Though supervisory scrutiny has been very much focussed in the last few years on banks' backlog of non-performing loans, the valuation and governance of banks' Level 2 and 3 assets continues to be an important topic. Banks with large trading operations especially should be aware that supervisory attention has been growing in the last months, especially in subjective areas such as observability and the associated financial statement impacts. Understanding likely supervisory challenges is vital if banks are to ensure they have appropriate controls and processes in place.

At times, activity within the SSM can seem like “a tale of two Europes”. On the one hand, the SSM aims to achieve consistent, harmonised supervision across Europe, ensuring systemic integration and stability. On the other, some of its measures can give the impression of geographical targeting. In particular, recent publications such as the Non-Performing Loan Guidance and related Addendum for provisioning seem to put the spotlight on a number of southern European institutions.

But supervisors are not only interested in the balance sheets of southern European banks. A recent letter (PDF 47.8 KB) from Daniele Nouy to Marco Zanni MEP shows that illiquid securities and derivatives - especially so-called Level 2 and 3 instruments - are an increasing area of focus for the ECB.

These assets and liabilities are largely concentrated in northern European banks with major trading operations. Indeed, recent reports in the German press suggest that the ECB has been examining the trading books of major French and German banks. Unlike previous inspections, which may have `stressed' these positions to understand the viability of banks financial positions, this time the focus is on the balance sheet pricing of these securities and their inherent valuation risk. 

If supervision were a numbers game, Level 2 and 3 assets and liabilities would appear to be a smaller issue than non-performing loans. European NPLs remain stubbornly high, but assets and liabilities held at fair value have declined from 30% and 20% of European totals to 23% and 14% respectively over the past three years. In particular, Nouy notes that European Level 3 assets have decreased from EUR 188bn to EUR 132bn. For comparison, European NPLs have been quantified at EUR 950bn.

However, such a comparison may be misleading. Instruments classified as Level 3 assets are not necessarily at risk of default, and may not even be of poor quality - they are performing. The nature of the risk centres instead around the suitability of valuations and the recognition of associated profits and losses.

So what are the ECB's main priorities when it comes to Level 2 and 3 securities?

As Nouy points out in her letter, Level 3 securities have been a focus of the SSM since its inception, and were a major part of 2014's asset quality review. With the inclusion of Level 2 securities, future on-site inspections will continue to focus broadly on the following topics:

  1. Governance and processes of the valuation framework
  2. Valuation risk, including pricing models
  3. Assignment to the Fair Value Hierarchy, or Levelling

Supervisory focus therefore on Level 2 and 3 instruments begins at the inception of transactions. This includes new product approvals, the effectiveness and reliability of controls and governance over the booking of trading operations, and whether appropriate up-to-date policies and manuals cover all roles and responsibilities in the valuation framework.

When it comes to reviewing Valuation Risk as part of the Independent Price Verification process, supervisors pay particular attention to valuation models and techniques. This typically includes reviewing Value at Risk, Stressed Value at Risk and Incremental Risk Charge models, as well as individual complex product selection and subsequent re-valuation.

Finally, when considering the classification of securities under the Level 2 and 3 hierarchy, both portfolios and individual transactions, the ECB is particularly interested that the observability of market data sources is being correctly implemented, reviewed, documented and re-reviewed on a timely basis so as to ensure that securities are being correctly classified as either Level 2 or 3.

This in particular is of concern due to “Day 1 P&L reserving”, whereby accounting standards state that institutions can only post Day 1 profits for instruments with no significant unobservable valuation inputs (Level 2). For the remaining portfolios with unobservable inputs (Level 3), this P&L should be deferred over the life of the instrument, assuming no change in observability.

It follows that banks have an incentive to classify instruments as Level 2, using the discretion over 'observability' allowed by accounting standards. Limiting Level 3 exposures by classifying them as Level 2 not only offers a potential P&L advantage, but can also signal a healthier balance sheet to analysts and investors. The ECB is well aware of this sensitivity, and observability will remain a key focus of valuation work carried out during deep dive and regular onsite inspections.

Overall, supervisors appear increasingly willing to sample Level 2 and 3 portfolios and isolate individual transactions in order to scrutinise the implementation of policies and procedures and the associated recognition of profits and losses. Banks with significant levels of fair valued instruments on their balance sheets should ensure that:

  • They have appropriate, clearly documented governance and processes in place around their valuation activities, from the inception of a trade through its subsequent valuation and eventual accounting classification as Level 1, 2 or 3; and that 
  • Their policies regarding fair value adjustments are kept up to date, especially documentation regarding the bank's own interpretation of observability.

The volume of Level 2 and 3 portfolios in European banks may pale in comparison to the total volume of NPLs. But the SSM's focus on the trading operations of a few predominantly northern European banks may be more subtle and demanding than is generally appreciated. Banks need to ensure they are doing all they can to stay 'on the level'!

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