Valuation Risk at European Banks: Empirical Evidence

Abstract

The risk that a financial institution will experience a loss because it did not accurately determine the fair value of the financial instruments on its balance sheet is known as Valuation Risk (VR). That risk is sometimes heightened because determining fair value is not always a simple or straightforward task. When market data is scarce or unavailable, or markets turn illiquid, banks tend to rely upon internally developed valuation models that use unobservable inputs, which may amplify VR. VR has attracted growing supervisory attention. Several supervisory agencies internationally have voiced concern over banks holding vast amounts of instruments that are potentially exposed to valuation uncertainty and the potential knock-on effects this VR could have on the stability of the financial system. Following up to our previous work discussing VR methodology and practice, this whitepaper seeks to expand the analysis by investigating European banks’ exposure to VR from a more quantitative perspective. To this end, we collected the evidence available from banks’ disclosures, looked for patterns, and drew as many sound conclusions as possible. However, in doing so, we encountered a frustrating reality: inadequacies in available data make it difficult to build an accurate view of these risks. We realized that the lack of data itself is an important lesson, as it informs us that crucial information is missing in banks’ disclosure. This paper delivers the results of the narrower analysis allowed by the limited data and delves into the implication of these constraints. The lack of data thwarts efforts to build an accurate view of the risks truly resting on financial institutions’ balance sheets. This is a serious matter. European banks hold amounts of assets and liabilities potentially exposed to VR that exceed their regulatory capital by many multiples. Even a relatively small unexpected shock or estimation error in instrument valuations could significantly impact banks’ capitalization and resilience. In the debate over VR, we believe a joint action by supervisors and standard setters to deepen banks’ disclosure of their holdings of assets and liabilities potentially more exposed to VR would significantly increase transparency and risk-awareness in the financial industry. By increasing clarity and transparency around bank risks through increased disclosure, banks can enhance public trust and allow observers and analysts to better assess bank balance sheets, leading to share prices that more closely reflect bank risks.