Fair value hierarchy and valuation of financial instruments

Fair value classification is not cosmetic: Level 1 signals a verifiable market price, while Level 3 signals a model-dependent estimate built on unobservable assumptions that management controls. Because banks report substantial trading and treasury books at fair value, the Level 1/2/3 mix directly shapes how much of reported equity and earnings is 'hard' market evidence versus internally modeled judgment, which is exactly what investors, auditors, and regulators scrutinize most closely, especially for Level 3 positions.

Does an active market provide a quoted price for an identical instrument (Level 1), or are all significant inputs observable directly or indirectly, such as rate curves or credit spreads (Level 2)? Do any significant unobservable inputs (bespoke structured terms, unquoted equity, internally estimated volatilities) drive the valuation, requiring Level 3 classification? Has the level been reassessed at this reporting date rather than carried forward, particularly for instruments whose market may have become inactive? For Level 3 positions, is the valuation model, its assumptions, and any independent price verification documented and available for sensitivity disclosure?

1. For each instrument, first check whether a quoted price for an identical instrument exists in an active market the bank can access at the measurement date, if so, use it unadjusted (Level 1).
2. If not, identify whether all significant valuation inputs are observable, directly or indirectly (interest rate curves, credit spreads, FX rates, quoted prices for similar instruments), this supports Level 2. 3. If any input significant to the entire valuation is unobservable (bespoke structured terms, unquoted equity, internally estimated correlations or volatilities), classify as Level
3. 4. Classify based on the lowest level input that is significant to the whole fair value, not the technique used. 5. Reassess the level at each reporting date, a market that becomes inactive can push an instrument from Level 2 to Level 3. 6. For Level 3, document the valuation model, assumptions, and any third-party or independent price verification performed.

Apply a valuation technique consistent with the market, income, or cost approach, using the technique that maximizes observable inputs and minimizes unobservable ones, applied consistently period to period. For derivatives, incorporate credit valuation adjustment (CVA) for counterparty credit risk and, where relevant, a debit/funding valuation adjustment; for Level 3 instruments, build a documented model with clearly stated unobservable assumptions (discount rates, growth rates, illiquidity discounts) and re-perform or independently validate the model periodically.

Disclose: (1) fair value hierarchy level for each class of asset/liability measured at fair value; (2) transfers between Level 1, 2, and 3 during the period and the reasons; (3) a full reconciliation of Level 3 opening to closing balances (purchases, sales, issues, settlements, gains/losses in P&L and OCI); (4) valuation techniques and significant unobservable inputs used for Level 3; (5) quantitative sensitivity of Level 3 fair values to reasonably possible changes in unobservable inputs; (6) for instruments not measured at fair value, the fair value disclosure required for comparison purposes where applicable.

• Classifying an instrument as Level 2 simply because a pricing model was used, without verifying that every significant input is actually observable
• failing to reclassify to Level 3 when a market becomes inactive or stale (e.g., stressed market conditions)
• omitting quantitative sensitivity disclosure for material Level 3 positions
• using a single broker quote without corroboration as if it were an active-market Level 1 price
• not adjusting derivative valuations for own and counterparty credit risk (CVA/DVA).