Fair Value Hierarchy - Open Risk Manual (2024)

Definition

The Fair Value Hierarchy categorises the inputs used in Valuation techniques into three levels. The hierarchy gives the highest priority (Level 1) to (unadjusted) quoted prices in active markets for identical assets or liabilities and the lowest priority (Level 3) to unobservable inputs.

IFRS 13 seeks to increase consistency and comparability in fair value measurements and related disclosures through a 'fair value hierarchy'.

If multiple inputs used to measure fair value are categorised into different levels of the fair value hierarchy, the Fair Value Measurement (the final valuation) is categorised in its entirety in the level of the lowest level input that is significant to the entire measurement (based on the application of judgement).

Level 1 inputs

Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. A quoted market price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available, with limited exceptions.

If an entity holds a position in a single asset or liability and the asset or liability is traded in an active market, the fair value of the asset or liability is measured within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the entity, even if the market's normal daily Trading Volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price.

Level 2 inputs

Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 2 inputs include:

• quoted prices for similar assets or liabilities in active markets
• quoted prices for identical or similar assets or liabilities in markets that are not active
• inputs other than quoted prices that are observable for the asset or liability, for example
  • interest rates and yield curves observable at commonly quoted intervals
  • implied volatilities
  • credit spreads
• inputs that are derived principally from or corroborated by observable market data by Correlation or other means (market-corroborated inputs).

Level 3 inputs

Level 3 inputs inputs are unobservable inputs for the asset or liability. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

An entity develops unobservable inputs using the best information available in the circ*mstances, which might include the entity's own data, taking into account all information about market participant assumptions that is reasonably available.

Level 3 input examples:

• Constant prepayment rate
• A financial forecast of cash flows for a cash-generating unit developed using own data and/or assumptions
• A financial forecast of profit or loss for a cash-generating unit developed own data and/or assumptions

Focus Areas for Review

Review of the the application of 'Fair Value Hierarchy in the context of an Asset Quality Review concerns identifying any issues that may have a material impact on the output of the level 3 fair value exposures review.

For example, if a material portfolio of securitisations has been incorrectly classified as Level 2, instead of level 3, these should be included as in-scope for the level 3 non-derivative asset revaluation^[1] +The areas for investigation are as follows:

• Appropriateness of policies for the classification of assets into the IFRS 13 fair value hierarchy levels for each asset type;
• Checks of positions classified as Level 1 and Level 2;
• Investigation of any assets currently classified as Level 1 and Level 2 which are included in a specific list of product types often expected to be level 3 (e.g. illiquid or complex derivatives ((For example, power reverse dual currency notes and equity basket quantos with single name underlyings.)), private placements, bespoke securitisations etc.)

Issues and Challenges

• There is a degree of subjectivity concerning the dividing lines between Level 1, 2 and 3 valuations

References