It reviews different frameworks that have been encountered in our discussions with risk managers and heads of valuation from several international banks. Topics addressed are data, valuation models, reserves for uncertainties, valuation adjustments (XVA) and regulatory additional valuation adjustments (AVA) that are computed for capital adequacy. The governance traditionally relies on the so-called Three Lines of Defence (3LOD) Model, in which the business line (Front Office) represents the first line and manages risks, while the second line oversees risks and is ensured by Finance/ Risk Department. The third line provides independent assurance and is held by Internal Audit. This schema has established itself as the dominant one despite critics pointing out several drawbacks, such as:
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Our first finding is that governance frameworks as seen in banks may be classified into three categories. First, valuation tasks are mainly supported by Finance. The role of the Risk Department is limited to model validation. Secondly, the Risk Department has the main role that goes beyond the validation function and encompasses valuation methodology design and even data quality control. Lastly, a hybrid framework is encountered that differs from the two previous ones as it largely mixes valuation functions between Risk and Finance.
Our discussions clearly highlight that banks have serious concerns about the practical application of the 3LOD model, whichever of the above the frameworks is present.
Among these concerns:
Accordingly, the risk is that longterm questions are not sufficiently investigated because short-term problems always tend to be prioritized at the expense of long-term ones.
Lastly, we find that the business line is not actually or not sufficiently involved in some crucial components of the valuation (mainly reserves, XVA and AVA). Yet, they have the best knowledge of the market. Therefore, they should give a documented opinion on any components of the valuation, and not only for data or valuation models. Such a framework makes sense only if the Front Office P&L is impacted by these components; otherwise, they would have no incentive to perform these functions.
Silos, when deeply rooted in the organisation, are generally perceived as a potential weakness in the valuation framework or even a source of additional risk.