29 Nov 2007, David Benyon, Operational Risk & Regulation
LONDON – The UK Financial Services Authority (FSA) has published its first Capital Markets Bulletin to reveal a series of findings and recommendations for the quality, pricing and structure of banks’ formal client valuations.
The bulletin is prepared by the FSA’s capital markets sector team (CMST), which focuses on the controls in place for the transfer of financial risk to clients’ investment portfolios.
The bulletin outlines the FSA’s responsibility to protect consumer and market confidence by promoting fair practice in the formal valuations banks provide to investors for products that – as recent market volatility has proven – are subject to wide and changing interpretations of value. This is particularly important for over-the-counter transactions in opaque structured products, which often lack the transparency and supervision of more traditional products on more traditional markets.
Demand for formal valuations has grown, accompanied by a shift from ad hoc product-specific responses by individual trading desks to bank-wide global capabilities.
Formal evaluations are becoming an industry in themselves, and the bulletin marks a supervisory reaction to take this expansion into account, with new scope for PRIN 2.1.1, Principle 7 of the FSA’s handbook: “A firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading.”
Michael Wainwright, partner at international law firm Eversheds, said: “This was originally applied to financial promotions and marketing material, and has now expanded in application to valuations, very much a part of the business as usual service of communication.” He added the FSA’s decision to focus on valuations for the first issue of the new bulletin highlights the subject’s importance.
The bulletin notes a lack of post-trade price transparency on formal valuations for over-the-counter products when compared with exchange-traded equivalents, and highlights the responsibility of the larger banks for improvement. The 17 biggest banks control 88% of OTC trades, according to the International Swaps and Derivatives Association 2007 Operations Benchmarking Survey.
The bulletin also highlights the dominance of the big banks in the mostly one-way path of valuation information, and the potential for unfair treatment of clients who are unable to cross-reference valuations with other sources of information.
“The FSA highlights banks failing to own up when they get a valuation wrong, and adjusting it in their next valuation, hoping the client won’t notice,” said Wainwright. The document signals the FSA disapproves of this practice.
To foster the better practices it says go together with a sounder understanding of the issues, the FSA has provided a list of best practice for client valuation policies – designed to increase transparency and iron out conflicts of interest.
“Time and again banks have run into problems if they allow their sales people to influence functions that ought to be the province of the back office, with sales staff massaging bad news, leading to conflicts of interest,” said Wainwright.
Sales staff should receive valuations but not generate them. All employees are expected to follow the same valuations policy, with communications to the customer and relevant permissions for approval from superiors, compliance officers or legal officers sent and received in writing – either electronic or hard copy.
When the bank has an interested position in the product, valuations must be from official records or trader best estimates, and internal audit or compliance work programmes should review the valuation process.
Unusual assumptions or parameters used in valuations and exceptional circumstances – for example, those surrounding early unwind adjustments – should also be communicated in writing.
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