Asset valuation: Is your framework fit for purpose?

Background

On the 14th December 2023, the Central Bank of Ireland (CBI) released a letter highlighting the main findings of its work on asset valuation, which sets out its expectations to be adopted by all firms to mitigate the issues identified in Irish Fund Management Companies (Firms). Firms are now required to conduct a review of their asset valuation frameworks by the end of Q2 2024 to ensure they are both fit for purpose and in line with relevant legislative requirements. The contents of the letter should also be considered in conjunction with the European Securities and Markets Authority’s (ESMA) report was published on 24 May 2023. This report sets out ESMA’s analysis and conclusions on its January 2022 Common Supervisory Action (CSA) exercise and presents ESMA’s views on the findings.

The CSA was targeted at National Competent Authorities (NCAs) on the supervision of asset valuation rules under both the Alternative Investment Fund Managers (AIFM) and Undertakings for Collective Investment in Transferable Securities (UCITS) Directives. It aimed to evaluate and enforce compliance of supervised entities with organisational requirements and valuation principles, ensuring accurate representation of financial positions in normal and stressed market conditions.

CBI and ESMA observations

Most NCAs considered that there is an overall satisfactory level of compliance of supervised entities with the applicable regulatory requirements, but a number of thematic shortcomings and vulnerabilities were identified under the following headings:

• Processes
• Infrastructure
• Methodologies

Why is this important?

ESMA and the CBI have made it clear that valuation procedure deficiencies that were identified throughout the course of the CSA will be a high priority in discussions with NCAs. Current market conditions have introduced challenges to many investment funds that have exposure to less liquid markets, namely private equity and real estate. Long term model dependency and exposure to large revaluation risks have been highlighted by ESMA.

Focusing on the four below critical areas in the coming months will mitigate much of the deficiencies discovered in the CSA:

• Policies and procedures
  • Creation of robust documentation, application and validation policies need to be prioritised.
  • Creation of asset valuation policies and procedures at entity level taking into account the local regulatory environment.
• Error detection
  • Establishing an early detection, escalation and investor transparency procedure is a key area of focus for the CBI and other NCAs.
• Lack of independent valuation
  • Particularly amongst portfolio managers (PMs), there was a lack of independent checks and validations of asset valuations. PMs need to revisit external vendors and the firm’s reliance on them.
• Normal and stressed market conditions
  • Periodic liquidity stress tests need to be performed in normal and stressed market conditions, with particular focus on less-liquid assets.

Valuation processes

Results showed a lack of robust documentation and established policies and procedures. The incorporated policies and procedures should undergo frequent reviews. The implementation of these procedures should be consistent across any asset valuations performed by the company. ESMA emphasises that such processes promote valuation modelling that is both transparent and appropriate particularly in stressed market conditions.

Infrastructure

Effective infrastructure is crucial for maximising the benefits of these processes. With the following areas noticeably lacking:

• Systematic incorporation of Liquidity Stress Tests (LST) outcomes.
• Insufficient automatic triggers for deploying new models.
• Pre-scheduled meetings to tackle identified weaknesses.

ESMA emphasises the need for a systematic incorporation of the outcome of LST under stressed market conditions, particularly for less liquid assets.

The monitoring systems in place should have predefined conditions signaling when a different valuation model should be used.

ESMA advise that pre-planned follow up meetings should be held frequently to address any weaknesses identified in the asset valuation model. Appropriate personnel should be in place to assess these weaknesses.

How can Grant Thornton support?

ESMA and CBI have highlighted the importance of implementing robust methods to ensure accurate reporting of valuation results and a strong governance framework to oversee such results. Grant Thornton can assist you as follows:

• Stress conditions
  • Grant Thornton Ireland’s financial services offering includes the largest dedicated advisory, financial services focused sector unit in the market that provides leading risk, consulting and advisory services to a range of EU banks and financial services firms.
• Vendors
  • Our quantitative risk advisory unit provide end-to-end support to banking clients in their quest to oversee and manage their credit, market and operational risk exposure, in accordance with European Central Bank (ECB) and Prudential Regulation Authority (PRA) regulatory requirements.
• Governance
  • Our quantitative risk services to financial services span across the areas of model development, validation, assurance and portfolio risk management.

Contact our team

Our services are flexible and efficient, designed to facilitate and support your business model. Contact us today to discuss any challenges you may have in respect of your valuation framework, and to find out more about how we can assist you in advance of the CBI’s upcoming Q2 deadline.