FAS 157, the new accounting standards launched in November in the United States to regulate the way banks value their assets, are likely to lead to a significant change in the way financial assets are valued, according to OTC Valuations (OTC Val), a provider of valuation and risk reports for over-the-counter (OTC) derivatives. FAS 157 has been adopted by many US investment banks. Any firms that have yet to adopt the standards will need to do so by the first quarter of 2008.
The new rules divide bank assets into three ‘levels’, depending on their liquidity. Level-one assets, which are easy to value or trade, have to have quoted prices in active markets such as US government bonds. Level two comprises assets less tradable than those in level one, but that still have a definite value. Level-three assets do not have quoted prices in active markets but are usually artificial financial instruments.
One significant impact of FAS 157 is to drive firms to adopt a ‘mark-to-model’ approach to valuation when there is a degree of uncertainty as to the value of a particular financial instrument due to a lack of observable data, according to OTC Val. OTC Val has published a white paper that provides derivative valuation insights into measuring fair value under FAS 157. The paper has several functions. It provides guidance in the use of level-one, -two and -three assets; defines the differences between ‘mark-to-market’, matrix, consensus, and ‘mark-to-model’ pricing; illustrates the advantages of using a ‘mark-to-model’ valuation technique; and reviews bid and ask price considerations.