ESRB Report on Macro-Prudential Implications of Financial Instruments
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
Related Links
Keywords: Europe, EU, Banking, Accounting, IFRS 9, Financial Instruments, Macro-prudential Policy, Disclosures, Regulatory Capital, Fair Value Accounting, FRTB, ESRB
Featured Experts
María Cañamero
Skilled market researcher; growth strategist; successful go-to-market campaign developer
Nicolas Degruson
Works with financial institutions, regulatory experts, business analysts, product managers, and software engineers to drive regulatory solutions across the globe.
Scott Dietz
Scott is a Director in the Regulatory and Accounting Solutions team responsible for providing accounting expertise across solutions, products, and services offered by Moody’s Analytics in the US. He has over 15 years of experience leading auditing, consulting and accounting policy initiatives for financial institutions.
Previous Article
FFIEC Publishes Guide to HMDA Reporting for Data Collected in 2020Related Articles
BIS and Central Banks Experiment with GenAI to Assess Climate Risks
A recent report from the Bank for International Settlements (BIS) Innovation Hub details Project Gaia, a collaboration between the BIS Innovation Hub Eurosystem Center and certain central banks in Europe
Nearly 25% G-SIBs Commit to Adopting TNFD Nature-Related Disclosures
Nature-related risks are increasing in severity and frequency, affecting businesses, capital providers, financial systems, and economies.
Singapore to Mandate Climate Disclosures from FY2025
Singapore recently took a significant step toward turning climate ambition into action, with the introduction of mandatory climate-related disclosures for listed and large non-listed companies
SEC Finalizes Climate-Related Disclosures Rule
The U.S. Securities and Exchange Commission (SEC) has finalized the long-awaited rule that mandates climate-related disclosures for domestic and foreign publicly listed companies in the U.S.
EBA Proposes Standards Related to Standardized Credit Risk Approach
The European Banking Authority (EBA) has been taking significant steps toward implementing the Basel III framework and strengthening the regulatory framework for credit institutions in the EU
US Regulators Release Stress Test Scenarios for Banks
The U.S. regulators recently released baseline and severely adverse scenarios, along with other details, for stress testing the banks in 2024. The relevant U.S. banking regulators are the Federal Reserve Bank (FED), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).
Asian Governments Aim for Interoperability in AI Governance Frameworks
The regulatory landscape for artificial intelligence (AI), including the generative kind, is evolving rapidly, with governments and regulators aiming to address the challenges and opportunities presented by this transformative technology.
EBA Proposes Operational Risk Standards Under Final Basel III Package
The European Union (EU) has been working on the final elements of Basel III standards, with endorsement of the Banking Package and the publication of the European Banking Authority (EBA) roadmap on Basel III implementation in December 2023.
EFRAG Proposes XBRL Taxonomy and Standard for Listed SMEs Under ESRS
The European Financial Reporting Advisory Group (EFRAG), which plays a crucial role in shaping corporate reporting standards in European Union (EU), is seeking comments, until May 21, 2024, on the Exposure Draft ESRS for listed SMEs.
ECB to Expand Climate Change Work in 2024-2025
Banking regulators worldwide are increasingly focusing on addressing, monitoring, and supervising the institutions' exposure to climate and environmental risks.