Fair-value hierarchy: Levels 1, 2 and 3#
The fair-value hierarchy is the classification in IFRS 13: Fair Value Measurement that ranks the inputs to a fair value measurement by how observable they are. It does not change the number. It tells the reader of the accounts how much of that number comes from market prices and how much from the firm’s own judgement.
The principle is that fair value is an exit price: the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The hierarchy gives the highest priority to quoted prices in active markets and the lowest to unobservable inputs.
The three levels#
Level |
Inputs |
Typical examples |
|---|---|---|
1 |
Unadjusted quoted prices in active markets for identical assets or liabilities that the firm can access at the measurement date. |
Listed equities, exchange-traded futures, and government bonds with a quoted price in an active market. |
2 |
Inputs other than Level 1 prices that are observable for the asset or liability, directly or indirectly. These include quoted prices for similar instruments, prices in inactive markets, and observable inputs such as yield curves, implied volatilities and credit spreads. |
Vanilla interest rate swaps, FX forwards, vanilla options with observable implied volatility, and corporate bonds priced from comparable or dealer-quoted data. |
3 |
Unobservable inputs, used where there is little or no market activity. The firm uses its own assumptions about what market participants would use. |
Exotic derivatives with unobservable correlation, long-dated volatility beyond quoted tenors, illiquid structured credit, and private equity. |
Level 1 needs no model: the price is the fair value, and IFRS 13 does not allow it to be adjusted, for example for the size of the holding. Level 2 and Level 3 both rely on a valuation technique, and the difference between them is whether the inputs to that technique can be observed.
How an instrument is classified#
A valuation usually uses many inputs, and they are not all at the same level. IFRS 13 classifies the whole measurement at the level of the lowest level input that is significant to the measurement as a whole.
A common case is an interest rate swap that is valued from observable curves (Level 2), with a CVA adjustment that depends on the counterparty’s credit spread:
if the spread is observable, or the adjustment is small, the swap stays at Level 2
if the spread is a proxy that is not observable and the CVA is a significant part of the fair value, the whole swap moves to Level 3
This is why the XVA calculations in the XVA series matter for the hierarchy. The classification depends on a judgement of what is significant, and a firm should set out its approach in a policy, for example a threshold for the share of the value that comes from unobservable inputs.
Active and inactive markets#
An instrument can move between levels as the market changes. A price is only Level 1 if the market is active, meaning that transactions take place with enough frequency and volume to provide pricing information on an ongoing basis. When trading dries up, a price that was Level 1 becomes a Level 2 input at best, and may need adjustment. Structured credit moved from Level 2 to Level 3 across much of the market during the 2007 to 2009 crisis for this reason.
Why the level matters#
The level drives the disclosure, the level of scrutiny, and in some cases the accounting:
Disclosure: for each class of instrument, the firm discloses the amounts at each level. For Level 2 and Level 3 it describes the valuation technique and inputs. For recurring Level 3 measurements it gives a reconciliation from the opening to the closing balance, covering gains and losses, purchases, sales, issues, settlements and transfers.
Sensitivity: for Level 3, the firm discloses the effect of using reasonably possible alternative values for the unobservable inputs, if this changes the fair value significantly.
Transfers: movements between levels are disclosed, along with the firm’s policy for deciding when a transfer has happened.
Day-one profit or loss: under IFRS 9, a difference between the transaction price and the model value at inception can only be recognised in profit or loss if the fair value is evidenced by a Level 1 price or by a technique that uses only observable data. Otherwise the difference is deferred and released over time.
Scrutiny: Level 3 positions attract more control, more reserves and more attention from auditors and regulators, because the number depends on judgement.
US GAAP uses the same three levels under ASC 820, so the classification is the same for firms reporting under either framework. See US GAAP: How It Differs from IFRS.
A valuation control view#
For the valuation control function, the hierarchy is where independent price verification meets financial reporting. IPV is the process that provides the evidence for the level assigned to each position, so the controls are:
Observability testing: for each input, evidence that it can be observed, such as executed trades, firm quotes, or contributions to a consensus pricing service. The test checks both the quality of the source and the tenor, strike or maturity it covers.
Levelling policy and methodology: documented criteria for Level 1, 2 and 3, including the threshold for when an unobservable input is significant. The policy should be applied consistently across desks and products.
Review of transfers: level changes should be investigated and explained, since a transfer may signal a change in market liquidity, or in the quality of the data, that needs a response.
Level 3 governance: independent validation of the models, challenge of the unobservable inputs against any available evidence, and a view on the range of reasonable values.
Reserves and adjustments: where there is valuation uncertainty, for example from a wide range of plausible inputs or from low market liquidity, a reserve or adjustment is considered. This links to prudent valuation for regulatory capital.
Completeness and consistency: every position must be assigned a level, and the levels used in the financial statements should reconcile to the levels in the valuation control reports. These controls are tested each year as part of the internal control over financial reporting. See Sarbanes-Oxley: Internal Controls over Financial Reporting.
These are the same themes as for the XVA reserves in the XVA series: independent data, a challenged methodology, and a clear explanation of the movements.