ESRB published a report on the macro-prudential implications of financial instruments that are measured at fair value according to IFRS 9 and IFRS 13 and classified as Level 2 and Level 3 instruments for accounting purposes. The analyzed data reveal a significant heterogeneity across banks regarding the relative importance of Level 2 and 3 instruments as well as the underlying portfolios, instruments, and models associated with them. The report concludes that policy responses should focus on increasing transparency through improved disclosure; making full use of the mandates assigned to auditors, accounting enforcers, and micro-prudential supervisors; and promptly incorporating the Fundamental Review of the Trading Book, or FRTB, into the prudential framework in EU.
Supervisory data from EBA show that EU banks had fair value financial assets totaling EUR 7,279 billion on their balance sheets in December 2018 (accounting for about 25% of total assets), with EUR 2,379 billion in Level 1 (mostly debt securities), EUR 4,600 billion in Level 2 (mostly derivatives) and EUR 300 billion in Level 3. Relative to the situation at the end of 2016, data for December 2018 show a sizable decline in the total value of financial instruments measured at fair value, driven by a decline in derivative positions. The report identifies three main areas in which financial instruments measured at fair value can affect financial stability and, thus, have a macro-prudential impact. These relate to inaccurate valuation of financial instruments, possible volatility and illiquidity in times of stress (particularly for financial instruments classified as Levels 2 and 3), and inadequate reflection of underlying risks in the prudential framework.
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 global systemically important banks by FSB, reflecting the size of their balance sheets. The data analyzed in this report, however, 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. The report concludes that, in terms of transparency, more comprehensive and more granular disclosure by banks would support the efforts of regulatory authorities in this area and result in more effective market discipline. Additionally, FRTB represents a significant improvement in the way that market risk is considered in the regulatory capital requirements of banks. It should be promptly implemented in EU, so that capital requirements better reflect the underlying market risk, learning the lessons from the global financial crisis.
Finally, given the significant heterogeneity observed across EU banks, auditors, accounting enforcers, and micro-prudential supervisors should make full use of their mandates with regard to Level 2 and 3 instruments. The efforts should be aimed at:
- Ensuring that banks treat similar instruments in a similar manner and that uncertainty in the valuation of financial instruments is adequately reflected
- Conducting more detailed assessments of the prudential valuation framework for banks
- Understanding the performance of banks’ valuation models in the presence of market stress and even back-testing models
- 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 the adherence to disclosure requirements
Keywords: Europe, EU, Banking, Accounting, IFRS 9, Financial Instruments, Macro-prudential Policy, Disclosures, Regulatory Capital, Fair Value Accounting, FRTB, ESRB
Previous ArticleBIS Presents Results of IFC Survey on Fintech Data Issues
EBA issued a revised list of validation rules with respect to the implementing technical standards on supervisory reporting.
EBA published its response to the call for advice of EC on ways to strengthen the EU legal framework on anti-money laundering and countering the financing of terrorism (AML/CFT).
NGFS published a paper on the overview of environmental risk analysis by financial institutions and an occasional paper on the case studies on environmental risk analysis methodologies.
MAS published the guidelines on individual accountability and conduct at financial institutions.
APRA published final versions of the prudential standard APS 220 on credit quality and the reporting standard ARS 923.2 on repayment deferrals.
SRB published two articles, with one article discussing the framework in place to safeguard financial stability amid crisis and the other article outlining the path to a harmonized and predictable liquidation regime.
FSB hosted a virtual workshop as part of the consultation process for its evaluation of the too-big-to-fail reforms.
ECB updated the list of supervised entities in EU, with the number of significant supervised entities being 115.
OSFI published the key findings of a study on third-party risk management.
FSB is extending the implementation timeline, by one year, for the minimum haircut standards for non-centrally cleared securities financing transactions or SFTs.