Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes : February 2020.
Date: 2021-02-05
Institutions: European Systemic Risk Board
Subjects: EU banking union, European Systemic Risk Board, credit, financial stability, world economy

Macroprudential 
implications of  
financial instruments in 
Levels 2 and 3 for 
accounting purposes 

February 2020 

 
 
 
 
 
 
 
 
Contents 

Executive summary 

1 

2 

3 

Introduction 

Overview of the use of fair value accounting by European banks 

Fair valuation of financial instruments and financial stability 

3.1 

Valuation of financial assets and liabilities 

Box 1  Empirical analysis of disclosures made about Level 3 assets by a sample of EEA 

banks 

3.2 

3.3 

Potential volatility and illiquidity in times of financial stress 

Reflection of underlying risks in capital requirements 

4 

Concluding remarks 

References 

Annex 1: Literature review 

Annex 2: Accounting and regulatory frameworks 

1 

2 

Accounting framework 

Prudential framework 

Annex 3: Stylised aggregate balance sheet for EU banks 

Annex 4: Further insights into European banks’ use of fair value accounting 

2 

5 

8 

18 

20 

22 

24 

27 

30 

33 

38 

41 

41 

48 

52 

53 

Annex 5: Additional information on the empirical analysis of disclosures made about Level 3 
57 

assets by a sample of EEA banks 

1 

2 

Descriptive statistics 

Methodology for the assessment of disclosures 

Imprint and acknowledgements 

57 

59 

60 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Contents 

1 

 
 
 
Executive summary 

As the global financial crisis showed, it is difficult to determine the fair value of some financial 

instruments, given the lack of liquidity in the relevant markets, the complexity of some of those 

instruments and the need, in a significant percentage of cases, to use unobservable inputs. Taking 

the current accounting framework as a given, this report discusses the macroprudential implications 

of financial instruments that are measured at fair value according to IFRS 9 and IFRS 13 (with a 

focus on those classified in Levels 2 and 3, since they are typically measured using models and 
other market-based techniques, as well as affording the greatest degree of discretion).1 The 
prudential regulatory framework distinguishes between exposures in the banking book and the 

trading book on the basis of the intentions underlying the holding of the financial instruments in 

question, with the former subject to prudential requirements relating to credit risk and the latter to 

prudential requirements relating to market risk. These instruments are also subject to the 

requirement to consider prudential valuation adjustments for all financial instruments measured at 

fair value. 

Given the limited evidence on the impact that the fair values of financial instruments in Levels 2 and 

3 have on financial stability, this report adopts a descriptive approach, relying on supervisory 
reporting data provided by the European Banking Authority (EBA), a review of academic literature,2 
and the financial statements of a small sample of European banks.3 

On the basis of those data, financial assets measured at fair value totalled approximately 

€7,279 billion in December 2018 (accounting for around 25% of total assets), with €2,379 billion in 

Level 1, €4,600 billion in Level 2 and €300 billion in Level 3. Debt securities (72% of which are 

classified in Level 1) and derivatives (the majority of which are allocated to Level 2) make up more 
than two-thirds of all assets measured at fair value.4 In terms of distribution across countries, banks 
domiciled in the United Kingdom, France and Germany account for two-thirds of all financial assets 

measured at fair value. As regards financial liabilities measured at fair value, they totalled 

€4,915 billion at the end of 2018 (equivalent to around 17% of total assets), with fair value liabilities 

strongly concentrated in deposits and derivatives in Level 2. The relative importance of financial 

assets and liabilities measured at fair value varies across EU countries and can be explained by the 

prevailing business models of the banks domiciled in each country. Relative to the situation at 

end-2016, data as at end-2018 show a sizeable decline (of around €1.1 trillion) in the derivative 

positions reported on both sides of the balance sheet, which may be explained by (i) the obligation 

to clear certain derivatives centrally and (ii) the use of compression. After declining steadily 

1   Under IFRS 13, financial instruments for which there are quoted prices in an active market whose inputs are fully 

observable are allocated to Level 1. Inputs used in the valuation of financial instruments in Level 2 are not quoted market 
prices, but are still observable, either directly or indirectly. Finally, financial instruments are allocated to Level 3 if there are 
significant unobservable inputs. IFRS 9 sets out the criteria that determine whether financial instruments are to be 
measured at amortised cost or at fair value. 

2   See Annex 1. 
3   The cut-off date for the contents of this report was 18 December 2019. Consequently, all references to the European Union 
include the United Kingdom, as do all data aggregates, as that country was a member of the European Union on that date. 

4   Under IFRS, derivatives with a positive gross market value are shown on the assets side of a bank’s balance sheet, and 
derivatives with a negative gross market value are shown on the liabilities side. Thus, the distinction between assets and 
liabilities is, in this case, not as neat as it is with other financial instruments, a fact that must be taken into account when 
looking at this report. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Executive summary 

2 

 
                                                                            
between 2014 and 2017, Level 3 assets increased in 2018, rising from €191 billion at end-2017 to 
€300 billion at end-2018.5 

In terms of volume, holdings of Level 2 and 3 assets remain highly concentrated. In the recent EBA 

Transparency Exercise, five banks accounted for half of all Level 2 assets reported by banks in that 

sample, with ten banks accounting for half of all Level 3 assets. The majority of banks with large 

amounts of Level 2 and 3 assets have been classified as G-SIBs by the Financial Stability Board 

(FSB), reflecting the size of their balance sheets. In relative terms, when measured as a 

percentage of CET1 capital, the concentration of Level 2 and Level 3 assets remains high, with a 

significant right tail in both distributions (meaning that there is a limited number of banks with 

relatively high ratios of Level 2 and Level 3 assets to CET1 capital), although in the case of Level 3 

instruments there is greater heterogeneity in terms of the main characteristics of the banks in 

question (size, country of domicile, etc.). 

This report identifies three main areas where financial instruments measured at fair value can affect 

financial stability and thus have a macroprudential impact: 

1. 

The correct valuation of financial instruments is crucial for an accurate determination of banks’ 

solvency positions. If financial instruments are found to be misvalued, the correction of that 

misvaluation may generate a large loss for the bank in question and affect its solvency, via the 

profit and loss account and other comprehensive income. Given the significant degree of 

discretion that exists when allocating financial instruments to Levels 2 and 3 (as a result, for 

example, of the lack of any definition of observability and the lack of operational guidance 

covering the allocation of financial instruments to the various levels of the fair value hierarchy 

or the treatment of Day 1 profits) and the various incentives that may exist in this regard, 

macroprudential concerns are focused on those instruments. Transparency and disclosure 

can help to address market concerns about discretion in relation to Level 2 and 3 instruments, 

and they should be accompanied by efforts on the part of auditors, accounting enforcers and 

microprudential supervisors to ensure consistent application of regulatory and accounting 

frameworks. 

2. 

In times of stress, Level 2 and 3 instruments may become even less liquid (or fully illiquid), 

their fair value may be imprecise or subject to greater variability (not reflecting the realisable 

sale price and potentially leading to sizeable fair value losses, losses on disposal, and even 

fire sales), and there may ultimately be an impact on banks’ profitability and solvency. 

Moreover, the risk of imperfect modelling may be more pronounced in times of financial stress 

in the form of extreme valuations that can result in significant changes to the fair value of the 

underlying Level 2 or 3 instruments. Given the expected negative dynamics of Level 2 and 3 

instruments in times of stress, accounting enforcers and supervisors should be aware of the 

importance of monitoring banks’ exposures to complex financial instruments (which will 

typically be allocated to Levels 2 and 3). 

3. 

The underlying risks stemming from financial instruments measured at fair value should be 

appropriately reflected in capital requirements. Level 2 and 3 financial instruments are 

5   This may also have been influenced by the implementation of IFRS 9 as of 1 January 2018. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Executive summary 

3 

 
                                                                            
typically related to the trading activities of banks and, as such, will fall within the definition of 

“trading book” for regulatory purposes, with market risk-related capital requirements being 

applied to them. The global financial crisis highlighted deficiencies in the regulatory framework 

as regards market risk-related capital requirements, and the entry into force of the 

Fundamental Review of the Trading Book (FRTB) – and, to a lesser extent, the leverage 

ratio – is expected to improve the way in which market risk is considered for in the regulatory 

framework. 

Vulnerabilities stemming from these three identified areas will affect financial stability through both 

a capital and a transparency channel. As accounting figures are inputs in the calculation of 

prudential regulatory requirements, banks’ behaviour, market perceptions and supervisory actions 

may be affected, depending on the extent to which Level 2 and 3 financial instruments are able to 

move banks away from their desired regulatory targets in time of stress. This channel is also 

influenced by the discretion that is afforded to management. As regards the transparency channel, 

the accounting framework for Level 2 and 3 financial instruments can also affect banks’ 

transparency and information asymmetries, which can, in turn, affect stability through the role they 

play in influencing market and supervisory discipline, financial frictions, debt overhang problems 

facing banks and opportunistic risk-shifting activities. 

The analysis in this report seems to point to significant heterogeneity across banks as regards the 

relative importance of Level 2 and 3 assets and liabilities, as well as the underlying portfolios, 

instruments and models associated with them. Consequently, transparency and targeted action by 

relevant stakeholders (auditors, accounting enforcers and microprudential supervisors) are very 

important. 

In terms of transparency, more comprehensive and more granular disclosure by banks (e.g. as 

regards the sensitivity of valuations or Day 1 profits) would support the efforts of regulatory 

authorities in this area and result in more effective market discipline. 

Given the significant heterogeneity observed across EU banks, auditors, accounting enforcers and 

microprudential supervisors should make full use of their mandates as regards Level 2 and 3 

instruments. Those efforts should be aimed at: (i) ensuring that banks treat similar instruments in a 

similar manner, and that uncertainty in the valuation of financial instruments is adequately reflected; 

(ii) conducting more detailed assessments of the prudential valuation framework for banks; 

(iii) understanding the performance of banks’ valuation models in the presence of market stress, 

and even back-testing models; and (iv) understanding how disclosures relating to financial 

instruments classified in Levels 2 and 3 under IFRS 13 are effectively put in practice by European 

banks, and ensuring that the disclosure requirements are adhered to. 

Finally, the FRTB represents a significant improvement in the way that market risk is considered in 

banks’ regulatory capital requirements. It should be promptly implemented in the EU, so that capital 

requirements better reflect the underlying market risk, learning the lessons from the global financial 

crisis. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Executive summary 

4 

 
1 

Introduction 

As the global financial crisis showed, it can be difficult to determine fair values, given the 

lack of liquidity in the relevant markets, the complexity of some financial instruments and 
the need, in a significant percentage of cases, to use unobservable inputs. Financial 

instruments that are allocated to Levels 2 and 3 of the fair value hierarchy in IFRS 13 are, by 

definition, difficult to value accurately, owing to their possible complexity, a lack of liquidity and/or 

(in the case of Level 3 instruments) the use of unobservable inputs for their valuation. It is worth 

noting that the difficulty of obtaining an accurate value for Level 2 and 3 instruments does not 

necessarily mean that these instruments are always riskier or more complex than those in Level 1. 

Nevertheless, during the global financial crisis, there was significant misalignment between the fair 

values observed for certain financial instruments in financial markets and those reported in banks’ 

financial statements. When the fair values reported in financial statements were aligned with the fair 

values observed in financial markets, banks incurred substantial losses. The Basel Committee on 

Banking Supervision (BCBS) noted in this regard that those valuation challenges (and losses) 

stemmed mainly from instruments which were initially classified as Level 1 when the crisis erupted, 

concluding that “[…] the uncritical use of ‘level 1 prices’ taken from ‘virtual’ secondary markets (or 

at least, markets with very reduced liquidity) was a clear source of trouble when it became clear 
that those ‘alleged market prices’ were not real” (BCBS, 2008).6 

Following the global financial crisis, the accounting and regulatory frameworks for financial 
instruments measured at fair value have been enhanced. On the regulatory side, the first draft 

of the Fundamental Review of the Trading Book (FRTB) was published by the BCBS in 2016, and 

those rules were then finalised in January 2019 following a review of certain aspects, with a target 
implementation date of 2022.7 In the EU, amendments to the Capital Requirements Regulation 
envisage a reporting obligation for FRTB positions, awaiting the incorporation into the EU’s 
regulatory framework of the international standard agreed in January 2019.8 On the accounting 
side, IFRS 9 introduced new criteria governing the classification of financial instruments as 
measured at fair value, which are expected to bring increased consistency (see ESRB, 2017).9 
Moreover, the International Accounting Standards Board (IASB) carried out a post-implementation 

review of IFRS 13 between May 2017 and December 2018 and concluded that although follow-up 
measures were required in some areas, no major amendments were necessary for IFRS 13.10 

6   On the basis of an earlier exercise conducted by the United Kingdom’s Financial Services Authority, the European Banking 
Authority (EBA) showed in 2015 that €193 billion of UK banks’ total losses of €240 billion had come from cash securitisation 
and monoline or leveraged loan positions (EBA, 2015). 

7  

It is worth noting that not all financial instruments that are measured at fair value will be classified as part of the trading 
book, as defined for prudential purposes. 

8   See Recitals 40 and 41 of Regulation (EU) 2019/876 of the European Parliament and of the Council of 20 May 2019 

amending Regulation No 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own 
funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures 
to collective investment undertakings, large exposures, reporting and disclosure requirements, and Regulation 
(EU) No 648/2012. 

9   Under IFRS 9, financial instruments are measured either at fair value or at amortised cost, depending on two factors: (i) the 
business model within which the asset is held (the business model test); and (ii) the contractual cash flow for the asset. As 
regards the latter, the cash flows generated by financial instruments are assessed to determine whether they reflect solely 
payments of principal and interest (SPPI). 

10   See Post-implementation Review of IFRS 13 Fair Value Measurement. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Introduction 

5 

 
                                                                            
Under IFRS 13, financial instruments measured at fair value are allocated to one of three 
different levels depending on the inputs used in the calculation of the fair value.11 If prices for 
a financial instrument are quoted in an active market and the inputs for those prices are fully 

observable, the instrument is allocated to Level 1. Inputs used in the valuation of financial 

instruments in Level 2 are not quoted market prices, but are still observable, either directly or 

indirectly. Level 2 inputs include (i) prices quoted for similar assets or liabilities in active markets, 

(ii) prices quoted for identical or similar assets or liabilities in markets that are not active, (iii) inputs 

other than quoted prices that are observable (e.g. interest rates and yield curves observable at 

commonly quoted intervals, implied volatilities or credit spreads) and (iv) inputs derived principally 

from or corroborated by observable market data by correlation or other means (“market-

corroborated inputs”). Finally, financial instruments are classified as Level 3 if there are significant 

unobservable inputs. Unobservable inputs require the use of the best available information, may 

imply the use of own data and should take into account all information about market participant 

assumptions that is reasonably available. 

The prudential regulatory framework has no equivalent to the fair value hierarchy set out by 

IFRS 13.

12 By contrast with IFRS 13, the prudential regulatory framework distinguishes between 

exposures in the banking book and the trading book, with the former subject to prudential 

requirements relating to credit risk and the latter to prudential requirements relating to market risk. 

The main criterion determining whether exposures are allocated to the trading book or the banking 

books is whether the financial instrument in question is held for trading purposes. However, 

prudential regulation does not provide for any more detailed classification of financial instruments 

measured at fair value, as prudential requirements focus on the types of risk that are embedded in 

financial instruments, rather than the manner in which the fair value is calculated. There is, though, 

a requirement to consider prudential valuation adjustments for all financial instruments measured at 

fair value (including financial liabilities), regardless of whether they are held in the trading book or 

the banking book. These prudential valuation adjustments are deducted directly from CET1 capital. 

However, according to the latest available data, prudential adjustments are not particularly 
significant.13 

The objective of this report is to discuss the macroprudential implications of financial 

instruments measured at fair value – particularly those allocated to Levels 2 and 3 of the fair 
value hierarchy in IFRS 13. In the aftermath of the global financial crisis, there was a lengthy 
debate in academia and among policymakers about the contribution that fair value accounting 

makes to the difficulties experienced by banks around the world (Laux and Leuz, 2010; Schaffer, 

2010; Acharya and Ryan, 2016). This report does not seek to contribute to the discussion about the 

most appropriate method for the measurement of financial instruments. Rather, it takes the current 

accounting framework as a given and analyses the possible macroprudential impact of fair value 

measurement, with a focus on financial instruments in Levels 2 and 3, since they are typically 

valued using models and other market-based techniques (leading, for example, to correlation with 

11   For further information on the accounting treatment of financial instruments measured at fair value, see Section A of 

Annex 2. 

12   For further information on the prudential treatment of financial instruments measured at fair value, see Section B of 

Annex 2. 

13   The recent inclusion of a template on valuation in the supervisory reporting framework for EU banks will allow further insight 

to be gained into the use of prudential valuation adjustments and other value adjustments. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Introduction 

6 

 
                                                                            
credit default swap spreads) and afford the greatest degree of discretion.14 There is currently 
limited evidence on the impact that financial instruments in Levels 2 and 3 have on financial 

stability, and this report tries to fill that gap to the extent possible. However, the information that is 

currently available is not granular enough to identify all relevant factors (e.g. the valuation method 

used by banks to calculate the fair value of their financial instruments in Levels 2 and 3 – be it 

prices quoted for similar assets, other observable inputs, etc.) that are necessary for a full and 
complete analysis of the macroprudential impact of Level 2 and 3 instruments.15 Consequently, this 
report adopts a descriptive approach and tries to present as much evidence as possible, using 

supervisory data, a review of academic literature and the financial statements of a small sample of 

European banks. 

The report is structured as follows: Section 2 provides an overview of the use of fair value 

accounting by European banks, on the basis of supervisory data collected by the EBA; Section 3 

elaborates on the main transmission channels between fair value accounting and financial stability; 

and Section 4 contains concluding remarks, with a focus on possible policy action. A brief literature 

review can be found in Annex 1 to the report, while Annex 2 describes the accounting and 

prudential frameworks that govern the valuation of financial instruments. Annex 3 contains a 

stylised depiction of EU banks’ aggregate balance sheet, Annex 4 provides further insight into 

banks’ use of fair value accounting, and Annex 5 contains additional information supplementing the 

analysis presented in Box 1. 

14   For a discussion of the expected impact of the new criteria governing financial assets’ measurement at amortised cost or 

fair value, see ESRB (2017). 

15   Such information goes far beyond the current supervisory reporting framework for EU banks and the disclosure 

requirements in IFRS 13. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Introduction 

7 

 
                                                                            
Overview of the use of fair value 

2 
accounting by European banks 

This section provides an overview of the use of fair value accounting at European banks. On 

the basis of consolidated supervisory data for 128 EU banking groups as at 31 December 2018 

(provided by the EBA), it describes European banks’ use of fair value accounting, paying particular 
attention to financial instruments in Levels 2 and 3.16 This will help to frame the assessment of the 
macroprudential implications of Level 2 and 3 instruments in subsequent sections. Annex 4 

provides additional insight into the use of fair value accounting at European banks. 

Financial assets measured at fair value totalled approximately €7,279 billion in December 
2018, accounting for around 25% of EU banks’ aggregate balance sheet. This represents a 

marked decline relative to the €8,838 billion of fair value assets that were observed two years 
earlier.17 Meanwhile, assets valued at amortised cost totalled €17,613 billion (up slightly on 2016), 
accounting for 61% of EU banks’ aggregate balance sheet. Banks’ remaining assets consist of 
cash (8.5%)18 and other (non-financial) assets (approximately 5%). €2,379 billion of EU banks’ fair 
value assets are in Level 1 (8.1% of total assets), €4,600 billion is in Level 2 (15.7% of total assets), 

and €300 billion is in Level 3 (1% of total assets). After declining steadily between 2014 and 2017, 

Level 3 assets increased significantly in 2018, rising from €191 billion to €300 billion (a 57% 
increase).19 In terms of capital, Level 1 assets are equivalent to 142% of EU banks’ CET1 capital, 
with ratios of 275% and 18% being observed for Level 2 and Level 3 assets respectively. As 

Chart 1 shows, debt securities now account for the largest percentage of EU banks’ fair value 

assets (€2,719 billion; 38% of fair value assets), overtaking derivatives (€2,244 billion; 29% of fair 

value assets). 95% of derivatives are classified as Level 2 instruments, while 72% of debt securities 

are in Level 1 and 26% are in Level 2. Other significant asset classes measured at fair value 

include loans and advances (€1,841 billion; 25% of fair value assets) and equity instruments 

(€475 billion; 6% of fair value assets). Derivatives and debt securities have both declined since 

2016, falling by approximately €1,174 billion and €625 billion respectively, while loans and 

advances have increased by €376 billion. Derivatives tend to be held for trading purposes, with only 
6% of all derivatives being held for the purposes of hedge accounting.20 According to the EBA 
(2016), debt securities make up the largest percentage of small banks’ fair value assets. Moreover, 

16   The assets of the 128 EU banks in that sample represent around 90% of the total assets of the EU banking sector, 

according to consolidated banking data held by the ECB. See Annex 3 for a stylised aggregate balance sheet for the banks 
in that sample. 

17   Supervisory reporting data do not allow us to differentiate between changes that are due to valuation changes (changes in 
prices) and changes that are derived from real transactions (changes in volumes). This limitation is particularly important 
when making cross-temporal comparisons. 

18   Although cash is a financial asset measured at fair value, it is treated separately for the purposes of this report, given that it 
does not give rise to any of the macroprudential considerations which are typically associated with other financial assets 
and liabilities measured at fair value. 

19   Changes observed in 2018 may also have been influenced by the entry into force of IFRS 9. 
20  

It should be noted that the conditions which must be met in order to describe a derivative as being held for hedging 
purposes are fairly strict under IFRS. Indeed, a bank cannot designate a derivative as being held for hedging if the 
underlying asset is measured at fair value, so hedging may be more widespread than accounting figures would suggest. 
Similarly, the netting of positions is significantly more limited under IFRS than, for example, under US-GAAP rules. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

8 

 
                                                                            
for these banks, fair value assets and liabilities account for around 15% of total assets and 1% of 

total liabilities. 

Chart 1 

Composition of fair value assets in the EU banking sector as at 31 December 2018 

(EUR billions) 

Debt securities - Level 2

Equities - Level 1

Level 3 assets

Other Level 1 and  Level 2 assets

Derivatives - Level 2

Debt securities - Level 1

Loans and advances - Level 2

1,699
23%

1,947
27%

712
10%

372
5%

109
2%

2,141
29%

Derivatives
52

Equities
56

Loans and 
advances
132

Debt 
securities
60

Sources: EBA and ESRB Secretariat calculations. 
Note: These consolidated data refer to FINREP template F14.00 on a consolidated basis, and cover 128 EU banking groups. 

In terms of the distribution of fair value assets across countries, banks domiciled in the 
United Kingdom, France and Germany account for two-thirds of the total (see Chart 2). If we 

look at absolute volumes of financial assets measured at fair value, British (€2,212 billion; 30%), 

French (€1,783 billion; 24%) and German (€1,049 billion; 14%) banks hold 68% of all fair value 

assets in the EU, reflecting the activities of large universal banks domiciled in these countries. 
Meanwhile, banks headquartered in Spain (€526 billion; 7%), Denmark (€464 billion; 6%),21 Italy 
(€377 billion; 5%), the Netherlands (€270 billion; 4%) and Finland (€215 billion; 3%) account for an 

additional 25% of EU banks’ fair value assets. 

21  

In the case of Denmark, the large amounts of fair value assets and liabilities are explained by specificities in the national 
mortgage market. Indeed, the fair value option is used by Danish banks in light of the institutional link between mortgage 
loans and the corresponding covered bonds. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

9 

 
 
                                                                            
Chart 2 

Distribution of fair value assets across EU countries as at 31 December 2018 

(EUR billions) 

FI
215 

NL
270 

IT
377 

Other
526 

UK
2,212 

DK
464 

ES
526 

DE
1,049 

FR
1,783 

Sources: EBA and ESRB Secretariat calculations. 
Note: These consolidated data refer to FINREP template F14.00 on a consolidated basis, and cover 128 EU banking groups. 

Financial liabilities measured at fair value totalled €4,915 billion at the end of 2018, 

equivalent to around 17% of total assets, with liabilities strongly concentrated in Level 2 
deposits and derivatives (see Chart 3). Similar to the marked decline observed for financial 
assets measured at fair value, the amount of financial liabilities measured at fair value in the 

balance sheet of European banks has declined by 16% since 2016. €804 billion of EU banks’ total 

fair value liabilities are in Level 1 (equivalent to 2.8% of total assets), €3,942 billion is in Level 2 

(13.5% of total assets), and €169 billion is in Level 3 (0.6% of total assets). Level 3 liabilities grew 

by around 5% in 2018, rising from €160 billion to €169 billion. As Chart 3 shows, Level 2 derivatives 
and deposits make up two-thirds of all financial liabilities measured at fair value.22 Since 2016, 
holdings of derivatives have declined by approximately 35% (€1,152 billion), while deposits have 

increased by almost 25% (€219 billion). 95% of all derivatives are in Level 2 of the fair value 

hierarchy, as are 97% of deposits, while debt securities are mainly allocated to Level 1 (35%) and 

Level 2 (57%). 

22   Deposits could, for example, be measured at fair value in order to manage interest rate risks. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

10 

 
 
                                                                            
Chart 3 

Composition of fair value liabilities in the EU banking sector as at 31 December 2018 

(EUR billions) 

Short positions - Level 1

Debt securities issued - Level 1

Sum derivatives, debt securities , deposits,
short positions of L3
Other Level 1 and Level 2 liabilities

Derivatives - Level 2

Deposits - Level 2

1,148
23%

Debt securities issued - Level 2

541
11%

409
8%

329
7%

200
4%

Other liabilities
8

Deposits
18

Debt 
securities 
issued
80

Derivatives
62

2,119
43%

Sources: EBA and ESRB Secretariat calculations. 
Note: These consolidated data refer to FINREP template F14.00 on a consolidated basis, and cover 128 EU banking groups. 

The declines reported for derivative positions since 2016 are of a similar size on both sides 

of the balance sheet and can be explained by the obligation to clear derivatives centrally 
and the use of compression. If we assume that market values for derivative positions have 
remained broadly stable over the last few years, that declining trend can also be observed at a 

global level. The Bank for International Settlements (BIS, 2019) explains that development as 

follows: “[…] the rise of central clearing has been an important structural change in OTC derivatives 

markets over the past decade. This change has gone hand in hand with an increase in trade 

compression – the elimination of economically redundant derivatives positions […]. New practices 

such as settle-to-market – where banks, instead of posting collateral against the change in market 

value (i.e. variation margin), make outright payments to restore the market value to zero – have 

additionally contributed to the observed decline in their market values.” 

There is significant variation across EU countries in terms of the breakdown of assets and 
liabilities by measurement method (see Charts 4 and 5). The countries with the highest ratios of 
fair value assets to total assets are Denmark (65%), the United Kingdom (34%), Finland (31%), 
Luxembourg (29%), Germany (28%), France (26%) and Romania (20%).23 With the exception of 
Romania, the same countries also have the highest ratios of fair value liabilities to total liabilities, 

whereby the distribution is even more concentrated (see Chart 5). Indeed, with the exception of 

Denmark (60%), Luxembourg (25%), the United Kingdom (24%), France (21%), Finland (20%) and 

Germany (18%), all countries have ratios of less than 10%. As regards Level 3 assets, the following 

EU countries have the largest amounts of Level 3 assets as a percentage of total assets: 

Luxembourg (€25 billion; 11.8%), Denmark (€45 billion; 6.3%), Portugal (€8 billion; 2.5%), Poland 

23  

It should be noted that the various figures reported in relation to the assets of German banks do not add up to 100%. This 
data quality issue is currently being investigated. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

11 

 
 
                                                                            
(€4 billion; 2.2%), Germany (€45 billion; 1.7%), Belgium (€12 billion; 1.2%) and Cyprus 

(€429 million; 1.1%). 

Chart 4 

Breakdown of total assets across EU banking sectors as at 31 December 2018 

(percentage of total assets) 

Fair value - Level 1
Fair value - Level 2
Fair value - Level 3

Amortised cost
Cash
Other

100

90

80

70

60

50

40

30

20

10

0

AT BE BG CY CZ DE DK EE ES FI FR UK GR HR HU IE IT LT LU LV MT NL PL PT RO SE SI SK

Sources: EBA and ESRB Secretariat calculations. 
Notes: Data refer to FINREP template F14.00 and cover 128 EU banking groups. They were reported on either a consolidated 
or a sub-consolidated basis, depending on the country of residence. 

Chart 5 

Breakdown of total fair value liabilities across EU banking sectors as at 31 December 2018 

(percentage of total liabilities) 

Fair value - Level 1
Fair value - Level 2
Fair value - Level 3

70

60

50

40

30

20

10

0

AT BE BG CY CZ DE DK EE ES FI FR UK GR HR HU IE IT LT LU LV MT NL PL PT RO SE SI SK

Sources: EBA and ESRB Secretariat calculations. 
Notes: Data refer to FINREP template F14.00 and cover 128 EU banking groups. They were reported on either a consolidated 
or a sub-consolidated basis, depending on the country of residence. 

With the exception of French and German banks, debt securities account for the largest 
percentage of fair value assets in most EU countries. Although the value of derivatives has 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

12 

 
 
 
generally declined since 2016, French and German banks – probably driven by the largest 

players – still have derivatives as the largest class of fair value assets. In general, use of 
derivatives is typically more pronounced in countries with larger banking systems.24 In Denmark 
(and, to a lesser extent, Luxembourg), fair value assets are driven primarily by loans and advances, 
which are matched on the liabilities side by debt securities.25 In terms of IFRS portfolios, the 
countries with the most assets and liabilities held for trading purposes as a percentage of total fair 

value assets and liabilities are Belgium, Germany, Finland, France, the United Kingdom and 

Sweden. 

Level 2 and 3 financial assets vary significantly across EU countries as a percentage of total 
assets and CET1 capital (see Charts 6 and 7). Since the holdings of financial assets allocated to 

Level 2 are higher, their comparison with CET1 capital (which is used solely as a benchmark to 

facilitate comparison across EU countries) reveals that there are 11 countries where Level 2 assets 

(including derivatives) exceed CET1 capital (see Chart 6). Meanwhile, the following EU countries 

have the largest amounts of Level 3 assets as a percentage of CET1 capital: Denmark (€45 billion; 

139%), Luxembourg (€25 billion; 105%), Portugal (€14 billion; 36%), Germany (€45 billion; 34%), 

Poland (€4 billion; 21%), Belgium (€12 billion; 20%) and France (€66 billion; 19%). Denmark and 

Luxembourg saw particularly strong increases in Level 3 assets in 2018, and those countries now 

have the highest ratios of Level 3 assets to CET1 capital. While no general pattern can be 

identified, most countries recorded increases in Level 3 assets in 2018 (a year that also saw the 

introduction of IFRS 9). 

24  

25  

In 2016, Finland, France, Germany and the United Kingdom were the only countries where derivatives were the largest 
class of fair value assets. 

In Denmark, this is due to the specific nature of the local covered bond/mortgage market, where a direct link exists between 
a mortgage loan and the corresponding covered bond, with an option for the borrower to repay the loan by buying the 
covered bond on the market and returning it to the bank. Thus, the value of the mortgage loan is connected to that of the 
covered bond, which allows banks to measure it at fair value. See also EBA (2013b). 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

13 

 
                                                                            
Chart 6 

Evolution of the ratio of Level 2 assets to CET1 capital, 2016-18 

(percentage of total CET1 capital) 

600

500

400

300

200

100

0

100

80

60

40

20

0

DK

FI

DE

FR

UK

ES

SE

NL

LU

IT

BE

GR

HR

AT

1,200

1,000

800

600

400

200

0

80

60

40

20

0

IE

HU

PL

CZ

BG

PT

SI

MT

SK

RO

LV

LT

CY

EE

Sources: EBA and ESRB Secretariat calculations. 
Notes: This chart shows Level 2 assets as a percentage of CET1 capital in the fourth quarter of 2016, 2017 and 2018. These 
consolidated data cover 128 EU banking groups. 

Chart 7 

Evolution of the ratio of Level 3 assets to CET1 capital, 2016-18 

(percentage of total CET1 capital) 

60

50

40

30

20

10

0

DK

LU

PT

DE

PL

BE

FR

CY

AT

GB

IT

NL

FI

ES

140

120

100

80

60

40

20

0

10

8

6

4

2

0

IE

CZ

GR

SI

HU

SK

HR

SE

RO

BG

MT

LV

LT

EE

Sources: EBA and ESRB Secretariat calculations. 
Notes: This chart shows Level 3 assets as a percentage of CET1 capital in the fourth quarter of 2016, 2017 and 2018. These 
consolidated data cover 128 EU banking groups. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

14 

 
 
 
Level 2 and 3 assets remain highly concentrated in terms of volume. Indeed, in the recent 

EBA Transparency Exercise, five banks accounted for half of all Level 2 assets reported by banks 

in that sample, with ten banks accounting for half of all Level 3 assets. The majority of those banks 

with large amounts of Level 2 and 3 assets have been classified as G-SIBs by the FSB (particularly 

those with the largest volumes of Level 2 assets). This mainly reflects the size of those banks’ 

balance sheets, as G-SIBs do not necessarily have large amounts of Level 2 and 3 assets in 
relative terms, as a percentage of total assets or total CET1 capital.26 As Chart 8 shows, 10, 20 and 
37 banks respectively accounted for 50%, 75% and 90% of all Level 3 assets reported by 

participants in the latest EBA Transparency Exercise. What is more, the level of concentration is 

even higher for Level 2 assets, probably reflecting the more intensive derivative-based activities of 

the largest banks, with 5, 13 and 22 banks respectively accounting for 50%, 75% and 90% of all 

Level 2 assets reported. 

Chart 8 

Distribution of Level 2 and 3 assets across the sample of banks participating in the 2019 

EBA Transparency Exercise 

(percentages) 

Level 3
Level 2

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

1

6

11

16

21

26

31

36

41

46

51

56

61

66

71

76

81

86

91

96 101 106 111 116 121 126 131

Sources: EBA and ESRB Secretariat calculations. 
Notes: The x-axis indicates the number of banks, ordered by their holdings of Level 2 and 3 assets at the end of June 2019, as 
reported in the 2019 EBA Transparency Exercise. The y-axis indicates the cumulative proportion of the total that is accounted 
for by the banks on the x-axis. 

The concentration of Level 2 and 3 holdings remains high when considered in relative 
terms. Looking at Level 3 assets as a percentage of total CET1 capital, it can be seen that the 

majority of the banks participating in the EBA Transparency Exercise are located on the left-hand 

side of the distribution, meaning that their ratio of Level 3 assets to CET1 capital is relatively low 

(see Chart 9). At the same time, there are 19 banks where Level 3 holdings represent more than 

30% of CET1 capital, which could be subject to heightened stress if a sudden negative revaluation 

of those assets were to occur. Those banks, which are headquartered in eight different countries, 

have a total combined balance sheet of more than €4.2 trillion and Level 3 assets totalling just over 

26   One criterion that is used to identify and calibrate G-SIBs is the amount of Level 3 assets as a percentage of total assets. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

15 

 
 
                                                                            
€110 billion. A similar profile can be observed when looking at the ratio of Level 2 holdings to total 

CET1 capital – although, given the larger volumes for holdings of Level 2 assets, the resulting 

values for the ratios are much higher (see Chart 10). In this case, more than half of all banks 

participating in the EBA Transparency Exercise have values at the left-hand end of the distribution, 

while there are 21 banks where holdings of Level 2 assets are more than three times CET1 capital. 

These banks are not necessarily those with the largest balance sheets and show a certain degree 

of geographical concentration (reflecting, in some instances, particular features of national banking 

systems), as they are all headquartered in Sweden, Denmark, Germany, the United Kingdom, 

France or Finland. 

Chart 9 

Level 3 assets as a percentage of CET1 capital 

(number of banks in each category) 

45

40

35

30

25

20

15

10

5

0

0%-5%

5%-10% 10%-15% 15%-20% 20%-25% 25%-30% 30%-35% 35%-40% 40%-45% 45%-50%

>50%

Sources: EBA and ESRB Secretariat calculations. 
Note: This chart shows the number of banks in each of the various categories in terms of the ratio of Level 3 assets to CET1 
capital. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

16 

 
 
Chart 10 

Level 2 assets as a percentage of CET1 capital 

(number of banks in each category) 

80

70

60

50

40

30

20

10

0

0%-50% 50%-100% 100%-150% 150%-200% 200%-250% 250%-300% 300%-350% 350%-400% 400%-450% 450%-500% >500%

Sources: EBA and ESRB Secretariat calculations. 
Note: This chart shows the number of banks in each of the various categories in terms of the ratio of Level 2 assets to CET1 
capital. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Overview of the use of fair value accounting by European banks 

17 

 
 
Fair valuation of financial instruments and 

3 
financial stability 

This section discusses the channels through which fair valuation of financial instruments 
may affect financial stability. It identifies three main areas of concern (related to the accurate 
valuation of financial assets and liabilities, the potential for volatility and illiquidity in times of 
financial stress,27 and the reflection of underlying risks in capital requirements), which are 
described in the paragraphs below. As outlined in Figure 1, these issues extend far beyond the 

accounting and regulatory frameworks. Indeed, they also reflect underlying economic phenomena 

(e.g. holdings of complex financial instruments, which are expected to be classified in Levels 2 and 

3). 

Figure 1 

Fair valuation and financial stability 

Financial instruments in Levels 2 and 3: lack of active market, use of models, 
and unobservable inputs (Level 3)

Complex financial 
instruments, 
potential illiquidity 
and volatility in 
times of stress

Appropriate 
reflection of 
underlying risks in 
the regulatory 
capital framework

Accurate valuation 
of fair value assets 
and liabilities, 
importance of 
transparency

Underlying economic 
reality

Prudential framework

Accounting framework

Capital channel

Transparency  channel

Financial stability

Source: ESRB. 

Vulnerabilities stemming from these three areas will affect financial stability through a 

capital channel and a transparency channel, which may have macroprudential implications 

27   Financial instruments in Levels 2 and 3 are expected to be generally illiquid at all times. However, the importance of 
periods of financial stress for macroprudential policy means that the issue of illiquidity will be more relevant in these 
periods. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

18 

 
 
                                                                            
if large numbers of banks are affected during periods of financial stress. Accounting figures 

serve as inputs for the calculation of prudential regulatory requirements (as regards capital, 

leverage and bail-in debt) and other covenants (e.g. bail-inable bonds related to MREL 

requirements), so banks’ behaviour, market perceptions and supervisory actions may be affected, 

depending on the impact that Level 2 and 3 financial instruments have in terms of moving banks 

away from their intended regulatory targets in times of stress. In principle, the extent to which 

regulatory requirements (capital, leverage and bail-in requirements) are affected by the 

vulnerabilities identified in this report may differ across banks (as may the mechanisms through 

which that impact occurs), making this primarily an issue for microprudential supervision. However, 

if several banks were to be affected simultaneously at a time of acute fragility in the financial 

system, concerns could spread to the macroprudential domain and affect financial stability. This 

channel is also shaped by the degree of discretion that is afforded to management. For example, 

discretion that permits delays in the recognition of declines in assets (or increases in liabilities) can 

heighten capital inadequacy concerns during downturns (when such information is revealed more 

fully). As regards the transparency channel, disclosures relating to Level 2 and 3 financial 
instruments can influence the transparency of banks’ balance sheets and risk profiles.28 The 
accounting framework for Level 2 and 3 financial instruments can also affect banks’ transparency 

and information asymmetries – which, in turn, can affect financial stability, particularly at times of 

financial stress, through the role they play in influencing market and supervisory discipline, financial 

frictions, debt overhang problems facing banks and opportunistic risk-shifting activities. 

Although empirical evidence remains limited in this area, an important channel through 

which Level 2 and 3 financial instruments can affect financial stability is the extent to which 
they allow banks’ management to exercise discretion. In theory, credible disclosures can help 

to shape corporate governance and market and supervisory discipline as regards banks’ risk taking 

(BCBS, 2015b). If accounting standards generally facilitate transparency, this may reduce 

uncertainty (e.g. uncertainty about a bank’s underlying asset quality and, in turn, its capital 

adequacy and likelihood of failure) and the financial frictions associated with banks’ efforts to raise 

capital (especially when capital is most needed), which can help to foster financial stability. At the 

same time, however, accounting standards often give reporting entities considerable discretion, 

with both positive and negative effects on financial stability. On the one hand, discretion creates 

scope for informational benefits by allowing larger amounts of private information to be incorporated 

into banks’ accounting reports. However, it also increases the potential for opportunistic behaviour 

by managers. Ultimately, this can heighten investors’ uncertainty about the fundamentals of the 

bank and weaken market discipline as regards risk-taking behaviour (see, among others, Bushman 
and Williams, 2012, 2015).29 As accounting figures are used in the calculation of prudential capital 
requirements, management discretion may lead to inaccurate valuation of financial assets and 

liabilities, ultimately affecting the solvency position of the bank. Hence the importance of ensuring 

28   At this point, it is important to distinguish between disclosure and transparency, since it is often assumed – wrongly – that 
increasing disclosure will always improve transparency. Disclosure is the act of providing information to the financial 
markets, while transparency arises only if the information is reliable and appropriately interpreted and used by participants 
in those financial markets. It is the concept of transparency that underpins effective market discipline. In its broadest sense, 
market discipline is the mechanism through which market participants (e.g. shareholders, debtholders and depositors) 
monitor and discipline, through price and quantity responses, excessive risk-taking behaviour by reporting entities. 
29   Bushman and Williams (2012) find evidence suggesting that management discretion in the application of accounting 
standards which allows banks to manage earnings can inhibit markets’ ability to discipline risk taking, which can be 
detrimental to financial stability. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

19 

 
                                                                            
that the valuations assigned to financial instruments are as accurate as possible. In addition, 

discretion that lowers transparency can increase financial frictions, inhibiting banks’ ability to raise 

capital and increasing the risk of failure. To the extent that discretion also allows banks to conceal 

negative information, this can result in concerns about capital adequacy at a later date when that 

information is ultimately disclosed. 

3.1 

Valuation of financial assets and liabilities 

From a macroprudential perspective, the correct valuation of financial assets and liabilities 
is essential for an accurate assessment of banks’ capital levels and solvency positions.30 
Where assets are measured at amortised cost, valuation is based on the effective interest method 

and correct identification and estimation of impairment and uncollectability, resulting in sufficient 

provisioning. For fair value instruments, however, an accurate valuation involves the calculation of 

a fair value – equivalent, to the extent possible, to the market price of an arm’s-length transaction. 

This is particularly challenging for Level 2 and 3 instruments, where market prices are not available, 

so various modelling techniques and a significant number of unobservable input parameters are 

used to determine the value of the relevant assets and liabilities. 

The main concern about financial instruments measured at fair value is that financial assets 
and liabilities may be misvalued (i.e. overvalued or undervalued). More specifically, the 

overvaluation of financial assets (or the undervaluation of financial liabilities) will produce an overly 

optimistic impression of the bank’s financial position which does not reflect the underlying economic 

reality. When such misvaluations are subsequently corrected, banks’ overall solvency positions 

may be affected via an impact on the profit and loss account or other comprehensive income. 

Moreover, if such financial instruments are used to manage the bank’s daily treasury activities, their 

overvaluation could also generate liquidity problems (which, in a worst-case scenario, could lead to 

a situation where financial obligations can no longer be settled on time, with subsequent indirect 

effects on the solvency position of the bank). The global financial crisis provided several examples 

of the problems that misvaluation can cause, with UBS, Citigroup and Deutsche Bank (and many 

other banks besides) posting significant losses derived from fair value assets (at all levels of the fair 
value hierarchy) between the end of 2007 and the spring of 2009.31 

Given the significant degree of discretion that exists as regards Level 2 and 3 financial 

instruments and the various different incentives that apply when it comes to their valuation, 
such instruments may be the subject of macroprudential concerns.32 Given the 
principle-based nature of accounting standards, IFRS 13 does not provide exhaustive operational 

guidance on all specific aspects (e.g. which model to use, or whether or not inputs are observable) 

30   While this report focuses mainly on banks, many of the issues that it outlines are also relevant to other financial institutions, 
particularly insurance companies, given the introduction of the Solvency II regime based on fair valuation of assets and 
liabilities. 

31   See, for example, UBS Writes Down $14 Billion, Loses Money for Year, and Citigroup to shed 9,000 jobs after 

posting $5.1bn loss. 

32   Anecdotal evidence indicates that a significant percentage of the financial instruments that are classified in Levels 2 and 3 

are not complex (standardised derivatives and repos), and are therefore less likely to be misvalued, but this varies 
significantly across banks. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

20 

 
                                                                            
and judgement should be exercised by the reporting entity (see also EBA, 2017).33 This, in turn, 
has the potential to result in a significant degree of discretion when it comes to the calculation of 

fair values, with the border line between Level 2 and 3 financial instruments becoming increasingly 

blurred. In terms of incentives, the inability to immediately recognise Day 1 profits for Level 3 

instruments (by contrast with Level 2 and 1 instruments) may also be a factor when banks come to 
decide on the allocation of financial instruments across the fair value hierarchy.34 

Banks, auditors, accounting enforcers and microprudential supervisors all have a role to 

play when it comes to ensuring consistent application of the regulatory and accounting 

frameworks (particularly as regards the boundary between Level 2 and Level 3 financial 
instruments). Significant heterogeneity and a lack of transparency could potentially give rise to 

questions about whether institutions are exercising their limited freedom in a comparable manner or 

trying to gain comparative advantages by means of accounting and regulatory arbitrage. The 

boundary between Levels 2 and 3 is particularly relevant in this regard. Supervisory initiatives 

undertaken in this domain typically find shortcomings and flaws in the way that Level 2 and 3 

instruments are measured in banks’ balance sheets. For example, the ECB’s 2014 comprehensive 

assessment revealed that only 67% of banks applying IFRS had a clear policy when it came to 

defining the term “active market” and only 72% had a clear policy on the definition of Level 3 inputs 
(ECB, 2014a).35 What is more, that comprehensive assessment also revealed €4.6 billion in 
additional valuation adjustments stemming from Level 3 assets (out of a total of €37 billion for all 
asset value adjustments), as well as highlighting errors in the classification of fair value assets.36 

Transparency and disclosure can both help to address market concerns about the degree of 
discretion in relation to Level 2 and 3 financial instruments. Indeed, academic literature seems 
to point to a trade-off between the level of detail in disclosures about Level 3 instruments and the 

discretion that is exercised by banks in their valuations (Magnan et al., 2015; Chung et al., 2017; 

Robinson et al., 2018). Banks providing full and comprehensive disclosures seems to lead to lower 

discounts by market participants on their stocks of Level 3 financial instruments, while also 

preventing – or at least hindering – opportunistic behaviour by management when it comes to the 

calculation of fair values for Level 3 instruments. For market participants, such disclosures enable a 

full assessment of the risks relating to fair value assets and liabilities across various different 

institutions. Box 1 below looks at the disclosures that 22 EEA banks made about Level 3 financial 

instruments in their 2018 IFRS financial statements, finding further evidence of such a trade-off. 

33  
In these circumstances, judgement is required by all valuation systems, with such requirements not being limited to IFRS. 
34   Technically, Day 1 profits can only be recognised immediately if the fair value of the financial instrument is evidenced by a 

quoted price in an active market or based on a valuation technique that uses only data from observable markets. 
Consequently, it is possible that some instruments in Level 2 will not satisfy the requirements for immediate recognition of 
Day 1 profits. 

35  

It should be noted, though, that 2014 was the first year in which IFRS 13 was implemented, so those requirements were 
new and banks could still have been adapting to them. 

36   The manual governing the ECB’s asset quality review (ECB, 2014b) describes the methodology used to assess Level 3 

instruments (Level 1 and 2 instruments were not assessed in that exercise). The combined assets of all banks participating 
in the asset quality review totalled around €22 trillion, and the risk-weighted assets of all portfolios covered by the asset 
quality review totalled €3.72 trillion. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

21 

 
                                                                            
Box 1 
Empirical analysis of disclosures made about Level 3 assets by a sample of 
EEA banks 

Under IFRS 13, entities using fair valuation of assets and liabilities are required to disclose 
information on the valuation techniques and inputs used in the measurement of fair values. 
Disclosure serves to enhance transparency and comparability, especially for assets in Level 3 of 

the fair value hierarchy (i.e. assets where the valuation process relies on significant unobservable 

inputs). The transparency and disclosure requirements in IFRS 13 include quantitative information 

on the significant unobservable inputs used in the valuation process, reconciliation of opening and 

closing balances for Level 3 assets, and details of the impact that reasonably practicable alternative 

assumptions would have on the valuation process. 

The analysis in this box looks at a sample of 22 EEA banks in order to review the quality of 
the disclosures required by IFRS 13. That sample consists of the 11 G-SIBs that are domiciled in 
the EU, plus a further set of 11 banks with particularly large or small amounts of Level 3 assets.37 
Geographically, the sample comprises five UK banks, four French banks, three Dutch banks, two 

Austrian banks and two Norwegian banks, as well as one bank from each of Belgium, Denmark, 

Germany, Italy, Malta and Spain. The banks in the sample are diverse in terms of their business 

models, with the 11 G-SIBs sitting alongside cooperative banks, mortgage banks, and trade 

financiers, and some of them being not listed or state-owned. All reported amounts relate to 

31 December 2018 and have been taken from the relevant consolidated annual report for 2018. On 

the basis of reported data, each bank has been categorised as “full disclosure”, “partial disclosure” 

or “no disclosure” for each specific disclosure requirement (for more information on the 
methodology applied, see Annex 5). 38 

While G-SIBs exhibit high ratings across all disclosure requirements, the quality of other 
banks’ disclosures is found to decline as holdings of Level 3 assets increase (see Chart A). 
In general, the quality of G-SIBs’ disclosures is high across all requirements in IFRS 13. However, 

when looking at other banks in this sample, six of the seven banks with the largest holdings of 

Level 3 assets (as a percentage of total fair value assets) do not disclose quantitative information 

on significant unobservable inputs. Interestingly, it seems that unlisted banks tend to have lower 

ratings in this regard. Furthermore, disclosure objectives relating to sensitivity analysis of fair value 

measurements and the impact that reasonably practicable alternative assumptions would have on 

the measurement of fair value are also frequently unmet. All banks reconcile opening and closing 

balances, but some either fail to disclose transfers into and out of Level 3 separately or fail to 

indicate the reasons for such transfers. The reporting of (deferred) Day 1 gains/losses for Level 3 

instruments varies widely across the sample: while some banks even disclose balances for Day 1 

gains/losses associated with Level 3 instruments as at the reporting date, a few others (including 

37  

Ideally, the disclosure of this information under IFRS 13 would allow the use of a larger sample. However, owing to 
difficulties in the manual compilation of data, this exercise has been forced to focus on the largest EU banks, plus a small 
number of other banks with large holdings of Level 3 instruments (while also trying to span a variety of different business 
models). 

38   Where a bank is categorised as “no disclosure”, it may, of course, be the case that no underlying transactions requiring 

disclosure occurred, so no disclosure was necessary. Besides, there is also a materiality threshold in IFRS, whereby IFRS 
requirements (including disclosure requirements) need not be applied if the effect of not applying them is not material. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

22 

 
 
                                                                            
two G-SIBs) make no reference to them whatsoever in their annual reports. That being said, it 

should be noted that Day 1 gains/losses are not included in IFRS 13 transparency and disclosure 

requirements (stemming, instead, from IFRS 7). 

Chart A 

Banks’ disclosure ratings and compliance with disclosure objectives 

(left-panel, x-axis: Level 3 assets as a percentage of total fair value assets (%); units) 

Unlisted/state-owned
Other banks in the sample

G-SIB – full disclosure
G-SIB – partial disclosure
G-SIB – No disclosure
Not available

Other – full disclosure
Other – partial disclosure
Other – no disclosure

1.0

0.8

0.6

0.4

0.2

0.0

0

10

20

30

40

50

60

70

80

(a)

(b)

(c)

(d)

(e)

(f)

(g)

(h)

Sources: Banks’ consolidated IFRS annual reports as at 31 December 2018 and ESRB Secretariat calculations. 
Notes: The left-hand panel depicts banks’ disclosure ratings and their holdings of Level 3 assets as a percentage of total fair 
value assets. The right-hand panel shows banks’ compliance with eight individual disclosure and transparency objectives: 
(a) detailed Level 3 reporting; (b) description of the valuation process; (c) quantitative information on significant unobservable 
inputs; (d) Day 1 profits/losses; (e) reconciliation of opening and closing balances; (f) transfers into and out of Level 3 and 
reasons for those transfers; (g) narrative description of sensitivity of fair value measurement and possible relationships with 
unobservable inputs; and (h) effect that reasonably practicable alternative assumptions would have on the measurement of fair 
value. 

An analysis of Level 3 assets by asset class shows that banks with large amounts of Level 3 

assets (i.e. banks where they account for more than 10% of total fair value assets) exhibit a 
high degree of concentration in one asset class (see Table A). Most G-SIBS hold a relatively 

broad range of Level 3 assets, with the most prevalent asset classes being loans, derivatives (with 

positive gross market values) and securities. As regards the other banks in our sample, several of 

them do not provide a detailed breakdown of their Level 3 assets, and those that do provide such a 

breakdown seem to be fairly strongly concentrated in a single asset class (loans and advances, 

derivatives or securities). 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

23 

 
 
Table A 

Level 3 assets by asset class 

(percentage of total Level 3 assets held by each bank) 

Loans and 
advances  Derivatives  Securities 

Units in 
investment 
funds 

Private 
equity 

Repos 

Other 

Level 3 assets as a 
percentage of total 
fair value assets 

NO1 

MT1 

NO2 

BE1 

UK5 

AT2 

NL3 

NL2 

AT1 

FR2 

DE1 

NL1 

IT1 

ES1 

UK2 

DK1 

UK1 

FR4 

FR1 

FR3 

UK3 

UK4 

99.8 

N/A 

N/A 

95 

7.6 

1.1 

N/A 

N/A 

20.9 

85.7 

0 

0 

0 

0 

0.2 

N/A 

N/A 

5 

6.7 

98.9 

N/A 

N/A 

79.1 

N/A 

N/A 

N/A 

N/A 

30.9 

39.9 

29.1 

63.6 

14.1 

32.3 

32.2 

0 

0.3 

30.7 

12.7 

12.9 

27.5 

0 

23.3 

13 

34.6 

3.6 

22.9 

17 

37.7 

15.4 

14.5 

41.4 

0 

11.7 

0.7 

0 

44 

47.1 

24.1 

23.9 

46.7 

50.7 

13.4 

84.6 

13.2 

28 

83.5 

75.2 

71.8 

100 

0 

0 

0 

0 

0 

0 

0 

0 

0 

16.2 

0 

0 

0 

0 

0 

0 

0.2 

0 

0 

N/A 

N/A 

0 

0 

0 

0 

0 

N/A 

N/A 

N/A 

N/A 

1.8 

0 

0 

0 

0 

0 

1.4 

0 

33.3 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

8.9 

0 

0 

5.5 

0 

0 

0 

3.8 

0 

0 

0 

N/A 

N/A 

N/A 

0 

0 

0 

0 

0 

0 

0 

12.2 

0 

0 

0 

9.8 

0 

38.7 

0 

0 

0 

0 

0 

69.9 

66.6 

22.9 

21.3 

20.8 

17.6 

13.2 

6.4 

5.6 

5.6 

3.9 

3.6 

3.3 

3.1 

2.7 

2.2 

2 

2 

2 

1.9 

0.7 

0.3 

Sources: Banks’ consolidated IFRS annual reports as at 31 December 2018 and ESRB Secretariat calculations. 
Notes: Purple shading on the first column indicates the 11 G-SIBs. The reporting of Level 3 assets in the annual reports of MT1, 
AT2 and NL2 does not allow for a breakdown by asset class. N/A stands for “non-available”. 

3.2 
stress 

Potential volatility and illiquidity in times of financial 

The fair value of derivatives (which account for the majority of fair value assets) may be 

volatile during periods of financial stress, with the potential to significantly affect banks’ 
profitability and solvency. Derivatives are by far the largest component of EU banks’ fair value 
assets and liabilities and are mainly classified as Level 2 (albeit some countries also have 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

24 

 
 
 
 
significant amounts of derivatives classified as Level 3). Indeed, the balance sheets of European 

banks contain more than €2 trillion of derivatives, both on the assets and on the liabilities side. In 

times of financial stress, it may be difficult or costly for a bank to exit or hedge existing derivative 

positions, leaving the bank with two options: exit certain open positions at a known loss, or leave 

positions open and monitor fair value movements in a potentially volatile market, with a risk of 

further balance sheet deterioration via fair value losses. As Chart 11 shows, the fair value of 

derivatives may vary significantly in times of stress, generating losses in the profit and loss 

accounts of affected banks – which may, in extreme circumstances, negatively affect the solvency 
of the underlying institutions.39 For that to occur, variations in the fair value of derivatives would 
need to be abnormally large or would need to affect a significant percentage of the derivatives held 

by the bank (which, in turn, would need to account for a large percentage of the total assets held by 
the bank).40 

Chart 11 

Changes in gross market valuation of total derivatives 

80%

60%

40%

20%

0%

-20%

-40%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: BIS. 

More generally, periods of stress may result in Level 2 and 3 instruments becoming even 

less liquid or fully illiquid, and fair values may be imprecise or subject to greater variability 

and may not reflect the realisable sale price, potentially leading to sizeable fair value losses, 
losses on disposal, and even fire sales.41 Level 2 and 3 instruments are classified as such 

39   To the extent that derivatives are used for hedging purposes, changes in their valuation should be offset by countervailing 
changes in the values of the hedged assets or liabilities. However, as the stylised balance sheet of EU banks in Annex 3 
shows, derivatives are far more likely to be used for trading than hedging. 

40  

In these situations, banks without offsetting derivatives exposures will be more vulnerable than banks whose derivatives 
positions have largely been offset. 

41   Under IFRS 13, the fair value of a financial instrument should not be representative of a forced transaction (see Annex 2 for 
further details). So, in principle, a bank that decides not to dispose of a certain portfolio of financial instruments during 
financial turmoil will not be affected by the prices observed for similar transactions to the extent that it considers that they 
are forced (falling, therefore, within the category of “fire sales”). That, though, will involve discretion on the part of the bank 
when deciding which transactions may be considered to be “forced” and, as such, not representative of the fair value of the 
financial instruments that it holds. Banks may use this provision in IFRS 13 to avoid recognising fair value losses on their 
financial instruments. The impact that market volatility has on financial instruments may vary across the fair value 
hierarchy, with greater uncertainty probably surrounding the identification of “forced transactions” for Level 2 and 3 
instruments. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

25 

 
 
                                                                            
because they are not traded in an active market and their fair value cannot be determined directly 

using market prices. The liquidity of Level 2 instruments can reasonably be expected to decrease 

even further during times of stress, while Level 3 instruments are generally illiquid even in normal 

times. In the presence of financial stress, data used for the valuation of financial instruments in 

Levels 2 and 3 may become highly sparse and volatile, potentially leading to greater variability in 
the valuation of these instruments.42 In such circumstances, liquidity concerns and uncertainty 
about valuations will probably increase, and banks will only be able to unwind their positions in 

these instruments with substantial losses. If, on the other hand, banks decide to keep these 

instruments on their balance sheets, their fair values will, in principle, be subject to significant 

variation, reflecting their lower levels of liquidity and high uncertainty about valuation. That will be 

the case if banks decide to avoid recognising financial instruments in Level 3 and are then forced to 

do so in the presence of financial stress (with poorly designed or untested valuation models). It is 

also possible that banks could decide to classify financial instruments in Level 3 in times of financial 

stress, in order to avoid reporting the significant fair value adjustments that would need to be 

disclosed if those instruments were classified in higher levels of the fair value hierarchy (IMF, 2008; 

Acharya and Ryan, 2016). These hypothetical situations highlight the importance of monitoring the 

boundary between Level 2 and 3 instruments. Either way, the losses involved, either via the 

disposal of Level 2 and 3 instruments or via adjustments to fair values, have the potential to be 

significant and impair the profitability of institutions in such times of stress (IMF, 2008; Acharya and 

Ryan, 2016; Roca et al., 2017). Indeed, the global financial crisis provides a recent example of 

large losses being caused by complex financial instruments (those related to mortgage-based 

securities), indirect contagion and fire sales (Kamin and DeMarco, 2010; Clerc et al., 2016). In such 

situations, the impact on financial stability will come through the capital channel, as large losses 

stemming from financial instruments in Levels 2 and 3 have the potential to negatively affect 

regulatory capital ratios. 

While accounting standards aim to reflect the underlying economic value of Level 3 

instruments in such instances, the potential macroprudential impact may warrant increased 
supervisory action. Accounting standards must, by definition, reflect the underlying economic 

value of the assets and liabilities of the reporting entity. Thus, declines in the fair values of Level 2 

and 3 instruments in times of stress should not be watered down (by allowing banks to behave 
opportunistically in terms of their valuations or through amendments to reporting standards).43 On 
the contrary, the expected impact of massive negative revaluations of Level 2 and 3 instruments 

should raise awareness among accounting enforcers and supervisors regarding the importance of 

monitoring banks’ exposure to complex financial products (which will typically be classified in 

Levels 2 and 3), including the way relevant accounting policies are applied (IMF, 2008). 

Finally, for Level 2 and 3 instruments, the risk of imperfect modelling (e.g. as regards the 

elasticity of prices to liquidity and the correlation with market prices) may be exacerbated in 
times of financial stress. The valuation of Level 2 and 3 instruments is heavily reliant on models, 

42   Where valuations are based entirely on internal information, rather than on inputs available in the market, the perceived 

valuation uncertainty for these instruments will arguably increase. 

43  

In 2008, for example, the IASB introduced an amendment to IAS 39 (the accounting standard governing the measurement 
of financial instruments that was in place at that time) allowing reclassification from fair value to amortised cost, bypassing 
its usual processes. For more details, see IAS 39/IFRS 7 – Reclassification of financial assets. That amendment has 
also attracted the attention of academics (see Fiechter, 2011, and Lim et al., 2013). 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

26 

 
                                                                            
and inputs are not usually easily observable. Those models may involve a certain degree of 

complexity and be subject to sizeable modelling risk, which may be particularly high in times of 

financial stress, when inputs deviate greatly from their average values (Danielsson, 2002). 

Modelling risk will materialise if (i) the fair value is not appropriate because the correct input 

variables are not captured, (ii) the assumptions made are not correct or change abruptly, or 

(iii) there is a significant difference between the estimated fair value and the current sale price 

(which can be exacerbated during periods of market stress, especially if the bank needs to sell the 

instruments in question). If modelling risk materialises in periods of stress, this can generate 

extreme valuations, which could result in significant changes to the fair values of the underlying 

Level 2 or 3 instruments. 

3.3 

Reflection of underlying risks in capital requirements 

Within the regulatory framework, sources of vulnerability stemming from Level 2 and 3 

instruments are most likely to be addressed through the market risk component (which 
generally generates low risk weights). Level 2 and 3 financial instruments are typically 

associated with banks’ trading activities and, as such, will typically fall within the definition of 
“trading book” for regulatory purposes.44 Consequently, they should be subject to market 
risk-related capital requirements, together with other financial instruments in the trading book that 

are classified as Level 1 instruments. Looking at the regulatory framework as a whole, 

risk-weighted assets that are subject to market risk-related capital requirements make up around 

6% of total risk-weighted assets, with substantial cross-country heterogeneity (see Chart 12). Low 

risk weights are typically assigned to market risk exposures, since they are held for trading 

purposes and subject to continuous turnover in the balance sheet of the bank. 

44   Anecdotal evidence suggests that around 70% of all financial instruments in Levels 2 and 3 are included in the trading 

book. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

27 

 
                                                                            
Chart 12 

Risk-weighted assets for market risk as a percentage of total risk-weighted assets in the 

EEA 

EEA average

16%

14%

12%

10%

8%

6%

4%

2%

0%

UK RO DE DK IT SI HU CZ FI FR ES AT SE BE PT GR NL PL IE HR IS SK LT NO LU CY BG EE LV MT

Source: EBA Risk Dashboard. 
Note: Data indicate the situation as at end-2018. 

Overall, the use of prudential valuation adjustments seems to be fairly limited. In the 

prudential regulatory framework, there is a requirement to calculate prudential valuation 

adjustments for financial instruments that are measured at fair value in order to take account of 

situations where those instruments are illiquid or particularly complex, or their valuations are based 

on models or third-party calculations. According to data published by the EBA in the context of the 

2019 Transparency Exercise, prudential valuation adjustments totalled €24 billion in the second 

quarter of 2019, equivalent to 0.2% of total risk exposure and 1.08% of total own funds. 

The entry into force of the Fundamental Review of the Trading Book (and, to a lesser extent, 

the leverage ratio) is expected to improve the way in which market risk is taken into account 
in the regulatory framework. Fair value accounting may generally have a procyclical impact on 

banks’ regulatory capital at times when market illiquidity reduces estimated fair values (IMF, 2008). 

The global financial crisis revealed flaws and shortcomings in the existing regulatory framework as 

regards capital requirements for market risk. In response, the BCBS published in 2016 (with 

subsequent revisions) its Fundamental Review of the Trading Book (BCBS, 2019), with the aim of 

improving the way in which market risk is incorporated into regulatory capital requirements for 

banks. In particular, as regards the manner in which market liquidity is incorporated into the new 

prudential framework for market risk, the FRTB does away with the previous ten-day horizon, as 

the liquidity of transactions is often dependent on risk factors, and instead introduces liquidity 

horizons which are mapped to risk factors. For example, the volatility risk factor for foreign 

exchange rates has been assigned a liquidity horizon of 60 days. Those liquidity horizons indicate 

the time that is required for a transaction to be executed in the presence of market stress without 

affecting the price of the hedging instrument. In other words, they can be seen as the time that it 

takes to eliminate exposure to a risk factor. Initial estimates of the impact of the FRTB point to a 

substantial increase in capital requirements for market risk, which should better reflect the 

underlying risks in those positions. For example, an interim impact assessment by the BCBS points 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

28 

 
 
to an average increase of 41% in risk-weighted assets for market risk (BCBS, 2015a), and the EBA 

anticipates that the impact will be greater for banks adopting the standardised approach to market 
risk than it is for banks using internal models (EBA, 2016).45 The recently published amendments to 
the Capital Requirements Regulation envisage an obligation requiring EU banks to report on the 

impact of the FRTB, with a view to incorporating the FRTB into capital requirements as the next 

step. Finally, the introduction of a binding regulatory requirement for leverage ratios also addresses 

situations where accounting valuations for financial instruments depart significantly from the 

relevant risk-weighted amounts (ESRB, 2015). 

45   The EBA is currently working on an updated report on the FRTB’s impact on European banks, based on the latest text 

published by the BCBS. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Fair valuation of financial instruments and financial stability 

29 

 
                                                                            
4 

Concluding remarks 

There is significant heterogeneity across banks as regards the relative importance of 

Level 2 and 3 instruments, as well as the underlying portfolios, instruments and models 
associated with them. The data analysed in this report suggest that the relative importance of 

Level 2 and 3 instruments varies significantly across EU banks and is not always directly correlated 

with the size of the bank. At the same time, the underlying financial instruments also vary 

considerably, ranging from plain interest rate derivatives which might be cleared centrally in major 
currencies (typically classified as Level 2)46 to more complex and opaque products with values 
based on unobservable variables. In that context, transparency is particularly important, as are 

targeted actions by relevant stakeholders (auditors, accounting enforcers and microprudential 

supervisors). 

There are several ways of improving banks’ transparency as regards Level 2 and 3 
exposures. Academic literature has identified several concerns regarding the information that is 

disclosed about these instruments, which revolve around the reliability of data and the potential for 

opportunistic behaviour (see Annex 1 for further details). Consequently, it is not always easy for 

market participants to assess whether Level 2 and 3 financial instruments are being valued 

accurately. This relates to the transparency channel described in Section 3. Misvalued financial 
instruments can have a significant impact on accounting figures – and, in turn, regulatory capital.47 
More comprehensive and granular disclosures about Level 2 and 3 financial instruments 

(e.g. disclosure about the sensitivity of valuations or Day 1 profits) would potentially allow more 

market discipline to be exercised by helping market participants to compare banks (see also EBA, 

2017). The IASB is currently setting up a project with the aim of achieving targeted improvements 
to the disclosure requirements in IFRS 13.48 

Enhanced disclosure by banks would support the efforts of regulatory authorities in this 
area. ECB Banking Supervision publishes supervisory information on the fair value hierarchy for 
the banks under its supervision.49 Similarly, the EBA Risk Dashboard provides information on 
Level 2 and 3 financial instruments on a quarterly basis.50 In addition, the 2019 EBA Transparency 
Exercise provided, for the first time, bank-level data on Level 2 and 3 financial instruments. 

Besides, liquidity and model uncertainty shocks, and Level 2 and 3 financial instruments are now 
also considered in the EBA’s stress test exercises (EBA, 2018).51 Against that background, it would 
be helpful if the ESRB Risk Dashboard could also report information on Level 2 and 3 financial 

instruments. 

46   Under the current regulatory framework in the EU, only interest rate swaps denominated in major currencies (euros, 
pounds sterling, US dollars and Japanese yen) have to be cleared centrally, while those denominated in other EU 
currencies are still cleared on a bilateral basis. There are also other exemptions to central clearing (e.g. where one of the 
counterparties is an EU pension scheme). 

47   By virtue of their nature, Level 3 instruments (and, to a lesser extent, Level 2 instruments) will always involve a certain 

degree of valuation uncertainty.  

48   See Disclosure Initiative: Targeted Standards-level Review of Disclosures, November 2019. 
49   See Publication of supervisory data. 
50   See EBA Risk Dashboard. The EBA Risk Assessment Report, which is published on an annual basis, also contains 

information on Level 2 and 3 instruments. 

51   See EBA 2019 EU-wide transparency exercise. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Concluding remarks 

30 

 
                                                                            
The significant heterogeneity that can be observed across EU banks means that auditors, 

accounting enforcers and microprudential supervisors need to make full use of their 
mandates when it comes to Level 2 and 3 instruments. Financial instruments that are held by 

banks for trading purposes and measured at fair value (some of which – like derivatives and 

relatively illiquid instruments – are classified in Levels 2 and 3 of the fair value hierarchy) may be 

subject to sharp corrections and reassessments of their risk premia, which could trigger large 
adjustments to fair values.52 This is particularly relevant in the current macro-financial environment, 
where the repricing of risk premia is estimated to be a source of systemic risk for the EU financial 

system. Against that background, auditors, accounting enforcers and microprudential supervisors 

should be encouraged to make full use of their mandates (which could be strengthened if 

necessary), in order to: 

• 

• 

• 

• 

ensure that banks treat similar instruments in a similar way, and that the allocation of financial 

instruments to the fair value hierarchy adequately reflects the uncertainty surrounding the 

valuation of the instruments in question; 

carry out more detailed assessments of the prudential valuation framework for banks, with 

appropriate supervisory action being taken when deficiencies and/or unsatisfactory practices 

are detected; 

understand the way that banks’ valuation models perform in the presence of market stress 

(and even perform back-testing of models), in order to establish a sound understanding of the 

way that the value of Level 2 and 3 financial instruments varies in response to changes in the 

macro-financial environment; 

understand how the disclosure requirements for Level 2 and 3 financial instruments under 

IFRS 13 are effectively put into practice by European banks (ESMA, 2017) and ensure that 

the disclosure requirements of IFRS 13 are adhered to. 

On the regulatory side, the FRTB represents a significant improvement in terms of the way 

that market risk is reflected in the regulatory capital requirements for banks – and, as such, 
should be promptly implemented in the EU. The prompt incorporation of the FRTB in the EU’s 

regulatory framework should ensure that capital requirements for banks are better at reflecting 

market risk, learning from the developments seen in the global financial crisis. A key feature of the 

FRTB in this regard is the introduction of observability requirements for the assessment of the 

modellability of risk factors. This is particularly important following the withdrawal of prudential filters 

(which means that any unanticipated negative changes in fair values impact banks’ CET1 capital 
ratios in periods of stress)53 and the accumulation of vulnerabilities over time, which typically 
materialise in sudden and sharp price movements (such as the volatility spike in February 2018 or 

the correction in stock markets at the end of 2018). The fact that the FRTB will result in an increase 

in total capital requirements should not prevent it from being faithfully implemented in the EU. At the 

same time, in order to reap the full benefits of the FRTB, microprudential supervisors need to be 

52   Moreover, it is important to note that the allocation of financial assets and liabilities to higher levels of the fair value 

hierarchy does not necessarily mean that significant losses are impossible, and also that the level to which an asset or 
liability is assigned is no reflection of the volatility of the value of the underlying instrument. 

53   That being said, some countries continue to use these filters in relation to the distribution of profits. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Concluding remarks 

31 

 
                                                                            
able to validate and challenge the models that are used by banks to assess the capital 

requirements resulting from their trading books. Supervisors could also look at the estimation of fair 

values, including prudential adjustments, in dedicated on-site inspections. To that end, it could be 

useful to develop benchmarks against which such models could be tested. In addition, even if the 

FRTB does not enter into the accounting domain, it could prove to be useful in addressing some of 

the concerns that have been identified in relation to Level 2 and 3 instruments. In effect, the FRTB 

will largely be based on the same market data as the current assessment of the observability of 

inputs in the accounting domain, with similar representativeness assessments. Consequently, 

additional work exploring the possibility of greater convergence between the FRTB and IFRS 13 

could be considered. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Concluding remarks 

32 

 
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Roca, R., Potente, F. (coordinators), Ciavoliello, L.G., Conciarelli, A., Diprizio, G., Lodi, L., Mosca, 

R., Perez, T., Raponi, J., Sabatini, E. and Schifino, A. (2017), “Risks and challenges of complex 

financial instruments: an analysis of SSM banks”, Banca d’Italia Occasional Papers, No 417. 

Shaffer, S. (2010), “Fair value accounting: Villain or innocent victim – exploring the links between 

fair value accounting, bank regulatory capital and the recent financial crisis”, Federal Reserve Bank 

of Boston Working Papers, No QAU10-01, January. 

Siekkinen, J. (2016), “Value relevance of fair values in different investor protection environments”, 

Accounting Forum, Vol. 40, Issue 1, pp. 1-15. 

Song, C.J., Thomas, W.B. and Yi, H. (2010), “Value relevance of FAS No. 157 fair value hierarchy 

information and the impact of corporate governance mechanisms”, Accounting Review, Vol. 85, 

Issue 4, pp. 1375-1410. 

Tama-Sweet, I. and Zhang, L. (2015), “The value relevance of fair value financial assets during and 

after the 2008 financial crisis: evidence from the banking industry”, Journal of Finance and Bank 

Management, Vol. 3, Issue 1, pp. 11-24. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
References 

36 

 
Watts, R.L. (2003), “Conservatism in accounting part I: Explanations and implications”, Accounting 

Horizons, Vol. 17, Issue 3, pp. 207-221. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
References 

37 

 
Annex 1: Literature review 

This annex reviews existing academic literature on the interaction between Level 2 and 3 

instruments and financial stability, without looking at the wider topic of fair value 
accounting. The academic community has spent a number of years discussing the most 

appropriate way of measuring financial assets (historical cost or fair value) – a discussion that has 

gained attention in the aftermath of the global financial crisis. The ESRB’s 2017 report on IFRS 9 

considered these discussions, and some useful references can be found there (ESRB, 2017). 

Similarly, the BCBS has published two working papers on the interaction between accounting and 

regulation, and their interaction with banks’ behaviour, which also review existing literature on the 

subject (BCBS, 2015b and 2017). The post-implementation review of IFRS 13 that was carried out 

by the IASB between May 2017 and December 2018 also prompted the publication of a 

comprehensive review of literature on the implementation of IFRS 13 (Filip et al., 2017). Another 

useful resource in this regard is the literature review carried out by Ghio et al. (2018). 

Academic coverage of the interaction between Level 2 and 3 instruments and banks’ 

behaviour and financial stability has grown in recent years, albeit it usually looks at US 
banks. Accounting standards applied in the United States also define a hierarchy for fair value 

measurements, which is similar to that set out in IFRS 13 (KPMG, 2017). IFRS 13 was issued in 

2011, and FAS 157 (the equivalent US accounting standard) was substantially amended in the 

same year, and academic work on this subject seems to have intensified in the last few years. At 

the same time, that analysis tends to be based primarily on data from US reporting entities, 

probably because it is easier to access data in the United States. However, given the strong 

commonalities between IFRS 13 and FAS 157, findings in papers covering US banks can typically 

be extended to cover EU banks as well. 

There is agreement in the academic community that fair value estimates are important for 

investors, with estimates for instruments in Levels 2 and 3 usually found to be less 
important. In general, it is possible to establish a statistical relationship between accounting values 

for financial instruments measured at fair value and stock market performance (Barth, 2007; 

Magnan, 2009; Bosch, 2012). However, within the fair value hierarchy, investors seem to penalise 

Level 3 instruments, finding their fair values to be less reliable. Song et al. (2010), Bosch (2012), 

Goh et al. (2015), Tama-Sweet and Zhang (2015), Siekkinen (2016) and Freeman et al. (2017) all 

find that Level 2 and 3 valuations are less relevant than those of financial instruments classified in 

Level 1. Accordingly, Du et al. (2014) suggest that the relevance of fair value measurements 

increases when assets are transferred out of Level 3. At the same time, other academic papers find 

that Level 3 estimates provide more accurate information about the future cash flows of the relevant 

instrument (Altamuro and Zhang, 2013; Lawrence et al., 2016). 

Another stream of academic literature tries to identify the features that determine the size 
and reliability of Level 3 estimates. The reliability of Level 3 fair value estimates may depend on 

individual characteristics of the bank – particularly its performance and capital adequacy. Daifei et 

al. (2018) find evidence that less profitable banks (measured by the return on assets), larger banks, 

less well capitalised banks, banks that are not audited by one of the “Big Four” and banks in 

countries with less developed capital markets and legal systems are all more likely to use Level 3 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 1: Literature review 

38 

 
inputs. In the study by Altamuro and Zhang (2013), determinants for the allocation of financial 

instruments to Levels 2 and 3 were found to include bank size, accounting choice and mortgage 

risk. Bosch (2012) finds that the market perceives fair value estimates to be less reliable at banks 

with lower capital ratios, possibly because these banks are considered more likely to use 

accounting discretion for opportunistic reasons. In a similar vein, Ayres (2016) shows that there is a 

negative correlation between the amount of Level 3 instruments and the credit rating of the 

reporting entity, Magnan et al. (2016) find evidence that, for a sample of financial institutions 

between 2007 and 2014, higher Level 2 and 3 exposures are associated with higher debt costs, 

and Huang et al. (2016) identify a positive correlation between Level 3 exposures and the cost of 

capital in the United States during the global financial crisis. 

Academic literature has also tried to confirm the conjecture that fair value estimates provide 
significant room for managerial discretion (Watts, 2003). According to Robinson et al. (2018), 
when reported capital ratios are near the regulatory target, bank managers tend to increase their 

estimates of Level 3 valuations in order to report higher unrealised gains and boost capital 

adequacy ratios. Similarly, Hsu and Lin (2016) document a positive correlation between the amount 

of financial instruments in Level 3 and manipulation aimed at meeting or beating earnings targets. 

Lin et al. (2017) use accounting restatements as a proxy for the quality of financial reporting, 

arguing that the probability of a restatement is significantly higher for Level 3 fair values than it is for 

Levels 1 and 2, consistent with the idea that using less reliable fair values has a negative impact on 

the quality of financial reporting. Finally, Curtis and Raney (2016) show that managers tend to delay 

the incorporation of negative information into the fair values reported for Level 3 assets. 

Improvements to disclosure and enhanced corporate governance may help to constrain 
opportunistic behaviour in respect of Level 3 instruments. Providing investors with more 

transparent information regarding the measurement of fair values usually leads to lower discounting 
of Level 3 instruments by market participants.54 Magnan et al. (2015) show that the disclosure of 
inputs for fair value estimates helps to improve the information provided to market participants. 

Chung et al. (2017) show that additional disclosures regarding the measurement process for fair 

value estimates serve to alleviate investors’ concerns and reduce uncertainty around fair value 

measurements (particularly for instruments in Level 3). Furthermore, according to evidence 

provided by Robinson et al. (2018), banks that are close to internal capital ratio targets are less 

likely to boost capital through unrealised gains from Level 3 instruments after enhanced disclosure 

policies have been implemented. What is more, the reliability of fair valuations for Level 3 

instruments has been found to be positively correlated with the strength of corporate governance 

within the reporting institution (Song et al., 2010; Siekkinen, 2016; Badia et al., 2017). 

Academic research on financial liabilities measured at fair value has focused on the 

potential for misinterpreting the manner in which changes in fair value are reflected in the 
profit and loss account. In general, financial liabilities classified as Level 2 or 3 are much less 

significant than financial assets assigned to those levels of the fair value hierarchy, with most of 

them being derivatives (Badia et al., 2017). The main focus of academic research concerns the 

counterintuitive finding that a deterioration in the credit risk of the reporting entity generates a gain 

in the profit and loss account. Gaynor et al. (2011) note the important role that disclosures have to 

54   See also ESMA (2017). 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 1: Literature review 

39 

 
                                                                            
play in terms of unravelling this counterintuitive effect, while Bischof et al. (2014) find that, for a 

sample of 49 banks from 30 countries over the period 2008-10, most conference call questions and 

references in financial analysts’ reports related to fair value reclassifications and changes to fair 

value liabilities stemming from banks’ own credit risk. Looking at a sample of European banks over 

the period 2007-15, Dong et al. (2017) find evidence consistent with the idea that banks exercised 

discretion when it came to the fair values of their financial liabilities in order to smooth earnings. 

Similarly, Couch and Wu (2017) studied the adoption of the fair value option for liabilities (FVOL) in 

the United States and found that financially vulnerable firms were more likely to adopt the FVOL 

and that adopters were more likely to receive TARP bailout funds, suggesting that the adoption of 

the FVOL revealed information which had not previously been priced in by financial market 

participants. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 1: Literature review 

40 

 
Annex 2: Accounting and regulatory frameworks 

This annex provides an extensive description of the accounting and prudential requirements 
for financial instruments measured at fair value. The first section focuses on accounting 

requirements (most of which are set out in IFRS 13), while the second discusses the prudential 

requirements for fair value instruments, which relate mainly to the determination of regulatory 

capital ratios. 

1 

Accounting framework 

1.1 

Key principles 

IFRS 13 sets out the framework governing the measurement of fair values, and its 
requirements are applied to both financial assets and liabilities.55 A fair value is defined as 
“the price that would be received to sell the asset or to transfer the liability in an orderly transaction 
between market participants at the measurement date under current market conditions”.56 IFRS 13 
makes it clear that a fair value is a market-based measurement, and that it should take account of 

the specific characteristics of the instrument in question. This means that any restrictions on the 

sale or use of the instrument can influence its fair value. However, only instrument-specific 

restrictions (i.e. restrictions that would be transferred with the sale of the instrument) are relevant 

for measurement purposes, not entity-specific restrictions (i.e. restrictions that are specific to the 

entity in question and would not, therefore, be transferred in a sale). For example, a limitation on 

dividend distribution for participation exceeding certain thresholds would not be relevant for the 

measurement of fair value, since that limitation would not be transferrable in a market transaction. 

The relevant price is the amount that would be received in an orderly transaction under 
current market conditions. For the computation of fair values, the considered transaction would 

need to take place in the principal market for the financial instrument, with market participants 

acting in their best economic interest. Only markets to which the entity has access can be 

considered for valuation purposes. The principal market for the financial instrument is defined as 

the market with the greatest volume or level of activity. Otherwise, the fair value of a financial 

instrument must be calculated on the basis of a transaction in the most advantageous market. 

Since different entities with different activities may have access to different markets, IFRS 13 allows 

different entities to have different fair value outcomes for the same instrument. When performing 

that evaluation, the entity should adopt the assumptions that market participants would use when 

measuring the instrument in question. Market participants are assumed to possess the following 

characteristics: they are independent of each other; they have a proper understanding of the 

instrument in question; and they are motivated (i.e. they are not being forced) to enter into the 

transaction. 

IFRS 13 is also applicable to tangible and intangible assets, which lie outside the scope of this report. 

55  
56   See IFRS 13, paragraph 9. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
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41 

 
                                                                            
IFRS 13 is also applicable to the measurement of financial liabilities and provides for an ad 
hoc approach when prices are not available. In this case, an asset-side measurement is 
required: the entity should measure the fair value from the perspective of a market participant that 

holds an identical item as an asset. Adjustments are applied if the price quoted for an asset is 

influenced by factors that are not applicable to the liability or equity instrument in question 

(e.g. where the asset has a higher credit quality). 

While IFRS 13 generally relates to stand-alone financial instruments, a specific exemption is 

made for a group of financial assets and liabilities that are managed collectively on the 
basis of net exposure to either market risk or credit risk. In this situation, in order to properly 
take account of the entity’s approach to the management of the group of financial assets and 

liabilities, this can be measured on a net basis – i.e. using the price of the equivalent net long (or 

short) position. 

1.2 

Valuation techniques 

IFRS 13 provides little guidance on the use of valuation techniques, pointing out that 
valuation techniques should be appropriate and sufficient data should be available.57 As a 
general guide, the use of observable inputs should be maximised, and the use of unobservable 

inputs should be minimised. 

IFRS 13 describes two types of valuation technique for financial instruments: a market 
approach and an income approach. Other approaches are not prohibited, but the valuation 

approach selected should be consistent with one or more of the techniques presented. If an entity 

relies on valuation techniques, a single approach is only appropriate in certain circumstances – 

e.g. when evaluating an instrument using prices quoted in an active market for identical 

instruments. If multiple valuation techniques are used, the final outcome should be identified within 

the range of results by selecting the point that is most representative of fair value. The central 

outcome (i.e. the mid-point) is not necessarily the best estimate of fair value. Valuation techniques 

should be applied consistently over time and across instrument classes. Changes to either the 

technique itself or its application (e.g. a change of weighting where multiple approaches are used) 

are appropriate if they lead to a more representative measurement of fair value (e.g. where new 

information becomes available, or information that was used previously ceases to be available). 

The market approach is based on prices and other relevant information generated by market 

transactions involving identical or comparable financial instruments (e.g. the market 
multiples obtained by a group of comparable entities). Another example of such information, 

which IFRS 13 refers to specifically in the case of financial instruments (and debt securities in 

particular), is matrix pricing, which relies on quoted prices and the security’s relationship with other 

quoted securities that act as benchmarks. 

The income approach comprises a group of evaluation techniques that are based on the 

conversion of future amounts (cash flows or income and expenses) into a single discounted 

57   See IFRS 13, paragraph 24. 

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Annex 2: Accounting and regulatory frameworks 

42 

 
                                                                            
amount. Thus, the fair value represents current market expectations about future amounts to be 

obtained/delivered through the possession of the asset/liability. This includes several different kinds 

of evaluation technique: present value techniques, option pricing models (such as the Black-

Scholes-Merton formula or binomial models) and multi-period excess earnings methods (applicable 

to some intangible assets). Present value techniques are expected to capture the following: an 

estimate of future cash flows, expectations about variability in the volume and timing of cash flows, 

the time value of money, the risk premium for accepting the inherent uncertainty associated with 

cash flows, other factors that market participants would take into account, and the risk of 

non-performance in the case of a liability (i.e. the entity’s own credit risk). 

Discount rates and cash flows should be consistent, in order to avoid double-counting or 
omitting risk factors. In other words, if the uncertainty surrounding expectations of future cash 

flows is reflected in the discount rate, contractual (i.e. risk-free) cash flows can be used. The same 

discount rate would not be appropriate if expected cash flows were used in the evaluation, as 

expected cash flows already reflect assumptions about the uncertainty of future outcomes. 

IFRS 13 requires the inclusion of a risk premium to account for the uncertainty of present 

value techniques, allowing this to be based on either discount rates or expected present 
values. Uncertainty is embedded in present value techniques, as cash flows are estimated rather 

than being certain amounts (with even contractual cash flows being dependent on absence of 

default). Consequently, IFRS 13 requires the use of a risk premium in all instances, even where it 

could prove extremely difficult to calculate. Risk adjustment can be achieved using either discount 

rate adjustment techniques or expected present value techniques. 

• 

• 

Discount rate adjustment techniques are based on a single set of cash flows, which 
can be either contractual, promised or most likely cash flows. The principal characteristic 
of this set of cash flows is that it is conditional on the occurrence of specified events (in the 

case of a bond, the absence of default on the part of the debtor). The discount rate is derived 

from observed rates of return for comparable instruments that are traded in the market. 

Analysis is required in order to assess the comparability of selected instruments. In the 

absence of a single comparable instrument, the discount rate should be derived using several 

comparable instruments in conjunction with the risk-free yield curve. 

Expected present value techniques use a single set of cash flows, representing the 
probability-weighted average of all possible future cash flows. Thus, by contrast with 

discount rate adjustment techniques, all possible cash flows are taken into consideration in 

the probability weighting (i.e. they are not conditional on the occurrence of any specified 

event). IFRS 13 envisages two possible ways of adjusting expected cash flows in order to 
take systematic risk into account.58 The first method provides for an adjustment to the 
expected cash flows (i.e. a deduction), to make them equal to the certainty-equivalent cash 

flows (i.e. the certain amount that is equivalent to an expected and risky amount). The 

risk-free rate is then used for discounting. The second approach involves adjusting cash flows 

by applying a risk premium to the risk-free interest rate. 

58   Paragraph B24 of IFRS 13 refers specifically to portfolio theory, according to which only the systematic risks of holding a 

financial instrument are remunerated if markets are in equilibrium. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 2: Accounting and regulatory frameworks 

43 

 
                                                                            
1.3 

Types of input 

IFRS 13 categorises inputs for valuation techniques on the basis of a three-level fair value 

hierarchy (see Figure A.1), whereby observable inputs (Level 1 inputs) are preferred to 
unobservable inputs (Level 3 inputs). The input level determines the fair value level: a 
measurement based solely on Level 1 inputs results in a Level 1 fair value. Where inputs from 

different hierarchical levels are used, the fair value is categorised on the basis of the lowest level of 

input that is significant to the measurement as a whole. The significance of an input in relation to 

the measurement as a whole should be assessed with discretion, and no precise guidelines are 

provided. In addition, where an adjustment needs to be based on unobservable inputs and the 

measurement leads to a significantly different value, the fair value is categorised as Level 3. 

Figure A.1 

Allocating financial instruments to fair value levels 

Yes

Yes

Quoted price for an 
identical item in an 
active market?

No

Any significant 
unobservable 
inputs?

Price adjusted?

Level 1

No

No

Yes

Level 2

Level 3

Source: KPMG (2017). 

Level 1 inputs are “quoted prices in active markets for identical assets or liabilities that the 
entity can access at the measurement date”.59 These are considered the most reliable evidence 
of fair value and are used for many financial instruments.60 

Level 2 inputs are “inputs other than quoted prices included within Level 1 that are 

observable for the asset or liability, either directly or indirectly”.

61 Level 2 inputs include the 
following: prices quoted for similar instruments in an active market; prices quoted for identical or 

59   See IFRS 13, paragraph 76. 
60   Adjustments to Level 1 inputs are only allowed in specific circumstances: when the entity holds a large number of similar 
(but not identical) instruments and a quoted price in an active market is available, but not readily accessible, for each 
individual instrument (with a simplified approach – such as matrix pricing – being envisaged where individualised 
measurement of fair values is difficult owing to the large number of non-identical instruments); when a quoted price in an 
active market does not represent a fair value on the measurement date (e.g. when a significant event or announcement 
takes place after a market closes but before the measurement date); and when liabilities and own equity are measured on 
the basis of a quoted price for an identical item traded as an asset, and the price needs to be adjusted for factors specific to 
the item. Markets that present observable inputs include exchange markets, dealer markets, brokered markets and 
principal-to-principal markets (where transactions are negotiated independently, without intermediaries). 

61   See IFRS 13, paragraph 81. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 2: Accounting and regulatory frameworks 

44 

 
 
                                                                            
similar instruments in non-active markets; other observable inputs (such as interest rates and yield 

curves, implied volatilities and credit spreads); and market-corroborated inputs. Derivatives are 

typically categorised as Level 2 financial instruments. Adjustments to Level 2 inputs will vary 

depending on factors specific to the instrument in question (e.g. the volumes or levels of activity in 

the markets in which the inputs are observed). However, an adjustment that uses significant 

unobservable inputs can lead to categorisation in Level 3 if it is significant to the measurement as a 

whole. IFRS 13 includes some examples of Level 2 inputs for financial instruments. For instance, a 

LIBOR swap rate can be considered a Level 2 input for a swap if it is observable for substantially 

the entire residual life of the swap. If the residual life of a financial instrument exceeds the period for 

which the swap rate is observable, extrapolation of the yield curve is only allowed if it is not 

significant to the measurement of the swap’s fair value as a whole. 

Level 3 inputs are “unobservable inputs for the asset or liability”, and their use is allowed 
62 Such inputs need to reflect the assumptions 

only when observable inputs are not available.

that market participants would employ when pricing the financial instrument, including assumptions 

about the risks that are inherent in the valuation technique and the inputs used. Level 3 inputs also 

include the entity’s own data, which must be adjusted if there is evidence that other market 

participants would use different data. The requirement to take account of information about other 

market participants’ assumptions only ceases to apply if that information cannot be obtained 

without disproportionate efforts. As an example of a Level 3 input, IFRS 13 cites the interest rate for 

a specified currency that is not observable and cannot be corroborated by observable market data. 

Historical volatility (i.e. volatility obtained from instruments’ historical prices) is also a Level 3 input, 

as it does not typically reflect current market participants’ expectations about future volatility. 

Examples of Level 3 instruments include illiquid emerging market corporate bonds and illiquid 

highly structured corporate bonds, as well as holdings of notes issued by securitisation entities, 

commercial and residential mortgage-backed securities, collateralised debt obligation securities 

and other asset-backed securities. Certain parameters for derivatives also represent Level 3 inputs 

(e.g. certain correlations, longer-term volatilities, prepayment rates, credit spreads and other 

transaction-specific parameters). Level 3 derivatives include options where volatility is 

unobservable and basket options in which the correlations between the referenced underlying 

assets are unobservable, as well as longer-term interest rate options, multi-currency foreign 

exchange derivatives and credit default swaps where the credit spread is not observable. 

1.4 

Day 1 profit 

While the transaction price and the fair value will generally match, the two can diverge as a 
result of “Day 1 profit”. IFRS 13 is clear in defining the fair value as an “exit price”63 (i.e. the price 
that would be received to sell the asset or paid to transfer the liability), rather than an “entry price” 

(i.e. the transaction price that would be paid to acquire the asset or received to assume the liability). 

62   See IFRS 13, paragraph 86. 
63   See IFRS 13, paragraph 57. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
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45 

 
                                                                            
In such cases, IFRS 9 adopts a differentiated approaching, depending on how the fair value is 
derived.64 

Day 1 profit can only be recognised immediately if that fair value is evidenced by a quoted 

price in an active market (for all Level 1 financial instruments) or based on a valuation 

technique that uses only data from observable markets (for some Level 2 financial 
instruments). While IFRS 13 specifically mentions Level 1 inputs when talking about quoted 
prices, it does not refer directly to Level 2 inputs when talking about valuation techniques. It is 

possible, therefore, that a fair value obtained only from Level 2 inputs will not satisfy the 

requirements for immediate recognition of the difference between the transaction price and the fair 

value in the profit and loss account. 

In all other circumstances, the financial instrument is recognised at its transaction price, 

with the Day 1 profit being suspended and recognised (as either a gain or a loss) only 
gradually. That is only possible if the difference between the transaction price and the fair value 
arises from changes to factors that market participants would take into account when pricing the 

instruments. For example, for a bond with a defined term, the difference can be recognised 

gradually during the residual life of the instrument. However, this is not mandatory, and IFRS 13 

specifies that time is one factor that can be used, but not the only one. In other circumstances 

(e.g. in the case of a financial instrument with an indefinite residual life – such as an equity 

instrument), time might not be the most significant factor. Another approach involves releasing the 

initial reserves when unobservable parameters are deemed to have become observable. IFRS 13 

does not, however, provide further guidance in this regard, so discretion should be applied. 

1.5 

Other technical issues in IFRS 13 

IFRS 13 does not provide operational criteria that explain how to distinguish between active 

and inactive markets, or between observable and unobservable inputs, and discretion 

should be applied when deciding whether to allocate financial instruments to Levels 1, 2 or 
3. According to IFRS 13, quoted prices in active markets must not be adjusted. Although the 

frequency and volume of transactions are cited as relevant indicators, deciding whether a certain 

frequency or volume is sufficient to categorise a market as “active” requires judgement. Similarly, 

the fair value of Level 2 instruments should be based on observable inputs, but again, there is no 

fully operational definition of this concept. Consequently, the distinction between Level 1 and 

Level 2 instruments, or between Level 2 and Level 3 instruments, is not defined with precision. 

Another aspect that is specifically addressed by IFRS 13 is the impact on fair value 

measurement that stems from a significant decline in the level of activity for a financial 
instrument. The significance of that decline must be evaluated by the entity in question, taking 
note of factors such as the following: few recent transactions, significant variation in price 

quotations over time or across market-makers, loss of correlation between indices and financial 

instrument’s fair value, significant increase in implied liquidity risk premia/yields or performance 

indicators, increased bid-ask spreads, and declines in activity for new issues. However, a decline in 

64   See IFRS 9, paragraph B5.1.2A. 

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46 

 
                                                                            
the level of activity does not automatically mean that the quoted price is not representative of fair 

value and an assessment is required. Only if the entity decides that the quoted price is no longer 
representative does an adjustment become necessary.65 

While non-orderly transactions (e.g. fire sales owing to financial difficulties on the part of 

the seller, or transactions carried out under duress) are irrelevant for the purposes of 
IFRS 13, in some cases they are the only possible transaction. The measurement of fair value 
relies on the concept of orderliness, regardless of the level of market activity (i.e. that also applies 

to inactive markets). However, there are certain circumstances where the only way to achieve an 

orderly transaction is through an early termination, which has to be negotiated with the same 

contractual counterparty. Such sales can occur for some Level 3 and complex Level 2 products. 

Here, the complexity of the underlying instruments, combined with the lack of an active market, 

may result in a material gap between the accounting value and the sale price. 

A significant decline in the level of activity for an instrument does not automatically mean 
that transactions occurring in relation to that instrument are not orderly. In order to assess 

whether a transaction is orderly, many different factors have to be considered, such as the 

marketing period, whether the seller intends to market with a specific counterparty, and whether the 

transaction price is significantly different from other recent prices. 

1.6 

Disclosures 

Disclosure requirements for financial instruments measured at fair value follow an 
objective-based approach. Entities are required to disclose the following information in order to 

help users to achieve specific objectives: (i) for instruments measured on either a recurring or a 

non-recurring basis, the valuation techniques and inputs used; and (ii) for recurring measurements 

based on Level 3 inputs, the effect that such measurements have on the entity’s profit or loss and 
equity.66 IFRS 13 specifies a minimum level of information; however, if those objectives are not 
met, additional information is necessary. 

Disclosure requirements vary depending on the level of the fair value hierarchy, with more 
detailed information expected for Level 3 instruments. Generally speaking, transfers between 

categories need to be disclosed, as do the policies that determine when transfers are deemed to 

have occurred and the reasons for transfers. For instruments in Level 2 or 3, details of changes to 

valuation techniques are required. And for Level 3 instruments, quantitative information about 

significant inputs should be included (e.g. inputs such as prepayment speed, probability of default, 

loss given default and discount rate for asset-backed securities) – albeit such information is not 

necessary if the relevant data are not produced by the entity itself (as in the case of third-party 

pricing information). A description of the valuation process also needs to be provided. In addition, 

65  

IFRS 13 does not specify any particular methodology for adjustments to quoted prices. While it sets out a general approach 
to valuation techniques, it also demands proper consideration of the risks that are inherent in the evaluation process 
(including a risk premium reflecting the amount that is demanded by market participants as compensation for uncertainty). 
A significant decline in the volume of activity can lead to changes to valuation techniques or changes to the weights that are 
associated with the various valuation techniques that are being used. In any case, IFRS 13 acknowledges that discretion 
needs to be exercised when assessing the facts and circumstances that lead to the adjustment of quoted prices. 

66   See IFRS 13, paragraph 91. 

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47 

 
                                                                            
the entity must include a narrative description of the sensitivity of fair value to changes in 

unobservable inputs (i.e. an indication of whether changing those inputs would significantly affect 

the fair value). Instruments should be grouped together in different classes, taking account of their 

nature, characteristics and risks, as well as the fair value hierarchy. Greater diversification is 

expected for Level 3 instrument classes, given their higher degree of uncertainty and subjectivity. 

Disclosure requirements for Day 1 profit are defined by IFRS 7.67 Entities are required to 
disclose the accounting policy that governs recognition of the suspended gain/loss (i.e. describe the 

technique used and the factors considered), indicate the aggregate amount that is yet to be 

recognised and explain why the transaction price was not deemed the best evidence of fair value. 

2 

Prudential framework 

The current regulatory framework for EU banks provides institutions with a limited degree of 
freedom as regards the classification and measurement of financial assets and liabilities. In 

the regulatory framework, the Capital Requirements Regulation classifies financial assets as 

belonging to either the trading book or the banking book (non-trading assets). The trading book is 

defined as all positions in financial instruments and commodities that are held by an institution for 
the purposes of (i) trading or (ii) hedging positions held with intent to trade.68 The term “banking 
book” is not explicitly defined, but encompasses all positions in financial instruments that are not 

included in the trading book. 

The mapping of financial instruments between the regulatory and accounting frameworks is 
not straightforward, as those two frameworks are not unified and serve different purposes. 
The regulatory and accounting frameworks are designed to meet different objectives, so they apply 

different criteria when it comes to the valuation of assets and liabilities. For example, the assets 

and liabilities that are classified as “fair value through profit and loss” in the accounting framework 

do not necessarily mirror those that are included in the trading book in the regulatory framework. 

Anecdotal evidence suggests that instruments included in the “fair value through other 

comprehensive income” accounting category are generally in the banking book, while those 

classified as “fair value through profit and loss” are spread between the trading book and the 

banking book. 

Prudential capital requirements for credit risk apply only to the banking book and 

securitisation exposures in the trading book, while the trading book is subject to market 
risk-related requirements. The trading book and the banking book are subject to different 

prudential capital requirements. The ultimate goal in this regard is for prudential requirements for 

the relevant risks to be captured correctly across accounting classifications. Positions in the 

67   See IFRS 7, paragraph 28. 
68   See Article 4(1)(86) of Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on 

prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, OJ L 176, 
27.6.2013, as amended by Regulation (EU) 2019/876 of the European Parliament and of the Council of 20 May 2019 
amending Regulation (EU) No 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own 
funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to 
collective investment undertakings, large exposures, reporting and disclosure requirements, and Regulation (EU) 
No 648/2012. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 2: Accounting and regulatory frameworks 

48 

 
                                                                            
banking book are subject to capital requirements for credit risk to cover unexpected credit risk 

arising from the assets in question over a one-year horizon. Foreign exchange risk stemming from 

banking book positions is captured within the market risk requirements, and institutions are required 

to disclose information on the interest rate risk in the banking book. Trading book positions are not 

subject to the prudential credit risk charge, as it is expected that such positions will only be held for 

a short period of time. The aim of the capital charge is to cover short-term fluctuations in the market 

value of trading instruments (both assets and liabilities). Market risk requirements are based on net 

positions in identical instruments and include a capital charge for position risk and settlement risk 

(albeit that charge is significantly lower than the prudential credit risk charge). After the financial 

crisis, securitisation positions in the trading book were made subject to prudential credit risk 
requirements, given the limited scope for modelling the associated risks,69 and a requirement to 
use a stressed value-at-risk for banks’ internal models was also added. 

Banks are required to apply prudential valuation principles to their fair value instruments 
and ensure a sufficient degree of certainty in their fair value estimates.70 Banks should, in 
particular, consider valuation adjustments for less liquid positions when marking to model and in 

order to reflect model risk. They should also consider the need to apply a valuation adjustment 
when using third-party valuations, when marking to model and in the case of complex products.71 
Against this background, the EBA has issued regulatory technical standards on the application of 
prudential valuation,72 which establish the need for institutions to calculate the total additional 
valuation adjustments (AVAs) that are necessary to bring fair values into line with prudent values. 
AVAs can be calculated using a simplified approach when certain conditions are met,73 with a core 
approach being applied in all other instances. Under the core approach, total AVAs represent the 

sum of the AVAs that are calculated for the different categories: market price uncertainty, close-out 

costs, model risk, credit spreads, funding costs, concentrated positions, future administrative costs, 

early termination and operational risk. AVAs should only be applied to the proportion of the 

accounting valuation change that affects CET1 capital. 

Prudential filters, which used to shield banks’ capital positions from movements in the fair 

value of available-for-sale financial assets and liabilities in the aftermath of the global 

financial crisis, do not currently form part of the regulatory framework for banks.

74 Without 

prudential filters, unrealised fair value gains and losses that are directly recognised in the profit and 

69   See Recital 70 of Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on 

prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, OJ L 176, 
27.6.2013. 

70   See Articles 34 and 105 of Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 
on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, 
OJ L 176, 27.6.2013. 

71   There is also a requirement to calculate a credit valuation adjustment (CVA) for banks’ non-CCP-cleared derivative 

positions. 

72   See 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). 

73   The total absolute value of fair value assets and liabilities under the applicable accounting framework must be below 

€15 billion. 

74   See Article 35 of Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on 

prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, OJ L 176, 
27.6.2013, which states that institutions must not make adjustments with the aim of removing from their own funds 
unrealised gains or losses on their assets or liabilities measured at fair value. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 2: Accounting and regulatory frameworks 

49 

 
                                                                            
loss account (or in other comprehensive income) subsequently have an impact on the bank’s 

capital position. Moreover, changes to fair values are considered when banks define policies 
governing the distribution of profits.75 In periods of exuberance in financial markets, unrealised 
gains and losses from fair value assets may translate into a generous distribution of profits, an 

improvement in the bank’s capital position where unrealised gains and losses play a significant role 

and, more importantly, a general – but false – sense of security as a result of the increases in 

profits and capital ratios. Furthermore, it should always be borne in mind that a proportion of these 

unrealised gains and losses are derived from Level 2 and 3 assets, where prices are not directly 

observable and there is substantial modelling and discretion involved. 

However, the EBA (2013a) argues that there are prudential reasons for derecognising 

unrealised gains relating to banking book items in CET1 via the introduction of prudential 
filters. These prudential filters would cover “unrealised gains” recognised in both the income 
statement and the statement of other comprehensive income. These prudential concerns do not 

necessarily justify the introduction of prudential filters for items classified in the trading book, given, 

among other reasons, the existence of capital requirements for market risk and the intention to sell 

these instruments in the short term. The EBA expresses concerns “that unrealised gains may not 

be immediately available to absorb losses, as they can disappear as a result of negative 

movements in market prices; that own funds could be overstated if the fair values on which 

unrealised gains are based are not reliable; and the possible pro-cyclical effects if CET1 […] are to 

a large extent composed of unrealised gains, which could reverse in a crisis situation and therefore 

exacerbate pro-cyclicality”. However, there is also recognition of arguments supporting the current 

treatment of unrealised gains for instruments measured at fair value. The introduction of prudential 

filters could, for instance, have a negative impact on the level playing field for European and 

non-European banks (with current Basel III rules not accounting for such prudential filters), and it 

could have consequences in terms of institutional behaviour, as banks could be given an incentive 

to realise items with unrealised gains in order to avoid the capital impact of the prudential filter. 

The incorporation of the FRTB in EU law is expected to substantially improve the current 

regulatory regime for market risk, which was shown to be suboptimal during the global 
financial crisis. Soon after the peak of the global financial crisis, G20 leaders concluded that it 

was necessary to reform the way that trading instruments were considered in banks’ capital 

requirements. The FRTB represents the outcome of that reform workstream. After its completion, 

the BCBS published the revised market risk framework in January 2016. In a nutshell, the FRTB 

(i) limits implementation and promotes consistency across jurisdictions; (ii) establishes a strict 

boundary between the trading and banking books; (iii) reviews internal models with a focus on tail 

risks, liquidity horizons, constrained diversification and observability standards for risk factors; 

(iv) introduces a stringent approval process for internal models at the level of trading desks; and 

(v) amends the standardised approach to make it more risk-sensitive. In December 2016, the 

BCBS announced that implementation would be delayed until 2022, and it also published various 

revisions in January 2019. The most recent revision of the Capital Requirements Regulation, which 

was published in June 2019, initially enforces the new market risk rules as a reporting requirement 

75  

In some EU countries, there are restrictions on banks’ ability to carry out distributions relating to mark-to-model assets. 
More specifically, (a) several EU countries have corporate legislation that restricts the ability to distribute “unrealised profits” 
and (b) regulatory prudential valuation adjustments effectively restrict distributions that are supported by mark-to-model 
valuations. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 2: Accounting and regulatory frameworks 

50 

 
                                                                            
only. The European Commission adopted a delegated act in December 2019 in order to fully 

operationalise this new requirement. No later than one year after this delegated act starts to apply, 

institutions must start reporting market risk requirements on the basis of the revised standardised 

approach. Given that the implementation of the revised market risk framework represents a binding 

Pillar 1 requirement, the Commission must submit a legislative proposal by 30 June 2020. 

Last but not least, holdings of Level 3 instruments are used in the quantification of banks’ 
systemic importance. Indeed, Level 3 assets are one of the 12 indicators in the assessment 

methodology for G-SIBs, as Level 3 assets contribute to a bank’s complexity, with that indicator 

currently having a weight of 6.7% in the final score (BCBS, 2018). Level 3 assets are also one of 

the optional indicators that are listed in the guidelines on the assessment of other systemically 

important institutions (EBA, 2014). 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 2: Accounting and regulatory frameworks 

51 

 
Annex 3: Stylised aggregate balance sheet for 
EU banks 

ASSETS 

EUR billions  % of total assets 

Cash, cash balances at central banks and other demand deposits 

Assets measured at amortised cost 

Loans and advances 

  Debt securities 

Assets measured at fair value (excluding derivatives) 

Financial assets held for trading 

  Non-trading financial assets mandatorily at fair value through profit or loss 

Financial assets designated as being measured at fair value through profit and 
loss account 

Financial assets measured at fair value through other comprehensive income 

Derivatives 

Trading derivatives 

  Hedging derivatives 

Other assets 

TOTAL ASSETS 

Level 1 assets (excluding derivatives) 

Level 2 assets (excluding derivatives) 

Level 3 assets (excluding derivatives) 

2,482.4 

17,613.4 

16,639.2 

974.2 

5,035.2 

1,882.7 

966.0 

359.2 

1,827.4 

2,246.6 

2,100.4 

146.3 

1,556.1 

8.5 

60.1 

56.8 

3.3 

17.2 

6.4 

3.3 

1.2 

6.2 

7.7 

7.2 

0.5 

5.3 

29,285.9 

100.0 

2,328.3 

2,458.8 

248.2 

8.0 

8.4 

0.8 

LIABILITIES 

EUR billions  % of total assets 

Total equity 

  CET1 capital 

  Additional tier 1 capital 

Tier 2 capital 

Liabilities measured at fair value (excluding derivatives) 

Financial liabilities held for trading 

Financial liabilities designated at fair value through profit or loss 

Derivatives 

Trading derivatives 

  Hedging derivatives 

Other liabilities 

TOTAL EQUITY AND LIABILITIES 

Level 1 liabilities (excluding derivatives) 

Level 2 liabilities (excluding derivatives) 

Level 3 liabilities (excluding derivatives) 

2,157.5 

1,670.7 

177.7 

309.0 

2,678.3 

1,230.6 

1,447.7 

2,236.3 

2,060.1 

176.2 

22,213.9 

29,285.9 

748.7 

1,823.1 

106.5 

7.4 

5.7 

0.6 

1.1 

9.1 

4.2 

4.9 

7.6 

7.0 

0.6 

75.9 

100.0 

2.6 

6.2 

0.4 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 3: Stylised aggregate balance sheet for EU banks 

52 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Annex 4: Further insights into European banks’ 
use of fair value accounting 

This annex provides additional information on three fundamental issues relating to the 

measurement of financial instruments at fair value or at amortised cost, using supervisory 
data from the EBA. These fundamental issues relate to (i) the question of whether financial 
instruments measured at amortised cost generate more income than those measured at fair value, 

(ii) the issue of whether it is easier to determine a fair value for financial instruments measured at 

fair value or financial instruments measured at amortised cost, and (iii) the question of whether 

financial instruments allocated to Level 3 of the fair value hierarchy are traded less frequently than 

other financial instruments measured at fair value. 

Assets measured at amortised cost are still the main source of income for EU institutions, 

as (with the sole exception of Danish banks) they continue to account for the largest 
percentage of EU banks’ balance sheets (see Chart A.1). If we measure the relative profitability 

of financial assets measured at amortised cost and at fair value as income generated (mainly, 

interest, but also impairment, fair value gains and losses, and dividend income) as a percentage of 

total assets, it can be seen that the profitability of assets measured at amortised cost and the 

profitability of financial assets held for trading purposes have remained fairly stable over the last 

three years at around 2.5%. The income that is generated by assets measured at amortised cost 

has increased slightly in the last three years, in contrast with the decline observed for financial 

assets measured at fair value. As regards financial assets measured at fair value, those not held for 

trading purposes seem to be more profitable, probably reflecting the higher proportion of derivatives 

and equity instruments in these portfolios. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 4: Further insights into European banks’ use of fair value accounting 

53 

 
Chart A.1 

Profitability of financial assets held by EU banks 

(left-hand scale: return on financial assets in percentages; right-hand scale: income generated in EUR billions) 

Amortised cost (left-hand scale)
Fair value excluding assets held for trading (left-hand scale)
Held for trading (left-hand scale)
Amortised cost (right-hand scale)
Fair value excluding assets held for trading (right-hand scale)
Held for trading (right-hand scale)

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

450

400

350

300

250

200

150

100

50

0

2016

2017

2018

Sources: EBA and ESRB Secretariat calculations. 
Notes: For financial assets measured at amortised cost, the return on financial assets includes interest income and impairment. 
For assets measured at fair value, it includes interest income, fair value gains and losses and dividend income. Dividend income 
is distributed on the basis of the ratio of equity instruments held for trading purposes to total equity instruments measured at fair 
value. Bars show the income that is generated per asset type in absolute terms. Data are as at December of each year. 

Under IFRS 9, banks are also required to provide a fair value estimate for their financial 
assets held at amortised cost. Both debt securities and loans and advances can be held at either 

amortised cost or at fair value, thus allowing for a comparison of the fair value hierarchy structure. 

This comparison is shown in Chart A.2 below. For loans and advances, portfolio structures have 

been largely stable since 2016. On average, 75% of loans and advances held at amortised cost 

would be classified in Level 3 of the fair value hierarchy, while almost all of the remaining 25% 

would be in Level 2. For loans and advances that are actually held at fair value, the structure is 

fairly different: in 2018, 92% were Level 2 assets, while 7% were in Level 3. In the case of debt 

securities, assets held at fair value have been regularly distributed since 2016, with 72% in Level 1 

and 26% in Level 2. Debt securities held at amortised cost, meanwhile, have seen a shift in their 

portfolio structure, with Level 1 assets accounting for 61% in 2018, up from 45% in 2016. At the 

same time, debt securities that would be classified as Level 3 fell from 20% of assets in 2016 to just 

8% in 2018. This could be regarded (among many other possible interpretations) as a sign that 

banks are electing to measure loans and debt securities at amortised cost because fair values are 
more difficult to determine (as in the case, for example, of loans to SMEs). 76 

76   This also ignores situations where contractual provisions or the use of embedded derivatives require that financial 

instruments be measured at fair value. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 4: Further insights into European banks’ use of fair value accounting 

54 

 
 
                                                                            
Chart A.2 

Fair value hierarchy for debt securities, and loans and advances held at fair value and at 

amortised cost 

(percentages) 

Level 1
Level 2
Level 3

a) Debt securities

100

90

80

70

60

50

40

30

20

10

0

b) Loans and advances

100

90

80

70

60

50

40

30

20

10

0

2016

2017

2018

2016

2017

2018

Held at amortised cost
(at fair value)

Held at fair value

2016

2017

2018

2016

2017

2018

Held at amortised cost
(at fair value)

Held at fair value

Sources: EBA and ESRB Secretariat calculations. 
Notes: The bars show the fair value hierarchy for debt securities and loans and advances held at fair value (template F14) and 
at amortised cost (template F41). Data are as at December of the year in question. 

As regards the turnover of financial assets other than derivatives, it seems that debt 

securities and equity instruments in Levels 2 and 3 are traded less often than the equivalent 
instruments in Level 1. Using supervisory data, the turnover of financial assets can be defined as 

the accumulated change in fair value over the period in question as a percentage of the carrying 

amount at the end of that period. Given that financial instruments classified in Levels 2 and 3 are 

not quoted in financial markets and are relatively illiquid, one would expect them to be traded less 

often than equivalent financial instruments classified in Level 1. As Chart A.3 shows, this 

assumption holds for both debt securities and equity instruments, with turnover rates lower in 

Levels 2 and 3 than they are in Level 1. In the case of loans and advances, the turnover rate is 

lower for Level 3 than it is for Level 2, with only small amounts of holdings in Level 1. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 4: Further insights into European banks’ use of fair value accounting 

55 

 
 
Chart A.3 

Turnover of financial assets measured at fair value (excluding derivatives) across the fair 

value hierarchy 

(left-hand scale: turnover rate in percentages; right-hand scale: total accumulated change in EUR billions) 

a) Debt securities

b) Loans and advances

c) Equity instruments

20

18

16

14

12

10

8

6

4

2

0

450

14

400

350

300

250

200

150

100

50

0

12

10

8

6

4

2

0

250

30

200

150

100

50

0

25

20

15

10

5

0

180

160

140

120

100

80

60

40

20

0

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

Level 1

Level 2

Level 3

Level 1

Level 2

Level 3

Level 1

Level 2

Level 3

Sources: EBA and ESRB Secretariat calculations. 
Notes: The lines represent the total accumulated change in fair value in the period in question as a percentage of total 
recognised balance sheet amounts at the end of that period (from template F14). The yellow bars show the total accumulated 
change in fair value in EUR billions. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 4: Further insights into European banks’ use of fair value accounting 

56 

 
  
Annex 5: Additional information on the empirical 
analysis of disclosures made about Level 3 
assets by a sample of EEA banks 

1 

Descriptive statistics 

The amounts of assets in Level 3 of the fair value hierarchy are relatively small for G-SIBs, 

while for other banks they usually exceed 10% of total assets held at fair value (see 
Chart A.4). G-SIBs’ Level 3 assets generally account for between 2% and 5% of total assets held 
at fair value, with only one G-SIB exceeding 5%. Meanwhile, the 11 non-G-SIBs in our sample are 

all either (i) banks with a large concentration of Level 3 assets (with those assets totalling two-thirds 

or more of total assets held at fair value in two instances) or (ii) banks with a business model 

suggesting very small – if any – holdings of Level 3 assets. 

Chart A.4 

Level 3 assets as a percentage of total assets held at fair value and total assets 

(percentages) 

Level 3 assets as a percentage of total fair value assets – non-G-SIBs
Level 3 assets as a percentage of total assets
Level 3 assets as a percentage of total fair value assets – G-SIBs

69.9 66.6

30

20

10

0

NO1 MT1 NO2 BE1 UK5 AT2 NL3 NL2 AT1 FR2 DE1 NL1

IT1 ES1 UK2 DK1 UK1 FR4 FR1 FR3 UK3 UK4

Sources: EBA and ESRB Secretariat calculations. 
Notes: The blue bars for NO1 and MT1 have values of 69.9% and 66.6% respectively. Both were cut off for presentational 
reasons. Blue bars denote Level 3 assets as a percentage of total assets held at fair value, while yellow bars denote Level 3 
assets as a percentage of total assets. Lighter shading of blue bars indicates G-SIBs. 

When compared with their solvency ratios, there are five banks where Level 3 assets are 
equivalent to more than half of total CET1 capital (see Chart A.5). Three banks (which are not 

G-SIBs) have Level 3 asset holdings totalling more than 60% of CET1 capital, while two G-SIBs 

report Level 3 assets totalling slightly more than 50% of CET1 capital, with the majority of other 

banks reporting figures of less than 20%. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 5: Additional information on the empirical analysis of disclosures made about Level 3 assets by a sample 
of EEA banks 

57 

 
 
Chart A.5 

Level 3 assets as a percentage of CET1 capital 

(percentages) 

517.9

70

60

50

40

30

20

10

0

NO1 MT1 BE1 UK2 DE1 NO2 UK5 DK1 AT2 FR2 AT1 FR3 NL3 UK1 NL1

IT1 FR1 NL2 ES1 UK3 UK4 FR4

Sources: Entities’ annual reports and own calculations. 
Notes: The bar for NO1 has a value of 517.9% and was cut off for presentational reasons. Lighter shading of bars indicates 
G-SIBs. 

Gains and losses on Level 3 assets vary widely across the sample, with two notable outliers 
(see Chart A.6). One G-SIB registered gains on Level 3 assets representing 390.6% of its total 

profits for the year 2018, while another bank in our sample incurred losses equivalent to 221.6% of 

total (negative) profits. It is also interesting to note that six of the eleven non-G-SIBs in our sample 

reported a loss on Level 3 assets, compared with only two of the eleven G-SIBs. 

Chart A.6 

Gains and losses on Level 3 assets as a percentage of total profits/losses 

(percentages) 

Gain/loss as a percentage of positive profits – non G-SIBs
Gain/loss as a percentage of positive profits – G-SIBs
Loss as a percentage of negative profits

390.6

221.6

50

40

30

20

10

0

-10

-20

DE1 UK2 FR1 NL3 FR4 FR2

IT1 DK1 NO1 UK1 FR3 NL2 UK3 NO2 UK4 NL1 ES1 MT1 AT2 AT1 BE1 UK5

Sources: Entities’ annual reports and own calculations.  
Notes: The bars for DE1 and BE1 have values of 390.6% and 221.6% respectively, with both being cut off for presentational 
reasons. For BE1 and UK5, losses on Level 3 assets are shown as a percentage of negative profits. Blue bars denote gains and 
losses as a percentage of positive profits, while orange bars denote losses as a percentage of negative profits. Lighter shading 
of blue bars indicates G-SIBs. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 5: Additional information on the empirical analysis of disclosures made about Level 3 assets by a sample 
of EEA banks 

58 

 
 
 
2 

Methodology for the assessment of disclosures 

The assessment of Level 3-related disclosures by our sample of banks is based on a 

scoring system which assigns equal weights to all of the disclosure objectives set out in 
IFRS 13. That analysis uses information disclosed in the banks’ most recent consolidated annual 

reports (as at 31 December 2018). The scoring system is fairly straightforward: a bank that meets a 

disclosure objective in full is awarded a score of 1 point, while partial disclosure is rewarded with a 

score of 0.5 point, and no points are awarded for non-disclosure. Scores for individual disclosure 

objectives are then totalled at the level of each entity. There are eight disclosure objectives, so 

there is a maximum score of 8 points for full disclosure across all objectives. 

The minimum requirements that need to be satisfied in order to meet the eight disclosure 

objectives are as follows: 

•  Measurement of fair values at the end of the reporting period 

• 

• 

• 

• 

• 

Description of the valuation processes used by the entity 

Quantitative information about the significant unobservable inputs that are used in the 

measurement of fair values (with some exceptions) 

Reconciliation of opening and closing balances 

Details of total amounts for all transfers into or out of Level 3 of the fair value hierarchy, an 

indication of the reasons for those transfers, and details of the entity’s policy for determining 

when transfers between levels are deemed to have occurred 

A narrative description of the sensitivity of fair values to changes in unobservable inputs 

(i.e. an indication of whether changing those inputs to a different amount could potentially 

result in a significantly higher or lower fair value). If there are interrelationships between those 

inputs and other unobservable inputs used in the measurement of fair values, the entity must 

also provide a description of those interrelationships and explain how they could magnify or 

mitigate the effect that changes in unobservable inputs have on the measurement of fair 

values. 

• 

If changing one or more of the unobservable inputs to reflect reasonably practicable 

alternative assumptions would change fair values significantly, the entity is required to indicate 

that fact and disclose the effect of those changes. The entity is also required to explain how 

the effect of that change to reflect a reasonably practicable alternative assumption was 

calculated. 

• 

Disclosure of Day 1 profits/losses 

The summed rating is divided by the number of disclosure objectives that could actually be 
assessed and is thus normalised to 1. Some entities did not register any transfers into or out of 
Level 3, so there was no way of knowing whether they would have met the relevant disclosure 

objective. Similarly, it is possible that inmaterial transactions were not reported, as allowed by 

IFRS, which must be taken into consideration when assessing the results of this exercise. 

Macroprudential implications of financial instruments in Levels 2 and 3 for accounting purposes / February 2020 
Annex 5: Additional information on the empirical analysis of disclosures made about Level 3 assets by a sample 
of EEA banks 

59 

 
Imprint and acknowledgements 

This report has been prepared by the Exploratory Group on Accounting Developments and Financial Stability, 
which is chaired by Luca Serafini (Banca d’Italia). Comments from members of the Exploratory Group, the 
Advisory Technical Committee (chaired by Pablo Hernández de Cos) and the General Board (chaired by 
Christine Lagarde) are gratefully acknowledged. 

The following members made substantial contributions to the report: 

Andrea Canton 
Banca d’Italia, Rome, Italy; email: andrea.canton@bancaditalia.it 

Giorgia Conte 
European Systemic Risk Board, Frankfurt am Main, Germany; email: giorgia.conte@ecb.europa.eu  

Diego Hernández 
Banco de España, Madrid, Spain; email: diego.hernandez@bde.es  

Maximilian Ludwig 
European Systemic Risk Board, Frankfurt am Main, Germany; email: maximilian.ludwig@ecb.europa.eu 

Lourdes Ramos 
Banco de España, Madrid, Spain; email: lourdes.ramos@bde.es 

Antonio Sánchez Serrano 
European Systemic Risk Board, Frankfurt am Main, Germany; email: antonio.sanchez@esrb.europa.eu 

© European Systemic Risk Board, 2020 

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The cut-off date for the data included in this report was 18 December 2019. 

ISBN 
DOI 
EU catalogue No 

978-92-899-4255-3 (pdf) 
10.2866/99792 (pdf) 
QB-02-20-130-EN-N (pdf)