CHAPTER III

CORE APPROACH FOR THE DETERMINATION OF AVAs

Overview of the core approach
Article 7
1
Institutions shall calculate AVAs under the core approach, by applying the following two-step approach:
a
they shall calculate AVAs for each of the categories described in paragraphs 10 and 11 of Article 105 of Regulation (EU) No 575/2013 (‘category level AVAs’) according to paragraph 2 of this Article;
b
they shall sum the amounts resulting from point (a) for each of the category level AVAs to provide the total AVAs for the purposes of Article 1.
2
For the purposes of point (a) of paragraph 1, institutions shall calculate category level AVAs in one of the following ways:
a
according to Articles 9 to 17;
b
where the application of Articles 9 to 17 is not possible for certain positions, according to a ‘fall-back approach’, whereby they shall identify the related financial instruments and calculate an AVA as the sum of the following:
1. 100 % of the net unrealised profit on the related financial instruments;
2. 10 % of the notional value of the related financial instruments in the case of derivatives;
3. 25 % of the absolute value of the difference between the fair value and the unrealised profit, as determined in point (i), of the related financial instruments in the case of non-derivatives.
For the purposes of point (b)(i) of the first paragraph, ‘unrealised profit’ shall mean the change, where positive, in fair value since trade inception, determined on a first-in-first-out basis.

General provisions for the calculations of AVAs under the core approach
Article 8
1
For fair-valued assets and liabilities for which a change in accounting valuation has a partial or zero impact on CET1 capital, AVAs shall only be calculated based on the proportion of the accounting valuation change that impacts CET1 capital.
2
In relation to the category level AVAs described in Articles 14 to 17, institutions shall aim to achieve a level of certainty in the prudent value that is equivalent to that set out in Articles 9 to 13.
3
AVAs shall be considered to be the excess of valuation adjustments required to achieve the identified prudent value, over any adjustment applied in the institution's fair value that can be identified as addressing the same source of valuation uncertainty as the AVA. Where an adjustment applied in the institution's fair value cannot be identified as addressing a specific AVA category at the level at which the relevant AVAs are calculated, that adjustment shall not be included in the calculation of AVAs.
4
AVAs shall always be positive, including at valuation exposure level, category level, both pre and post aggregation.

Calculation of market price uncertainty AVA
Article 9
1
Market price uncertainty AVAs shall be calculated at valuation exposure level (‘individual market price uncertainty AVAs’).
2
The market price uncertainty AVA shall only be assessed to have zero value where both of the following conditions are met:
a
the institution has firm evidence of a tradable price for a valuation exposure or a price can be determined from reliable data based on a liquid two-way market as described in the second subparagraph of Article 338(1) of Regulation (EU) No 575/2013;
b
the sources of market data set out in Article 3(2) do not indicate any material valuation uncertainty.
3
Where a valuation exposure cannot be shown to have a zero AVA, when assessing the market price uncertainty AVA institutions shall use the data sources defined in Article 3. In this case the calculation of the market price uncertainty AVA shall be performed as described in paragraphs 4 and 5.
4
Institutions shall calculate AVAs on valuation exposures related to each valuation input used in the relevant valuation model.
a
The granularity at which those AVAs shall be assessed shall be one of the following:
1. where decomposed, all the valuation inputs required to calculate an exit price for the valuation position;
2. the price of the instrument.
b
Each of the valuation inputs referred to in point (a)(i) shall be treated separately. Where a valuation input consists of a matrix of parameters, AVAs shall be calculated based on the valuation exposures related to each parameter within that matrix. Where a valuation input does not refer to tradable instruments, institutions shall map the valuation input and the related valuation exposure to a set of market tradable instruments. Institutions may reduce the number of parameters of the valuation input for the purpose of calculating AVAs using any appropriate methodology provided the reduced parameters satisfy all of the following requirements:
1. the total value of the reduced valuation exposure is the same as the total value of the original valuation exposure;
2. the reduced set of parameters can be mapped to a set of market tradable instruments;
3. the ratio of variance measure 2 defined below over variance measure 1 defined below, based on historical data from the most recent 100 trading days, is less than 0,1.
For the purposes of this paragraph,
‘
variance measure 1
’
shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input and
‘
variance measure 2
’
shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input minus the valuation exposure based on the reduced valuation input.
c
Where a reduced number of parameters is used for the purpose of calculating AVAs, the determination that the criteria set out in point (b) are met shall be subject to independent control function review of the netting methodology and internal validation on at least an annual basis.
5
Market price uncertainty AVAs shall be determined as follows:
a
where sufficient data exists to construct a range of plausible values for a valuation input:
1. for a valuation input where the range of plausible values is based on exit prices, institutions shall estimate a point within the range where they are 90 % confident they could exit the valuation exposure at that price or better;
2. for a valuation input where the range of plausible values is created from mid prices, institutions shall estimate a point within the range where they are 90 % confident that the mid value they could achieve in exiting the valuation exposure would be at that price or better;
b
where insufficient data exists to construct a plausible range of values for a valuation input, institutions shall use an expert-based approach using qualitative and quantitative information available to achieve a level of certainty in the prudent value of the valuation input that is equivalent to that targeted under point (a). Institutions shall notify competent authorities of the valuation exposures for which this approach is applied, and the methodology used to determine the AVA;
c
institutions shall calculate the market price uncertainty AVA based on one of the following approaches:
1. they shall apply the difference between the valuation input values estimated according to either point (a) or point (b), and the valuation input values used for calculating fair value to the valuation exposure of each valuation position;
2. they shall combine the valuation input values estimated according to either point (a) or point (b) and they shall revalue valuation positions based on those values. Institutions shall then take the difference between the revalued positions and fair-valued positions.
6
Institutions shall calculate the total category level AVA for market price uncertainty by applying to individual market price uncertainty AVAs the formulae for either Method 1 or Method 2 laid down in the Annex.

Calculation of close-out costs AVA
Article 10
1
Close-out costs AVAs shall be calculated at valuation exposure level (‘individual close-out costs AVAs’).
2
When an institution has calculated a market price uncertainty AVA for a valuation exposure based on an exit price, the close-out cost AVA may be assessed to have zero value.
3
Where an institution applies the derogation referred to in paragraph 5 of Article 105 of Regulation (EU) No 575/2013, the close-out costs AVA may be assessed to have zero value, on the condition that the institution provides evidence that it is 90 % confident that sufficient liquidity exists to support the exit of the related valuation exposures at mid-price.
4
Where a valuation exposure cannot be shown to have a zero close-out costs AVA, institutions shall use the data sources defined in Article 3. In this case the calculation of the close-out costs AVA shall be performed as described in paragraphs 5 and 6 of this Article.
5
Institutions shall calculate close-out costs AVAs on valuation exposures related to each valuation input used in the relevant valuation model.
a
The granularity at which those close-out costs AVAs shall be assessed shall be one of the following:
1. where decomposed, all valuation inputs required to calculate an exit price for the valuation position;
2. the price of the instrument.
b
Each of the valuation inputs each of the valuation inputs referred to in point (a)(i) shall be treated separately. Where a valuation input consists of a matrix of parameters, institutions shall assess the close-out cost AVA based on the valuation exposures related to each parameter within that matrix. Where a valuation input does not refer to tradable instruments, institutions shall explicitly map the valuation input and the related valuation exposure to a set of market tradable instruments. Institutions may reduce the number of parameters of the valuation input for the purpose of calculating AVAs using any appropriate methodology provided the reduced parameters satisfy all of the following requirements:
1. the total value of the reduced valuation exposure is the same as the total value of the original valuation exposure;
2. the reduced set of parameters can be mapped to a set of market tradable instruments;
3. the ratio of variance measure 2 over variance measure 1, based on historical data from the most recent 100 trading days, is less than 0,1.
For the purposes of this paragraph, variance measure 1 shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input and variance measure 2 shall mean profit and loss variance of the valuation exposure based on the unreduced valuation input minus the valuation exposure based on the reduced valuation input.
c
Where a reduced number of parameters is used for the purpose of calculating AVAs, the determination that the criteria set out in point (b) are met shall be subject to independent control function review and internal validation on at least an annual basis.
6
Close-out costs AVAs shall be determined as follows:
a
where sufficient data exists to construct a range of plausible bid-offer spreads for a valuation input, institutions shall estimate a point within the range where they are 90 % confident that the spread they could achieve in exiting the valuation exposure would be at that price or better;
b
where insufficient data exists to construct a plausible range of bid-offer spreads, institutions shall use an expert-based approach using qualitative and quantitative information available to achieve a level of certainty in the prudent value that is equivalent to that targeted where a range of plausible values is available. Institutions shall notify competent authorities of the valuation exposures for which this approach is applied, and the methodology used to determine the AVA;
c
institutions shall calculate the close-out costs AVA by applying 50 % of the estimated bid-offer spread calculated in accordance with either point (a) or point (b) to the valuation exposures related to the valuation inputs defined in paragraph 5.
7
Institutions shall calculate the total category level AVA for close-out costs by applying to the individual close-out costs AVAs the formulae for either Method 1 or Method 2 laid down in the Annex.

Calculation of model risk AVA
Article 11
1
Institutions shall estimate a model risk AVA for each valuation model (‘individual model risk AVA’) by considering valuation model risk which arises due to the potential existence of a range of different models or model calibrations, which are used by market participants, and the lack of a firm exit price for the specific product being valued. Institutions shall not consider valuation model risk which arises due to calibrations from market derived parameters, which shall be captured according to Article 9.
2
The model risk AVA shall be calculated using one of the approaches defined in paragraphs 3 and 4.
3
Where possible, institutions shall calculate the model risk AVA by determining a range of plausible valuations produced from alternative appropriate modelling and calibration approaches. In this case, institutions shall estimate a point within the resulting range of valuations where they are 90 % confident they could exit the valuation exposure at that price or better.
4
Where institutions are unable to use the approach defined in paragraph 3, they shall apply an expert-based approach to estimate the model risk AVA.
5
The expert-based approach shall consider all of the following:
a
complexity of products relevant to the model;
b
diversity of possible mathematical approaches and model parameters, where those model parameters are not related to market variables;
c
the degree to which the market for relevant products is ‘one way’;
d
the existence of unhedgeable risks in relevant products;
e
the adequacy of the model in capturing the behaviour of the pay-off of the products in the portfolio.
Institutions shall notify competent authorities of the models for which this approach is applied, and the methodology used to determine the AVA.
6
Where institutions use the method described in paragraph 4, the prudence of the method shall be confirmed annually by comparing the following:
a
the AVAs calculated using the method described in paragraph 4, if it were applied to a material sample of the valuation models for which the institution applies the method in paragraph 3; and
b
the AVAs produced by the method in paragraph 3 for the same sample of valuation models.
7
Institutions shall calculate the total category level AVA for model risk by applying to individual model risk AVAs the formulae for either Method 1 or Method 2 laid down in the Annex.

Calculation of unearned credit spreads AVA
Article 12
1
Institutions shall calculate the unearned credit spreads AVA to reflect the valuation uncertainty in the adjustment necessary according to the applicable accounting framework to include the current value of expected losses due to counterparty default on derivative positions.
2
Institutions shall include the element of the AVA relating to market price uncertainty within the market price uncertainty AVA category. The element of the AVA relating to close-out cost uncertainty shall be included within the close-out costs AVA category. The element of the AVA relating to model risk shall be included within the model risk AVA category.

Calculation of investing and funding costs AVA
Article 13
1
Institutions shall calculate the investing and funding costs AVA to reflect the valuation uncertainty in the funding costs used when assessing the exit price according to the applicable accounting framework.
2
Institutions shall include the element of the AVA relating to market price uncertainty within the market price uncertainty AVA category. The element of the AVA relating to close-out cost uncertainty shall be included within the close-out costs AVA category. The element of the AVA relating to model risk shall be included within the model risk AVA category.

Calculation of concentrated positions AVA
Article 14
1
Institutions shall estimate a concentrated position AVA for concentrated valuation positions (‘individual concentrated positions AVA’) by applying the following three-step approach:
a
they shall identify concentrated valuation positions;
b
for each identified concentrated valuation position, where a market price applicable for the size of the valuation position is unavailable, they shall estimate a prudent exit period;
c
where the prudent exit period exceeds 10 days, they shall estimate an AVA taking into account the volatility of the valuation input, the volatility of the bid offer spread and the impact of the hypothetical exit strategy on market prices.
2
For the purposes of point (a) of paragraph 1, the identification of concentrated valuation positions shall consider all of the following:
a
the size of all valuation positions relative to the liquidity of the related market;
b
the institution's ability to trade in that market;
c
the average daily market volume and typical daily trading volume of the institution.
Institutions shall establish and document the methodology applied to determine concentrated valuation positions for which a concentrated positions AVA shall be calculated.
3
Institutions shall calculate the total category level AVA for concentrated positions AVA as the sum of individual concentrated positions AVAs.

Calculation of future administrative costs AVA
Article 15
1
Where an institution calculates market price uncertainty and close-out cost AVAs for a valuation exposure, which imply fully exiting the exposure, the institution may assess a zero AVA for future administrative costs.
2
Where a valuation exposure cannot be shown to have a zero AVA according to paragraph 1, institutions shall calculate the future administrative cost AVA (‘individual future administrative costs AVA’) considering the administrative costs and future hedging costs over the expected life of the valuation exposures for which a direct exit price is not applied for the close-out costs AVA, discounted using a rate which approximates the risk free rate.
3
For the purposes of paragraph 2, future administrative costs shall include all incremental staffing and fixed costs that are likely to be incurred in managing the portfolio but a reduction in these costs may be assumed as the size of the portfolio reduces.
4
Institutions shall calculate the total category level AVA for future administrative costs AVA as the sum of individual future administrative costs AVAs.

Calculation of early termination AVA
Article 16
Institutions shall estimate an early termination AVA considering the potential losses arising from non-contractual early terminations of client trades. The early termination AVA shall be calculated taking into account the percentage of client trades that have historically terminated early and the losses that arise in those cases.

Calculation of operational risk AVA
Article 17
1
Institutions shall estimate an operational risk AVA by assessing the potential losses that may be incurred as a result of operational risk related to valuation processes. This estimate shall include an assessment of valuation positions judged to be at-risk during the balance sheet substantiation process, including those due to legal disputes.
2
Where an institution applies the Advanced Measurement Approach for Operational Risk as specified in Part Three, Title III, Chapter 4 of Regulation (EU) No 575/2013, it may report a zero operational risk AVA on condition that it provides evidence that the operational risk relating to valuation processes, as determined in accordance with paragraph 1, is fully accounted for by the Advanced Measurement Approach calculation.
3
In other cases than those referred to in paragraph 2, the institution shall calculate an operational risk AVA of 10 % of the sum of the aggregated category level AVAs for market price uncertainty and close-out costs.
Substituted by Corrigendum to Commission Delegated Regulation (EU) 2016/101 of 26 October 2015 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for prudent valuation under Article 105(14) (Official Journal of the European Union L 21 of 28 January 2016).