proper documentation supporting the initial classification and any subsequent transfers between asset categories.

Senior management and the board must also ensure that an independent, adequately funded fair valuation process is implemented and subjected to periodic review. As a corollary, there must also be an ongoing review of valuation models.

For inactive markets, a firm needs to put more work into the valuation process to gain assurance that the transaction price provides evidence of fair value or to determine the adjustments to transaction prices that are necessary to measure the fair value of the instrument. When a market is not active, a firm will measure fair value using a valuation model reflecting current market conditions.

Basel said it is fundamental that final approval of valuations should not be the responsibility of the risk taking units. There should be clear and independent reporting lines to ensure that valuations are independently determined. Financial institutions should maintain functional separation between the risk taking units that typically provide the initial fair valuation estimates and the measurement unit providing independent price verification.

Sound internal and external auditor procedures play an important role in the bank’s validation process. Auditors should devote considerable resources to reviewing the control environment, the availability and reliability of information or evidence used in the valuation process, and the reliability of estimated fair values. This includes the price verification processes and testing valuations of significant transactions. Auditors should also evaluate whether the disclosures about fair values made by the bank are in accordance with applicable accounting standards.

The use of a third-party pricing service for fair valuations for financial instruments does not relieve the board of its oversight responsibility or senior management of its responsibility to ensure appropriate fair valuations and provide appropriate supervision, monitoring and management of risks. Management should have a due diligence process by which it assesses third party pricing services that it uses for fair valuations so that it has a sufficient basis upon which to determine the appropriateness of the techniques used, the underlying assumptions and selection of inputs and the consistency of application.