UNIVERSIT DEGLI STUDI DI PAVIA DIPARTIMENTO DI SCIENZE ECONOMICHE ED AZIENDALI Corso di Laurea Magistrale in International Business and Economics

IFRS ENFORCEMENTS FOR BANKS: THE CASE OF VALUE RELEVANCE OF THE FAIR VALUE HIERARCHY

Relatore: Prof. EMANUEL BAGNA Correlatore: Prof.ssa CAROLINA CASTAGNETTI

Tesi di Laurea di: CLAUDIA UDROIU Matricola 395642

Anno Accademico 2012/2013

ABSTRACT
La capacit informativa del bilancio di unazienda rappresenta unimportante elemento per i soggetti operanti nel mercato. In particolare, la categoria degli strumenti finanziari misurati al fair value costituisce una componente fondamentale nella valutazione delle banche. Con lintroduzione della Gerarchia del fair value, suddetti strumenti vengono presentati in nota integrativa secondo una gerarchia composta di tre livelli, al fine di dettagliare nel migliore dei modi la determinazione del loro fair value. Oltre allintroduzione della Gerarchia del fair value, le autorit di vigilanza sovranazionali e nazionali emanano i cd. IFRS Enforcements, tramite i quali si raccomanda la massima trasparenza e precisione nella descrizione degli strumenti finanziari e dei loro componenti. Le finalit del presente elaborato sono di verificare se lemanazione di Enforcements abbia avuto un impatto (positivo) sulla valutazione di tali strumenti e conseguentemente, sulla valutazione delle banche da parte del mercato. In particolar modo ci si concentra sulla valutazione degli strumenti il cui fair value determinato in base a modelli di stima interni allazienda, che incorporano informazioni non pubblicamente disponibili (iscritti al livello 3 della gerarchia). Dapprima si dimostrato che le attivit e le passivit iscritte ai livelli 1 e 2 (le cui misurazioni provengono teoreticamente da fonti maggiormente attendibili) contribuiscono in maniera rilevante alla valutazione di mercato delle banche. Tale risultato vale anche per le passivit iscritte a livello 3. Le attivit iscritte a livello 3 invece, contribuiscono alla determinazione del prezzo di mercato solamente quando lindicatore di profittabilit Return on tangible equity non viene considerato. Da ultimo, viene corroborata lipotesi riguardante il miglioramento della valutazione con riguardo alle passivit di livello 3, in virt dellemanazione degli Enforcements. Tali strumenti presentano un impatto sul prezzo di mercato notevole in termini numerico statistici (coefficiente molto vicino al valore teorico di -1). Inoltre, questo impatto maggiore, sia in confronto a risultati precedentemente trovati nella letteratura, sia in confronto agli effetti attribuiti al livello 1 e al livello 2.

ABSTRACT
Informativeness of financial statements is of great importance to market participants. Particularly, financial instruments measured at fair value represent a relevant category in market valuation of banks. As of requirements of amendments to IFRS 7, concerning the Fair value hierarchy, those instruments have to be disclosed according to a three level hierarchy, in order to present detailed information about the determination of related fair values. Along with the hierarchy, national and supranational authorities issue IFRS Enforcements, with the purpose of drawing more attention on the need of transparency and precision of disclosures concerning financial instruments. The aim of this thesis is to determine whether issuance of such Enforcements have had (positive) effects on investors perceived values of these instruments and consequently, on market values of banks. Focus is especially, on estimation determined fair values, thus fair values that are calculated through unobservable assumptions and entity internal estimation methods (level 3). First of all, it is proved that level 1 and level 2 (theoretically, the most reliable fair values) assets and liabilities and level 3 liabilities are relevant for explaining market values. Level 3 assets instead, are value relevant only when the indicator Return on tangible equity is not considered. Secondly, it is proved that IFRS Enforcements have had a positive impact on investors valuation of level 3 liabilities: these instruments have a large impact (very close to the theoretical value) on the market value of banks. Moreover, this effect is larger even in comparison with level 1 and level 2 effects.

TABLE OF CONTENTS

INTRODUCTION .......................................................................................................................................................... 7 1. REGULATION FRAMEWORK ABOUT FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT ........................................................................................................................................ 11 1.1 1.2 1.3 Measurement of financial assets and financial liabilities ....................................................... 14 Fair Value Hierarchy ............................................................................................................................. 16 IFRS Enforcement documents 2009/2010 ............................................................................... 22

1.4 Bank of Italy, Consob, Isvap Enforcement concerning application of IAS/IFRS .................................................................................................................................................................. 23 2. RELATED LITERATURE ................................................................................................................................ 25 2.1. Value relevance of fair value accounting....................................................................................... 25 An European study ........................................................................................................................ 29

2.1.1 2.2.

Research concerning value relevance of level 1, 2 and 3 ........................................................ 31 Two European studies ................................................................................................................. 40

2.2.1. 2.3. 3.

Literature: conclusions ........................................................................................................................ 41

STATISTICAL MODEL .................................................................................................................................... 43 3.1. 3.2. 3.3. Research questions and hypothesis development .................................................................... 43 Sample and variables description .................................................................................................... 45 Statistical regressions ........................................................................................................................... 48

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RESEARCH RESULTS ..................................................................................................................................... 55 4.1. 4.2. 4.3. 4.4. Regression results (1)........................................................................................................................... 55 Regression results (2)........................................................................................................................... 58 Regression results (3)........................................................................................................................... 60 Summary of regression results ......................................................................................................... 61

CONCLUSIONS ........................................................................................................................................................... 65 REFERENCES ............................................................................................................................................................. 67 APPENDIX ................................................................................................................................................................... 71

INTRODUCTION
Fair value measurement, the opponent accounting method of amortized cost, has sustainers and critics. Supporters, on one hand, argue than it improves timeliness and it provides the true current value of assets and liabilities, thus revealing risks better than amortized cost. Opponents, on the other hand, claim that this accounting method provides misleading values due to the possible use of estimation models and that it increases earnings and equity volatility. Even more so, when it is referred to financial instruments of banks. Some categories of financial instruments have to be mandatorily measured at fair value, therefore imprecise measurement lead to wrong recorded values (both in the Balance Sheet and in the Profit or Loss) and also to consequences on investors allocation decisions. Therefore, information contained in financial statements has to be presented in such a way, that market participants perceive it as being precise, free of error, useful and of quality. The two big accounting standards boards (IASB and FASB), which have in latter times expanded the use of fair value accounting, have reached their aim of convergence and consistency, through issuance of very similar financial reporting standards concerning fair value measurements. Although doubts regarding interpretation of some of these provisions still remain, both standard setters have provided detailed general guidance concerning financial instruments, and concerning the measurement and disclosures of assets and liabilities recorded at fair value. In 2007 in the US, had became effective the introduction of the Fair value Hierarchy requiring disclosures of financial assets and liabilities according to a three level hierarchy. Two years later, in 2009 the IASB too, has introduced almost identical provisions of a fair value hierarchy in which: level 1 includes quoted prices in active markets, level 2 includes prices determined with use of observable data and level 3 includes model estimated values calculated through use of non observable assumptions. In other words, (when markets are active) level 1 is expected to reflect the highest reliability of related fundamental values, level 2 lower reliability and level 3 the lowest. Undoubtedly level 2 and level 3 financial
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instruments have had a relevant role in the 2007 financial crisis given the high amount of these instruments recorded in financial statements of banks, and their features of illiquidity. Nevertheless, some of these instruments, at that time where valued AAA by rating agencies. Level 3 assets are, in other words, the hardest to put value on, thus are the most illiquid. The main purpose of accounting regulators is transparency of financial statements in order to provide usefulness to market participants investment decisions. Therefore are required enhanced disclosures about financial instruments measured at fair value. Accounting enforcers and authorities, in order to ensure the correct trend of financial markets, issued also a number of IFRS Enforcements to draw attention on the vital importance, for transparency purposes, of disclosing in detail all movements concerning level 3 instruments (additionally to the fair value hierarchy, entities should disclose also a table of Movements in and out level 3 instruments. Since the introduction of the fair value hierarchy, in the US, a number of researches has been held on fair value hierarchy, related disclosures in levels and their impact on the market value of the entity (e.g. Song et al. (2010), Goh et al. (2009), Kolev (2008)). In Europe, until now only few studies have been done (Fietcher (2010), Di Martino (2011), Bosch (2012)). Only two of these studies test the effect of each level of the hierarchy on market values of entities. The question is: do investors take into account financial instruments disclosed at levels 1, 2 and 3 in valuing an entity? Yes, they do. It has been demonstrated that the three levels are differently priced by investors. Most studies have shown that level 3 is the less priced, but some have also presented good results (a lower discount) for this category. This lower discount of these level 3 assets could be explained by the unreliability of markets (that is, not available quoted prices or not active markets) to determine asset values: in this case, investors could trust more an estimated value. A further explanation could be referred to the requirements of enhanced disclosures particularly about level 3 instruments (Di Martino (2011)). And detailed disclosures are a consequence of issuance by national and supranational authorities of IFRS Enforcement documents,

as mentioned above, in order to ensure a high degree of precision and transparency of financial statements. This latter assertion leads to the aim of this thesis. Preliminarily, general value relevance (that is, useful information) of financial instruments disclosed by levels is tested. But the primary aim is to test whether enforcements issued by authorities have had some kind of (positive) effect on the perceptions of investors about level 3 assets, which should be the least reliable ones. To this purpose, were used data gathered from the 2010 2011 annual reports of European listed banks. The sample has 83 observations. To capture the market value of banks it was made use of the indicator Price to tangible book value (P/TBV), and all considered variables were scaled by the Tangible Book Value (TBV). Were made three tests, in order to take into account different effects. Level 1 and level 2 assets and liabilities resulted to be value relevant for investors, and their impact on P/TBV is very similar. Level 3 assets are found to be value relevant only in one out of the three tests, and within this test, related impact on P/TBV is quite interesting. But the most noticeable outcome is related to level 3 liabilities, which confirm value relevance in all three tests and whats more, related impact on the P/TBV is far larger than impact of level 1 and level 2. The first chapter presents the framework of accounting regulation concerning financial instruments classification and provisions about fair value measurements with focus on fair value hierarchy, related issues and IFRS Enforcements. The second chapter provides a review of previous literature and findings concerning value relevance and reliability of fair value and fair value hierarchy, with special focus on researches held during the financial crisis. The third chapter presents the research questions, the hypothesis, a description of the sample, of variables and the formal regressions. The fourth chapter presents the regression results and related comments.

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1. REGULATION FRAMEWORK ABOUT FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT

The European Union has agreed on the adoption of International accounting standards (IAS/IFRS) in 2002. Authorities decided that, starting from 1st January 2005, IAS/IFRS would have mandatorily been applied to consolidated financial statements of listed companies. Prior to this date, European countries adopted national General Accepted Accounting Principles (GAAP). One of the relevant issues, with which IAS/IFRS deal, is fair value measurement. Particular importance is given to fair value measurement of financial instruments, given their more and more complex nature and their relevant impact on financial statements (both on balance sheets and income statements) of banks. Moreover, for financial institutions, along with the IAS/IFRS adoption, the percentage of financial instruments measured at fair value have increased (Bagna, 2009). Therefore, in November 2006, the IASB1 (International Accounting Standards Board) has issued a discussion paper, on the strength of regulation contained in Financial Accounting Standard 157 Fair Value Measurements (FAS 157), in order to express its views concerning fair value measurements2. IASB had based its provisions on FAS 157, because of its consistency with other regulation contained in International Financial Reporting Standards (IFRS) concerning fair value measurements. Since that year, when also a Memorandum of Understanding between the IASB and the FASB had been published, the two Boards have improved their commitment in creating a common set of high quality global
1

The IFRS foundation is a not-for-profit independent organization, that works in the public interest. Through IASB, its standard setting body, it develops and issues a set of worldwide accepted international financial reporting standards (called IAS/IFRS).

In September 2006, the FASB (Financial Accounting Standards Board) issued Statement no. 157 Fair Value Measurements, related to fair value measurement of assets and liabilities. It deals with definition, framework for measurement, three-level fair value hierarchy and expanding disclosures about fair value. Now, under FASBs new Accounting Standards Codification System, Statement n. 157 has been codified as Topic 820.

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accounting standards. The purpose was so, to improve convergence between the two sets of accounting provisions. In March 2009, the IASB issued amendments to IFRS 7. The name of the document is Improving disclosures about financial instruments (Amendments to IFRS 7 Financial Instruments: Disclosures) and it provides a complement to IAS 32 Financial Instruments: Presentation and to IAS 39 Financial Instruments: Recognition and Measurement (the latter is going to be replaced by IFRS 9. IFRS 9 was first issued in November 2009 and was afterwards updated. The last update is of September 2012 and it is effective for annual periods beginning on or after 1 January 2015. Until then, IAS 39 is the standard currently in use). The scope of amendments to IFRS 7 was bidirectional: on the one hand, it addressed enhanced disclosure requirements about valuations, methodologies and uncertainty related to financial instruments recorded at fair value and on the other hand it enhanced existing disclosure requirements with respect to the nature and the extent of liquidity risk (IASB, 2009). The decision of issuance of such provision was driven by requests of users of financial standards and other interested parties that, given the hard economic situation of that period, needed enhanced disclosures according to IAS 39 Financial instruments. Moreover, they asserted that financial statements had to be improved because their interpretation and application have not been easy, given the complex nature of some requirements. As far as concerns fair value measurement disclosures, the document introduced the Fair value hierarchy. According to this hierarchy, classification of assets and liabilities recorded at fair value is related to the nature of inputs3 used to measure their prices. IFRS 7 was also amended in October 2010 and in December 2011, in order to require entities to further enhance disclosures about financial instruments and about netting arrangements related to financial assets and financial liabilities respectively.

Inputs are the assumptions that market participants would use in pricing an asset or a liability (Cfr. IFRS 13, Appendix A).

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Regarding the combined work of the two Boards, in June 2010 IASB issued a proposal of requirements of quantitative analysis disclosures relating to unobservable inputs used to measure fair values. Also FASB exposed amendments to Topic 820 (former SFAS 157) concerning this issue. Finally, in May 2011 the project of convergence was completed by the issuance on the part of IASB, of IFRS 13 Fair Value Measurements and on the part of FASB, of a revised Topic 820. All kind of requirements and guidance about fair value measurement and disclosures about financial and non-financial assets and liabilities which are to be measured according to fair value hierarchy are now of new issued IFRS 13 concern.4 This standard is effectively applied starting from 1 January 2013 and it represents the result of the Boards cooperative effort in achieving the convergence goal; a common framework on how to measure fair value for entities around the world had been completed.5 Moreover, beyond improving convergence between the two sets of accounting requirements, IFRS 13 seeks (through establishing a single source of guidance) to reduce the often claimed complexity of application and improve comparability and consistency in fair value measurements and related disclosures about fair value hierarchy. There is an important addition to be done: within these provisions, the definition of fair value doesnt change6. The purpose is to aloud users of financial statements (market participants like investors, creditors and other interested
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See IFRS 7: Par. 27 and Par. 27B dealing with Fair Value Hierarchy have been deleted. Fair Value Hierarchy is, since May 2011, part of IFRS 13 requirements. However, in this thesis it is going to be referred to IFRS 7, since IFRS 13 is not applied by banks at the research date (annual reports 2010/2011). Cfr. IFRS 13, Par. IN 7. However some differences between the two set of regulations remain (e.g. US GAAP does not require a quantitative sensitivity analysis of changes in unobservable inputs of valuation techniques for level 3 instruments, while IFRS does). Fair value is defined as a sort of exchange price (exit price) under determined market conditions. It is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date (Topic 820, GAAP). IASBs definition of fair value is: the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties, in an arms length transaction. So, the fair value is not necessarily equal to the price at which the entity had acquired the instrument. Therefore, in contrast with historical cost accounting, in a fair value view, past related transactions or events are relevant only to determine predicted values of future cash flows.

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parties) to be provided with expanded information (disclosures) for a better assessment of valuation techniques and inputs used by entities to measure their own assets and liabilities. In other words, the expressed goal of financial accounting standards is to allow investors and creditors to make proper decisions of resource allocation, being aware of the riskiness of possible investment decisions.

1.1 Measurement of financial assets and financial liabilities

IAS 39, the currently in use accounting standard (as a reminder, it will be replaced by IFRS 9 starting 1 January 2015), requires financial assets and liabilities to be initially recognized, when the entity becomes party to the contractual provisions of the instrument. While initial measurement is at fair value, subsequent measurement depends on the nature of the instrument.

IAS 39 requires subsequent measurement for financial assets to be classified within one of the following categories: 1) Financial assets at fair value through profit or loss. These instruments are divided into two subgroups. The first one is Held for trading, which includes financial assets that are held for selling purposes within a short period of time. The second one is Other financial assets designated at fair value through profit or loss7. These assets have to be always measured at fair value and changes of fair values must be recognized in the profit or loss statement.

2) Loans and receivables. The nature of these instruments is non-derivative and they presume fixed or determinable payments. They are measured at amortized cost using the effective interest method.
Here the fair value option is applied. Fair value option is the possibility of recording financial instruments at fair value, unless they are held for trading within a short period of time.
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3) Held-to-maturity financial assets. They are non-derivative financial assets with fixed or determinable payments. The entity has an intention and ability to hold them until maturity and they have to be measured at amortized cost with the effective interest method.

4) Available for sale financial assets. They are non-derivative financial assets and have to be measured at fair value and they are all non-derivative instruments, which are classified neither within held to maturity, financial assets at fair value through profit or loss or loans and receivables. They are recorded in the financial statements for an uncertain period of time. Gains or losses of fair values must be recognized in equity.

Financial liabilities instead, are classified within the following categories: 1) Financial liabilities at fair value through profit or loss. It has 2 subcategories: Held for trading and Other financial liabilities designated at fair value through profit or loss. They have to be measured at fair value and changes of fair values have to be recognized in the profit or loss statement.

2) Other financial liabilities measured at amortized cost using the effective interest method. Here are included all financial liabilities that are not recognized at fair value through profit or loss. Furthermore, all derivative financial instruments must be accounted for at fair value. Summarizing, financial assets and liabilities that must be measured at fair value are held for trading, designated at fair value, available for sale and derivatives8. Finally, as mentioned above, the fair value option (see note 7) may be used for instruments which are normally recognized at amortized cost, but only if the fair value is reliably determinable, if the use of this measurement has the purpose of

Available for sale and Held to maturity categories are eliminated in the new IFRS 9.

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reducing an accounting mismatch or when a group of instruments is managed and its performance is valued by the management on a fair value basis. All financial instruments recorded at fair value (mandatorily or through fair value option) have to be disclosed according to the 3 level fair value hierarchy.

1.2 Fair Value Hierarchy

As stated in both sets of accounting standards, IFRS and US GAAP, fair value measurement reflects current market participants assumptions about the future economic inflows associated with an asset and future economic outflows associated with a liability. It attempts to answer a hypothetical question such as: What are my assets or liabilities worth today? (Shaffer, 2010). Since the theoretical definition of this accounting method makes reference to a market, fair value measurement is not entity-specific, it rather focuses on market factors. Indeed, the meaning of fair value, used by IASB in its standards, generally is market price9. IFRS 7 requires specific fair value disclosures for classes of financial assets and liabilities. This is mostly because, even though in a general interpretation fair value means market price, sometimes may happen that a market price is not readily available, or it does not effectively reflect the real value. Therefore, a hypothetical price (i.e. the cash equivalent of the hypothetical market value) has to be found, and its calculation is to be based on predictive mathematical models (the so called mark-to-model). According to methods used to calculate a price for an instrument, entities are required to classify assets and liabilities into a fair value hierarchy, which states the following:

Therefore, the term mark-to-market has often been used as a synonym for fair value. With the issuance of disclosure requirements of the hierarchy, mark-to-market is now generally used to indicate level 1 financial instruments, while mark-to-model is used to indicate level 3 instruments.

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Level 1 assets and liabilities:

Have to be measured based upon unadjusted quoted prices in active markets for identical assets or liabilities. This is the best evidence of a reliable fair value measurement. A principal market or the most advantageous market for the instrument has to be determined10. These prices dont have to be adjusted, thus if they are, this would represent an indication of a different pricing method and consequently, the instrument would be categorized within a lower level of the fair value hierarchy. Level 2 assets and liabilities:

Have to be measured based upon inputs other than quoted prices included in Level 1, directly or indirectly observable (based on market data e.g. expected volatility, expected dividend yield, risk-free interest rate). Observable inputs used to measure level 2 instruments may be quoted prices for similar assets in active markets, quoted prices for identical assets in inactive markets and market corroborated inputs. Adjustments to inputs are permitted, but shall not be based on unobservable inputs which are significant to the valuation in its entirety, otherwise this would lead to the insertion of the instrument within level 3. Level 3 assets and liabilities:

Shall be measured using unobservable inputs, but this is a residual category. Instruments are classified within level 3, only if relevant observable inputs are not available. Anyway, any unobservable input should reflect assumptions that market participants would make in pricing the asset or the liability. Assumptions about risks have to be taken into consideration: they relate to risks about valuation techniques and measurement uncertainty, since instruments included in this category are mostly based on internally developed models.

A principal market is the market with the greatest volume and level of activity for the instrument. The most advantageous market is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability.

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LEVEL 1: - Quoted prices for identical assets in active markets

LEVEL 2: - Quoted prices for similar assets in active markets - Quoted prices for identical assets in inactive markets - Market-corroborated inputs - Other observable inputs

LEVEL 3: - Unobservable inputs

Level 1 measurement is therefore, the best available measure: if a market is active and orderly transactions take place in it, observed market prices give evidence of the most precise, objective and fast way to determine fair value of assets. Most important, pricing according to quoted market prices in active markets guarantees to third parties, i.e. investors and creditors, that also risk features (e.g. market risk, liquidity risk, information risk, non-performing risk) are included in the price. Nevertheless, the issue is not straightforward, when taking into account the meaning of active markets: An active market is a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on a ongoing basis (IASB, 2011). According to this definition, problems of reliability may arise, when markets are not active and transactions are not orderly11. Paragraph 2.1. deals with this issue more in detail.

Examples of not orderly transactions are sales deriving from forced liquidations or distressed sales (e.g. in case of bankruptcy). When transactions are not orderly, there is sufficient time to induce potential buyers to decrease the price they are willing to pay. Then, in a distressed sale, the seller may be forced to agree on a price that could be lower than the value of the asset, only because the

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Level 2 and level 3 fair value measurements are determined using market related inputs or valuation techniques, which should maximize the use of observable inputs and minimize the use of unobservable ones12. The level within which an asset or a liability should be settled is determined according to observability and significance of inputs used to measure it. As an example, if unobservable inputs are used and they are significant to the entire valuation, instruments are qualified as level 313. If observable inputs, which dont require significant adjustments based on unobservable inputs are used, the asset or the liability shall be qualified within level 2. For this reason, it is necessary an extensive disclosure in the notes explaining assumptions and methods used to estimate fair values or changes in methods used during the current year with respect to the previous year. Concluding, according to standard setters, a valuation technique should reflect current market conditions and use risk adjustments (premiums or discounts) that market participants would use in pricing the asset.

time within which the transaction has to be concluded is shortened (KPMG, First Impressions: Fair Value Measurement, 2011).
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Examples of valuation techniques are exposed in IFRS 13: three widely used techniques are the market approach (use of market prices for identical or similar assets), the cost approach (amount that would be required currently to replace the service capacity of an asset) and the income approach (present value of expected future cash flows). Other present value techniques may be used too (e.g. the discount rate adjustment and the expected cash flows method) (IASB, 2011).

IFRS 13 par. 84 states: An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorized within Level 3 of the fair value hierarchy, if the adjustment uses significant unobservable inputs.

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Observable inputs, significant inputs and third parties pricing services Some important issues should be explained more in detail, and these are the concepts of observable input, significant input and third parties pricing services. An input is observable if it is developed using market data, such as publicly available information about actual events or transactions, and that reflects the assumptions that market participants would use when pricing the asset or the liability. Examples of markets which provide observable inputs are exchange markets, dealer markets, principal to principal markets. (IASB, 2011). As far as concerns the significance of an input, IFRS 7 doesnt expressively state what are the conditions according to which precisely to determine whether an input is significant or not. In any case, if a lower input is included in the estimation procedure of an asset or a liability, this may be significant, otherwise perhaps the entity wouldnt have taken into consideration the eventuality of using it. However, assessing this procedure, requires judgment and careful analysis including analysis of factors specific to the asset or the liability. Another issue regards prices obtained from third parties (pricing services or brokers). Using third parties services to estimate prices does not change the categorization within the fair value hierarchy. The reasoning is always the same: inputs matter most. Therefore, it is necessary an understanding of the source, the third party has used in providing the price. Level 1 sources are quoted prices in active markets and level 2 and 3 sources use valuation models and adjustments to observable inputs. Lastly, if after the valuation, there has been a decrease in the volume or level of activity of the asset or the liability, the entity has to evaluate if prices provided reflect orderly transactions or if the valuation techniques used to estimate the price are in line with market participants assumptions (IASB, 2009).

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Concerning third parties valuations of assets and liabilities, a number of debates are held. For instance, King14s assertion goes against the general idea about the fair value hierarchy. From his perspective the hierarchy has a negative critical view towards valuation techniques that use income approach and cost approach , thus FASB (and consequently, IASB too) is attributing less reliability than they really have, to these two methods. He explains that there is no the value for an asset or a liability, because valuation is an art, not a science, that is different appraisers will arrive to different results when valuing the same instrument. This happens because professional judgment and thus different assumptions are inherent to each valuation process. And one cannot prove a judgment is correct and univocal. When markets are not available, at least one among all the assumptions about the past, the future, the hypothetical markets, the hypothetical use of the asset that hypothetical knowledgeable market participants would do, will differ across different valuation methods. He states: every appraiser has at least one key assumption (King, 2006). Other points of view are totally different: there is a general agreement on the possibility that small adjustments of assumptions in valuation methods may bring to totally different results. Not only results may differ hugely one from another, but also their range of possible estimates may be very wide. But in this case, a measurement cannot be considered reliable. For Ernst & Young a measurement using a valuation technique is reliable if and only if, through the use of different reasonable methods and assumptions, not significantly different estimates of fair value are given. The key explanation is that users of financial statements should be provided with the most objective information possible, not with managements view of what predictions should b. Or at least, the best information about subjective measurements should be provided. This point of view is more in line with the objective-oriented point of view of accounting standards regulators. Therefore, par. 27 and 27B of IFRS 7 amended requires enhanced disclosures especially about level 3 measurements: valuation techniques and changes in valuation techniques, a sensitivity analysis of the fair value to changes in
King A. is the vice chairman of Marshall & Stevens, an American firm of appraisers. A similar point of view is expressed by. Martin R. D et al. (2006).
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unobservable inputs and transfers in and out of each level15. Is then important disclosing the effect of level 3 measurements on Profit or loss or Other comprehensive income and the reconciliations from the opening balance sheets to the closing balance sheets. Ernst & Young claims that these criteria are important, because the IASB believes that all movements in fair value measurement from one balance sheet to the next deserve to be regarded as components of a companys performance (the Comprehensive income) with the result that changes in fair value translate directly into performance gains and losses (Ernst&Young, 2005).

1.3 IFRS Enforcement documents 2009/2010

The effects of the financial crisis after 2008 started to be reflected in a higher degree of uncertainty about financial and economic situation of entities, particularly financial institutions. Therefore, in 2008 the Committee of European Securities Regulators (CESR)16, after reviewing IFRS 7 and related disclosures, issued the statement Fair value measurement and related disclosures of financial instruments in illiquid markets. The purpose of this document is to stress and ensure the proper use of disclosures when dealing with financial instruments in line with IFRS 7. Back in 2005, CESR had established a forum where its members and all national accounting enforcers meet and discuss important issues about enforcements to accounting standards within European countries. This forum is named EECS (European Enforcers Coordination Sessions) and its main purpose is [] to coA table including movements in and out level 3 should be disclosed. Focus is mainly on level 3 Instruments, since disclosures about level 1 and level 2 can be relatively easy. As indicated above, Level 3, given its illiquid and uncertain nature, a certain level of judgment and attention to factors that are specific to each asset or liability. As a matter of fact, the new IFRS 13 par. 94 states that the number of classes (of assets and liabilities) may need to be greater for fair value measurements categorized within level 3 (IASB, 2011).
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Since January 2011 CESR became ESMA European Securities and Markets Authorities. Even though ESMA is independent of the EU institutions, its overall purposes are the protection of investors and the insurance of well functioning financial markets in the European Union (ESMAs website). It contributes to the consistent application of IFRS by providing guidelines and recommendations. Summarizing ESMAs aim is the supervisory convergence in the EU securities markets, and issuance of IFRS Enforcements is a relevant part of its activity.

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ordinate the enforcement activities of member states in order to foster and maintain the investor confidence (CESR, 2010). Financial instruments are a main issue given times of financial crisis, especially those recorded at fair value. Because of this, during 2009 EECS met several times and discussed the decisions submitted by its members in order to increase convergence of national enforcements with respect to IFRS. Afterwards, CESR published a statement Application of disclosure requirements related to financial instruments in the 2008 Financial Statements. It is a study held on 96 European financial institutions in order to assess the adequacy of disclosures for financial instruments. Other identical studies were held in 2009, 2010 and 2011 with purposes of comparison between results each year. In fact, quality of disclosures on financial instruments improved year on year, even though further improvements could be done especially in disclosing information concerning level 3 financial instruments (ESMA 2012).

1.4 Bank of Italy, Consob, Isvap Enforcement concerning application of IAS/IFRS

To stay in line with this commitment, in March 2010 an Enforcement document has been issued in Italy by a coordinating committee of Bank of Italy, Consob and Isvap17. Specifically, the Enforcement draws attention on disclosures about impairment test, about contractual provisions on financial debt, debt restructuring and fair value hierarchy. This document is an appeal to entities to pay attention to IAS/IFRS requirements, in order to provide all necessary detailed information. On the other side, entities claim the fact that they dont accomplish requirements in a satisfactory way, because of the not straightforward interpretation of some

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Since January 2013, Isvap (Institution for the security of private and of social interest insurances) has been dissolved. All its powers have been transferred to the new established IVASS (Institution for the security of insurance companies).

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expressions used in accounting standards18. In any case, this document recalls, with regard to fair value hierarchy, the need to correctly determine and disclose the specific level according to the weight of used inputs (observable and unobservable), any changes in inputs with respect to the previous period, transfers between level 1 and 2, in and out level 3 and reasons for these transfers and a sensitivity analysis for level 3 measurements. Therefore, there is no new provision, that this document requires with respect to IFRS 7: it merely calls attention on the precise and correct use of the international financial standards when disclosing financial instruments, since precision is of vital importance for market participants. As said above, ESMA has already reported improvement of accounting information year after year since the application of IAS/IFRS in Europe in 2005. But since financial instruments are a particular asset category on which there was and there is most focus, the aim of this thesis is to test whether Enforcements of ESMA (along with the Italian enforcement document) has had some sort of impact on investors perceptions about financial assets and liabilities measured at fair value. If it hasnt, results are generally going to be in line with results of the literature. If it has, a smaller discount with respect to the theoretical values of 1 for the assets and -1 for liabilities is expected for level 3, given the higher confidence of investors after the issuance of IFRS Enforcements. But firstly, in order to provide a basis of comparison, previous literature is going to be analyzed

This issue is solved step by step also through meetings between ESMA, which provides feedback about uncertain interpretation, and the IFRS Interpretation Committee (CESR, 2010).

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2. RELATED LITERATURE 2.1. Value relevance of fair value accounting

IFRS Framework distinguishes between relevance and reliability of information included in accounting reporting. Information is relevant when it helps investors and creditors in making their ressource allocation decisions, thus when reporting information is reflected in the value and riskiness of the entity. A measurement is then considered reliable when it is free of material errors and bias (IASC, 2001). There are two different views in literature about fair value accounting in which the trade-off between relevance and reliability is one of the major debates: the fair value view (supporters of fair value) and the alternative view (opponents to fair value). The first one argue that fair value improves timeliness and transparency in comparison with other accounting methods. Indeed, fair value is defined as being the exit price of an asset or a liability: it is not the price at the acquisition date, but the price for which the asset would be sold or the liability transferred at the measurement date. This is where fair value gives proof of its timeliness. It has to be so, since the role of accounting reporting is to serve investors in capital markets; and achieving this goal is more probable within markets that are orderly (i.e. when market prices are the best measure of intrinsic fundamental values). In this sense fair value accounting is laudable for transparency purposes. Of note, for fair value supporters relevance is of primary importance and reliability comes next (Whittington, 2008). This claim is, in fact, supported by empirical results of working papers and researches run on fair value accounting. Value relevance of fair value assets and liabilities is generally demonstrated19. Concerns of investors and creditors, instead are reflected through the reliability of those instruments. This is the reason why arguments against this accounting method exist too. Fair value involves orderly transactions and market participants, but what if an active
19

Accounting information is considered value relevant when it has the predicted association with market value of equity, (Song, 2010) thus it is sufficiently significant to be reflected in share prices.

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market couldnt be determined? As long as quoted market prices in an active market are available, there is little room for unobservable inputs and information is generally reliable, but with no active market and no orderly transactions, market prices are misleading and different kind of problems may arise. Reliability issues are to be taken into consideration too. Opponents to fair value accounting claim that this lack of reliability leads to scarce relevance of assets held for a long period because their prices are distorted over time and become imprecise. So is reliability more important than value relevance? According to Ernst and Young, reliability is even considered as a precondition in order to allow reporting information to be value relevant. Ernst and Young claims that reliability assumes top significance in situations in which observed market prices are not available (i.e. level 3 measurements). Thus, they state that the IASB should explain in accounting standards why relative low reliable measurements should be considered as relevant to be used for financial reporting purposes (Ernst&Young, 2005). However, as stated above, most of studies run on this topic have proved the value relevance of all fair value measurements, even of the least reliable ones. The issue could be seen from a simpler point of view: that is, remembering that perfect and competitive markets exist only theoretically. In line with this shared opinion, fair value accounting may achieve its goals only from a theoretical point of view. Having said that, professor Whittington however argues that members of the alternative critical view, which relates mostly to the real world of market, didnt however provide a simple and coherent alternative solution (Whittington, 2008). Another concern of the alternative view is whether or not fair value accounting plays an important role in contributing to worsening economic situation in times of economic downturn (when in fact, markets are anything but perfect; they are rather illiquid and transactions often are not orderly). Literature has proved that it plays little or no role20.

20

For instance, at the end of 2008, Citigroup held on its balance sheet a value of level 3 assets equal to 455% of the value of its tangible common equity. Bank of America and JP Morgan were at 121% and 164% respectively. In 2012 things have changed: shares were much lower, of about 40% (see New

26

Basically, the argument of opponents to fair value accounting is that this measurement method, through asset write-ups in good economic times, leads banks to increasing their leverage. Then, in downturns they turn to be more vulnerable and increase the crisis negative effect, also through contagion. Historical cost accounting instead, doesnt allow write-ups in good times, therefore doesnt lead to higher leverage and vulnerability in bad times. But a bank could however increase its leverage in booms under historical cost accounting by selling an asset and retaining a small claim in it. Therefore, the issue of leverage and consequent higher vulnerability during economic downturns is not necessarily related to fair value accounting (Laux & Leuz, 2009). On the contrary, it has been argued more than once that this accounting method helps identifying problems and imminent crisis in advance. Concluding, the key issue seems to be the a priori transparency provided by financial statements, rather than measuring assets at fair value. Procyclical events may be indeed correlated with transparency and disclosure information, when this is not enough for investors in order to assess the riskiness of financial instruments. And this occurs in both cases: when these are or are not recorded at fair value. As already stated, international accounting regulation expressively states that objective of financial reporting is to provide useful information in order to allow investors and creditors, which are the focus group of the IFRS attention, to make their resource allocation decisions. Therefore, it is responsibility of entities, not of standard setters to determine which is the best way to ensure transparency and, in case of market downturns, to ensure stability for the industry. (Barth & Landsman, 2010). Turn back to the inactive markets argument and take into consideration an illiquid market, in which prices dont reflect fundamental values of assets and liabilities21.
York Times, may 2012). But is fair value and level 3 assets really part of the financial crisis engine, or it depends more on transparency of bank financial statements? See e.g. Ryan (2008), Laux and Leuz (2010), Shaffer (2010). These working papers are in line with fair value accounting view and sustain the not responsibility of fair value in worsening economic downturns.
21

To explain this scenario take as an example the economic and financial crisis in 2007. During this period there have been assertions that to determine fair values it had been taken into consideration the last transaction price on the market without paying attention to other issues like whether the market was or not orderly or whether the transaction was or not driven by a forced sale (Shaffer,

27

Within this scenario, a price has to be estimated either by using observable marketrelated inputs (probably distorted) or by using firm internally developed models which base their procedure on unobservable assumptions (probably biased). In fact, inherent to estimation procedures (especially those who use managerial assumptions), are some risks: measurement error, intentional or unintentional manipulation of data, in one word information risk. The result is that reliability of estimations is mined. Thus in serious circumstances, estimated fair values may give rise to perverted balance sheets and income statements. Concerning this problem, SFAS 157 Fair Value Measurements specifies how to estimate fair values and limits potential power of managers in manipulating estimation data. For example, managers are required to adjust observed prices, when these are provided by not identical assets, to obtain prices which reflect features specific to their assets. Furthermore, also the IASB Advisory Panel (2008) emphasizes the fact that market prices cannot be ignored. But this seems to be a dog chasing its own tail, since the issue remains always the same: market prices yes, but this means unreliable market prices when the market isnt active or liquidity risk is high. Many, indeed have argued that although model inputs are subject to managerial bias, their advantage is that are able to give more reliable estimates than market inputs when markets are inactive or reflect a higher liquidity risk (e.g. Ryan (2008), Altamuro&Zhang (2012)). Others, instead have argued that historical cost accounting could be the best solution (Allen & Carletti, 2007) . Lastly, some have concluded that when market prices dont reflect real values, marking-tomarket is of any use; the only way to report relevant information are honest entitybased disclosures (Burkhardt & Strausz, 2006) . Actually, from a management-oriented point of view, when marking-to-model is adopted, tasks of managers are not easy too: they should somehow determine how
2010). Indeed, during a financial crisis banks may be forced to sell their assets at a price that doesnt reflect their fair value, in order to be in line with regulatory capital constrains. On the other hand, accounting standards setters are quite restrictive about when managers may deviate from observed market prices: they even stress that an illiquid market is not necessarily a reason for not taking into consideration observed prices. Anyway it is difficult to write fair value accounting standards that provide the flexibility when it is needed and constrain managers behavior when it is not needed (Laux & Leuz, 2009).

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hypothetical market participants might use the assets in their own operations and the assets value in use to those firms, so that the price they might pay can be estimated (Benston, 2008). And carrying on this process is costly.

2.1.1 An European study

The only study about overall value relevance of fair value instruments held by IFRS European entities adopters (most studies are held on US GAAP entities adopters) is exposed in a discussion paper written by Fietcher and Novotny-Farkas (2011). This research contributes to general fair value accounting research, by testing effects of fair value accounting on investors pricing of banks. These banks are based in different geographical positions, and the time window is of three years: 2006, 2007, 2008. Here are considered three selected regions: EU15 (European member countries prior to 1May 2004), other European countries and the rest of the World. The model distinguishes among categories of financial instruments (available for sale, held for trading and designated at fair value through profit or loss) and it tests effects of these categories on the market value of equity of a sample of 322 financial institutions. Additionally, the authors run a further study controlling for low and high regulatory quality features. Finally, they test changes in estimated coefficients at different stages of the financial crisis. Results are different according to the provenience of banks; the reason may be because of the different interpretation across countries of the accounting standards. While in the U.S.A. interpretation of US GAAP is far much likely to be unique all over the country, in Europe and other countries, previous national GAAP are now compared with IAS/IFRS regulation. Anyway, fair value is generally value relevant, but coefficients across institutional factors differ. Moreover, non-mandatorily fair value adoption (fair value option, which involves the designated at fair value through profit or loss category) is discounted in countries with lower regulatory

29

quality22. Lastly, value relevance of these instruments has decreased with the worsening of the economic crisis. These results demonstrate that fair value is relevant for investors purposes, but its reliability is weakened in times of economic instability, and this is in line with other studies concerning fair value accounting. Remarkable are the results found in EU15 banks: valuation coefficients are not statistically different from predicted values of 1 and -1 and distinguishing between low and high regulatory regimes doesnt provide any difference for the value relevance of fair value estimates. On the contrary, in the rest of the world the discount is larger in both cases: for overall fair value with respect to non-fair value asset and liabilities, and particularly when controlling for low regulatory quality countries. Furthermore, valuation coefficients decreased earlier in EU15 than in other countries (already in 2007), which is an evidence of the fact that these EU15 countries have been hit firstly by the economic crisis. The general idea in literature is that even though, through several empirical research, has been assessed that fair value measurement is a relevant accounting method for investors (among the first researchers, Barth, Beaver, & Landsman, (1996)), they however discount financial instruments book values according to concerns about lower or higher degree of reliability they perceive about these assets.23 Critics about fair value claim that even though fair value may be value relevant during times of market stability, it may lack relevance and reliability during times of instability. Thus relevance and reliability of fair value accounting method are seen as a trade-off especially when deviating from market prices: the best solution would be relying on market quoted prices, but only within an active market. Furthermore, even in times of relative market stability pricing of assets using

22

Of note, when an entity decides to record at fair value an instrument, it is aware that changes in fair values will impact the income statement and the equity, because these changes have to be ascribed in profit or loss.

Studies about value relevance of fair value approach are: Barth (1994); Barth, Beaver and Landsman (1996); Eccher et al. (1996); Beaver et al. (2003) among others. Studies of Kolev (2008), Goh (2009), Lev and Zhou (2009), Song (2010) focus on value relevance of each of the three levels of fair value hierarchy, but they too, demonstrate correlation between stock prices and total net assets as a whole recorded at fair value too..

23

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unobservable assumptions may however lack of reliability and provoke investors concern about information assymetry, due to a higher degree of private, and not public, information.

2.2. Research concerning value relevance of level 1, 2 and 3

Investors and creditors, so, generally perceive as value relevant all information recorded at fair value.24 Further questions are: how much subjectivity do they perceive within level 2 and mostly level 3 fair values? To what extent do they discount these amounts? Do they discount also level 1 asset prices, in times of economic downturn and not orderly markets? Until today some studies have been carried on this specific topic25. All of them deal with information risk and differentials of risk perception across the three levels. Regression models are created in order to test the link between stock prices of entities (mostly financial institutions), amount of instruments disclosed within the fair value hierarchy and other firm fundamentals (such as leverage, other assets, etc.). Often authors control for firm governance quality, using specific indicators of ex-ante quality, with the purpose of splitting the sample in low and high quality governance of institutions. This control for other than firm fundamentals demonstrates in the end, that the discont applied by investors for lower levels assets (e.g. lower correlation between stock price and amount of instruments held at level 2 and mostly level 3) is mitigated for entities that exhibit more quality features.

24

A simple, but important assertion to point out is that accounting rules as a whole are value relevant because we live in an imperfect market. In a perfect market, without information asymmetry, reporting market values would be superfluous (Beaver, 1981). Excluding Song (2010), Goh (2009), Kolev (2008), Di Martino (2011) and Bosch (2012) few other authors have dealt with value relevance of fair value disclosed by levels. Baruch&Nan (2009) studied the impact of the three levels on investors reactions to 44 political and economic events of the last worldwide financial crisis. Altamuro&Zhang (2012) test the differences between level 2 and level 3 in reflecting intrinsic value of the mortgage servicing rights. Others are Riedl and Serafiem (2011) and Liao (2011). All these studies, however lead to results that are directly correlated to the effect of the last global crisis.

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Goh, Ng and Yong (2009) focus their study on information risk. Their research points to find out how come lack of trading for some assets exists, even though firms are able to provide fair value estimates of their prices. If fair value estimates are perceived to be the mirror of underlying value of an asset, trading of instruments should be continuous and frequent. Are marked-to-market assets (level 1) priced differently from marked-to-model assets (level 2 and level 3)? The answer is yes and the reasons are concerns of investors about illiquidity and information risk. The authors run a regression between stock price and assets disclosed under the three levels of the fair value herarchy, of a selected sample of financial institutions. They found out first, that the coefficients of levels 1, 2 and 3 are 0.85, 0.63, 0.49 respectively, and second, that the level 2 coefficient estimate is not significantly different from the level 3 coefficient estimate26. This result reflects the investors discounting of financial instruments, according to the nature and observability of inputs and assumptions used for measurement. As predicted, reliability of level 2 and level 3 assets is lower than reliability of level 1 assets, therefore discounting of level 2 and 3 is higher than discounting of level 1. Theoretically, level 1 shouldnt be discounted because it reflects observable market prices, but a reason its coefficient is not equal to one (one dollar of assets is not priced proportionally to one dollar of share price) also because, the period in which Goh has run this study was a period of economic downturn: investors were aware that market prices (i.e. level 1 instruments) didnt reflect fundamental values of instruments. Then the authors run another regression including additional variables reflecting capital ratios and presence of Big 4 auditors for each bank. Results are coherent with predictions: level 3 assets for banks with higher capital ratios and audited by one of the Big 4 auditors has now a higher estimated coefficient. In line with literature, features like capital ratios, quality of corporate governance and external auditing

26

This study is taken across quarters of 2008. More interestingly, he finds coefficient of level 3 significantly different from 0 in the first quarter (which proofs the value relevance of mark-to-model fair value prices), but in the following two quarters, this value becomes only marginally different from 0 (also because of the crisis consequences).

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services (quality features) mitigate concerns of investors about riskiness and reliability of a banks fair value financial assets.

MANAGEMENT BIAS

MEASUREMENT ERRORS

INACCURATE MODELS

INVESTORS' DISCOUNT

INFORMATION RISK

Goh has shown that, given their intrinsic measurement subjectivity, mark-tomodel assets (i.e. level 2 and level 3) are discounted with respect to mark-tomarket assets (level 1). Remarkable is that, even if these prices have to be estimated and estimation procedure lacks in precision by definition, management has a fundamental role in determining to what extent estimations can be considered as reliable. Managers make predictions not only about the future performance of the asset, but also about other variables which are included in the prediction model. As an example, Schwarz (2011) speaks about certain features that should always be part of a valuation model when estimating, for example, the value of instruments composed of subprime mortgages (e.g. likelihood the house prices becomes flat or decline, the geographical dispersion of the instrument, the location of the price stagnation, etc.). The most common way to derive inputs for a model is looking at historical data. More generally, demand, interest rates, economic growth rates etc., are of great importance for estimations. Looking at historical data to derive predictions is the basis, but events that have rarely happened shouldnt be excluded. Furthermore, these variables may change frequently, therefore frequent adjustments may be
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needed. In this case, perceived value of level 3 assets, which require most adjustments, may be at risk of huge discounts and even of being discarded as junk assets. Is it really so? Kolevs (2008) research question goes precisely in this sense. He attempts to find out if level 3 instruments are really perceived as being junk assets, thus being marking-to-myth. He uses word pun to show his purpose of shedding light on whether investors perceive mark-to-model assets as, actually being of discarding; if level 2 (whose prices are estimated using both observable and unobservable inputs) and most of all, level 3 fair values are too unreliable and therefore not value relevant. His conclusion concerning value relevance of assets and liabilities recorded at fair value is coherent with the vast majority of studies about value relevance of fair value: there is evidence of significant positive association between stock prices and estimations of each of the three levels independently. There is also evidence of positive correlation between stock price and total assets recorded at fair value. This means that even though valuations are not determined according to unadjusted market prices for identical assets, investors dont discard marking-to-model assets as being marking-to-myth. Anyway, as predicted, level 2 and 3 coefficient estimates are lower than markingto-market coefficient estimates and correlation between stock prices and levels of the hierarchy are high for level 1, smaller for level 2 and the smallest for level 3. However, using the coefficient of level 1 as a benchmark, the author calculates a maximum difference between level 1 and 3 estimates of only 35%. As expected, when running a test of equality between estimated coefficients of level 1 and estimated coefficients of level 3, the result is negative. This result changes when running the same test and controlling for two more variables which account for higher equity capital of the bank and valuation services for level 3 assets provided by external third parties (these variables account for ex-ante information quality of banks). A change of point estimates was expected, but only to a certain extent. What the author finds instead, is that difference between coefficients of level 1 and coefficients of level 3 is now statistically equal to zero. This would mean that features which account for the fact that the entity presents
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high information quality about its assets not only mitigate concerns about level 3 assets, but even remove them totally27. Kolev finally finds out that level 2 estimated coefficients are significantly lower than level 1 estimated coefficients, but the difference is statistically significant only between level 1 and level 3. In a study run by Song et al. (2010), a similar result is found: value relevance of level 1 and 2 is higher than value relevance of level 3. The author finds similar estimates of level 1 and level 2 coefficients, and even close to the theoretical value of 1 (dollar-to-dollar pricing). He focuses on information asymmetry between preparers and users of financial statements, thus once more, on discounts made by investors in valuating reported fair values. Investors again have concerns about reliability of fair values measured through unobservable inputs. This effect can be mitigated by the strength of corporate governance: a weaker corporate governance is positively correlated with greater perceived information asymmetry. Therefore, for banks with low corporate governance28, level 1 and 2 appear to be value relevant, while level 3 doesnt. Song finds evidence of strong impact of corporate governance on investors pricing of level 2 and level 3. Specifically, there is no impact on pricing of level 1 assets, but there is a relevant increase in level 2 and level 3 point estimates, which brings them close to the predicted value of 1 (-1 for liabilities). Similarly to Song, also Liao (2010) investigates whether the fair value hierarchy can be associated with information asymmetry. The novelty of his research is the use of quarterly bid-ask spreads as proxies for information asymmetry. That is, Liao tests whether total net assets and net assets disclosed by levels, are positively or negatively correlated with the bid-ask spread29. In other words, if
27

This result should be interpreted with caution because there is only a small number of banks which use third parties services in order to estimate fair values of level 3 assets. To describe corporate governance Song uses a standardized variable which takes into consideration, among others, the number of independent Board members, the number of financial experts in the audit committee, etc. Using the bid-ask spread as a proxy for information asymmetry is explained by the fact that, when uninformed investors perceive the risk of information asymmetry, they try to increase the bid-ask spread to protect themselves against possible losses deriving from trading with more informed investors. Thus, the bid-ask spread is higher when more information asymmetry is perceived.

28

29

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the accounting standard has the power to improve informativeness of fair value (in this case, SFAS 157), then the relationship between the bid-ask spread and the financial instruments differs across hierarchy levels. This hypothesis is validated: specifically, the relation with the bid-ask spread (information asymmetry) is positive for all three levels, but the value of this relation changes from one level to another. Furthermore, also total net assets as a whole are positively correlated with information asymmetry. This means that investors perceive some information asymmetry about all assets recorded at fair value, even about level 1 instruments. This result is similarly interpreted to results of other studies that didnt find a dollar-to-dollar pricing of all fair value levels (e.g. Song (2010)). Negative correlation, then is found between information asymmetry and variables which control for size, stock price and capital ratio Tier I of banks, which confirms the importance of such ex-ante quality factors on investors valuation of an entity and its assets. Riedl and Serafiem (2011), instead estimate the firm equity beta starting from the CAPM model. Then they decompose it in two parts in order to analyze the part that captures information asymmetry, thus information risk. They test the relationship between this measure and the three levels of the hierarchy. SFAS 157 and IFRS 7 require a higher information quality, through enhanced

disclosures for financial instruments, therefore the authors test the link between improvement of disclosure and the entitys cost of capital. If the latter is high, it is a consequence of higher information risk, which means higher beta values. The authors actually find increasing betas (increasing cost of capital) across portfolios of assets designed at levels 1, 2 and 3. To the extent that information risk increases with increasing levels, the conclusion is that level 3 assets lead to a higher cost of capital with respect to level 1 and level 2. Secondly, the authors give once more prove of how improving ex-ante information quality (having a higher level of analysts following, lower forecasts errors and dispertion, and higher market capitalization) mitigates the risk perceived about assets measured through unobservable inputs. Within this test,
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no difference is perceived across levels for higher information quality institutions, while for lower information quality institutions this difference is significant. Lev and Zhou (2009) argue that the classification in levels informs on liquidity risk. They test this claim using correlation between a set of political and economic events (that occurred during the last four months of 2008) and changes in raw returns observed on the stock exchange of financial and nonfinancial firms. Each event (e.g. statement of Wells Fargo to purchase Wachovia, Fed cuts on interest rates, Citi Group rescue etc.)30 is classified whether as a liquidity shrinking or as a liquidity expanding event and has a few trading days window. Returns on the stock exchange are measured as a mean of daily cumulative raw returns over the relative time window. The authors give proof of correlation between stock returns and events. Particularly, market reactions have been negative for the liquidity-constraint events and positive for the liquidity-expansive events in both financial and non financial sectors. As far as concerns the 3 levels hierarchy, for non-financial firms there has been a worse reaction regarding level 2 and level 3 liabilities with respect to reaction to level 1, when liquidity-constraint events had occurred. Also for financial firms, in which most fair value assets are level 2 and 3, reaction has been more marked, specifically for level 3.31 The opposite holds for liquidityexpanding events. That said, investors perceive liquidity risk and react consequently. Thus, they discount the second and third level because those levels provide information on higher liquidity risk. Again, concerning illiquid markets, the last US study on reliability of mark-tomodel versus mark-to-market fair values that I am going to mention, goes partially against (or at least mitigates) the negative results for level 3 instruments, found by Lev and Zhou (2009). It is a test that proves enhanced
30

Five groups of events are used: Distress, Policy, Rescue, Fed, Capital infusion . While the first two are liquidity-constraining, the last two are liquidity-expanding.

Financial institutions liabilities are mostly insured by the Federal Deposit Insurance Corporation (FDIC). Therefore no reaction was found, for liabilities of financial firms.

31

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information capability of mark-to-model methods in inactive, illiquid markets compared with mark-to-market. That is, when the market is not active and trading of an instrument is infrequent, use of managerial discretion is more informative for investors than the sole use of mark-to-market, simply because referring to market prices doesnt give a true reflection of fundamental values of instruments. Altamuro & Zhang (2012) studied the mortgage servicing rights and the correlation between the persistence of fees (as a proxy for future cash flows) and fair value of the mortgage.32 The results are in line with their conjectures: during periods of infrequent trading and illiquidity, mark-to-model methodology gives a fair value estimation that is more closely reflected by future cash flows arising from this instrument. Accounting regulators give less importance to estimation methodologies and managerial discretion, to the extent that FAS 157 even emphasize that illiquidity is not a sufficient reason to ignore market prices. But the matter is that managers have more information than regulators and this information is reliable, if properly used, when prices provided by markets are not a reflection of real fundamental values.

Mark-to-model and structured finance Structured finance33 is another relevant topic when analyzing mark-to-model assets and liabilities. Structured instruments, by definition, are unique because

MSR are the rights of serving a mortgage and are sold by the lender to another party. This party commits himself to collecting monthly payments and forwarding interests and principal to the lender. MSR market is not small, but it is not considered active because of the infrequent trading of these instruments. MSR give rise to cash flows for the lender, thus a service fee is paid, to the buyer of rights, by him. Theoretically the present value of future fee cash flows should be reflected by the MSR fair value at the balance sheet date.
33

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Structured finance and securitization have two different meanings. Securitization is the process of pooling similar financial instruments (e.g. loans, mortgages) which are not usually sold in an active market. Afterwards, securities with claims against these underlying instruments are issued. The aim is removing them from the balance sheet of the issuer and transferring the risk of default of original instruments from the issuer to the purchaser. Structured finance instead, concerns the conversion of these otherwise risky assets, in low risk rated ones, in order to increase the probability of their

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of the distinctiveness of the underlying instruments upon which they are issued (e.g. loans, mortgages). Therefore, they always include in their estimation a certain degree of modeling34. It is a difficult task to find quoted prices for values of these instruments and as well known, securitization and derivatives (the structured instruments) have been an important problem of the last financial crisis. To shed light on these opaque instruments, Schwarz (2011) creates a simple model based on tranches of derivatives and related probabilities of default through which he explains to what extent small errors in modeling structured instruments can lead to catastrophic consequences. His model basically uses the present value technique, which is one of the measurement methods that can be used to estimate level 3 instruments, as provided by SFAS157 and IFRS 7. Specifically, the most intuitive error is not including systematic risk, which by its non-diversifiable nature, leads to declines in senior tranches when all underlying instruments (e.g. subprime mortgages, as of the 2007 financial crisis) go bad. Indeed, senior tranches go very well when the model doesnt account for systematic risk: they have a very low probability of default. But when systematic risk is taken into account (which is actually a proxy for a bad economic period), while probability of default of the safest senior tranches increases (even by 25 times), probability of default of junior and mezzanine tranches decreases. The problem is that lower level tranches are usually held by hedge funds or institutions which are used to bear high degrees of risk. On the contrary, superior level tranches, which should be safer, are usually held by more riskadverse individual investors. Thats why a wrong, imprecise model can reduce overall social welfare. A measurement model has to incorporate all features that help explaining the real
settlement among investors. The purpose is receiving cash and transferring risks from ones own balance sheet.
34

In 2003, Warren Buffet claims about derivatives: The range of derivative contracts is limited only by the imagination of man (or sometimes, so it seems, of madmen). [] It is like you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem, at a price you will easily find an obliging counterparty.

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risk it reflects. So, even though a manager or a rating agency doesnt use private information and discretion to their own benefit (earnings management), simple small errors may miss the real explanation of the value of that instrument. The problem with derivative products is that they magnify risks of underlying instruments in both ways, upward and downward. Thats why the consequences may be enormous. And derivatives are always measured at fair value level 2 and 3. They are a time bomb especially for highly leveraged financial institutions.

2.2.1. Two European studies

As already claimed, Di Martino (2011) and Bosch (2012) held the unique researches on the distinct impact of the three levels on market values of European entities (specifically, of European banks). Di Martino (2011) found level 1 instruments to be value relevant, thus providing useful information to investors. These instruments, particularly present a market premium of 10% with respect to the total value. In his first test he also found that level 2 and level 3 instruments are not value relevant, that is not providing additional quality to information needed by the market. Moreover, of interest is the negative impact of level 3 instruments (which hypothetically is discounted, but positive), that is interpreted with a discount of the value of banks for investors. Interesting results are found when running a test that included also effects of further disclosure about level 3 instruments (the required Movements in and out level 3 instruments). Banks which provide this enhanced disclosure invert the market negative perception about level 3. In other words, these banks present a higher market value compared with those banks that dont provide such further disclosure. In this sense, investors perceive as useful this information. Bosch (2012) is the most recent study concerning this topic. He uses a sample of EU27 banks and make the same kind test about value relevance and reliability of

40

fair value hierarchy. He finds all levels to be value relevant, with level 3 being the least reliable one. What is important is that, like Fietcher (2010), he divides the sample in member countries of EU15 and Other European Countries and finds divergent results from one sample to another. In particular, while in EU15 all levels are value relevant and estimated values of each level converge with related expected values, in other European countries the outcome is different. For these countries, levels are generally priced less and their estimated values diverge more from the expected values. This is evidence of the fact that different regulatory qualities drive different market perceptions.

2.3. Literature: conclusions

Summarizing all the most recent findings, disclosures proposed by IFRS 7 and SFAS 157 are informative for investors. Value relevance has several times been tested and the overall conclusion is that enhancing disclosures requirements enhances information for users of financial statements. Generally, instruments measured using observable inputs (level 1) are priced more than level 2 and level 3 instruments. They are not, anyway, priced at 100% their reported value. The explanation of this result is that the period of time during which almost all tests have been conducted was a period of inactive markets, characterized by deviations of prices from their fundamental values. Investors knew that market prices were distorted. Furthermore, there is a general concern about fair value financial instruments: as seen above, opinions are conflicting towards fair value versus other methods of measurement (e.g. amortized cost). However, pricing differs across levels to the extent that level 1 is anyway, priced higher than the other two levels. Level 3 for some authors is even discounted as

41

much as level 2 (e.g. Goh (2009)). But generally admitted is that level 3 instruments are discounted the most35. Also prior to the introduction of the fair value hierarchy, fair value accounting has been demonstrated to be value relevant, but since the adoption of the new provisions, investors have had a more precise way to analyze an entity. Another relevant additional conclusion is that when investors consider also the quality of corporate governance, and the quality of provenience of reported values, their risk perception changes. That is, investors price level 3 instruments more, when an entity performs specific standards of ex-ante quality information, with respect to an entity that doesnt reach these standards. Some authors even find that considering quality features leads to a perceived value of level 3 assets equal to the perceived value of level 2 and level 1, thus a total annulment of the previous higher discount (Song, 2010; Riedl and Serafiem, 2011). All studies (with exception of the three European studies), have been made in the U.S.A., using U.S. GAAP provisions as a basis. As already stated at the beginning of this thesis, IFRS and U.S. GAAP have reached convergence with regard to fair value measurement and related disclosures, by issuing convergent provisions on this topic. Therefore, the two sets of principles are more identical than similar (with few little exceptions), thus U.S. literature is very helpful for comparison purposes of outcome of the present analysis.

As a reminder, Altamuro and Zhang (2012) find mark-to-model as being a good measure in illiquid markets.

35

42

3. STATISTICAL MODEL 3.1. Research questions and hypothesis development

The tested model is going to show if, with respect to fair value hierarchy of financial instruments, recent enforcements of IFRS (for financial information reported in the 2010 and 2011 annual reports) have had some mitigating impact on the lower perceived value of fair value instruments. Particularly, level 2 and level 3 assets as of previous literature are perceived as reflecting less than level 1 the theoretical pricing of one dollar-for-one dollar. This is due, as mentioned above, to the nature of inputs used in measuring fair value. Consequently, the issue is related discretion of management in using private information to provide estimates. Discretion of management and measurement errors are more probable within level 3, but sometimes level 2 and level 3 are seen as a macro category because of the common deviation from quoted prices in active markets. There is widely accepted belief that also level 1 is deviating from quoted prices in active markets, not because quoted prices arent used to measure it, but because during the tested periods markets were not totally active. Therefore, none of the previous studies has found a full 100% one dollar for one dollar valuation for either level 1, 2 or 3. If it was so, related coefficients would be equal to 1. This is a theoretical value and it means that an 1% change in value of assets is reflected in an 1% change in perception of investors about the value of the whole entity. After 2008 and the start of the financial crisis, as summarized above, European and national institutions issued enforcements concerning classification and disclosures of financial instruments as provided by IAS/IFRS. These enforcements regard 2009 onwards annual reports in order to provide investors with all relevant information about the financial situation of entities. The stress is most on financial instruments because of their importance in the crisis and particularly, in the banking sector. Have these recalls and recommendations about enhanced precision produced any effects on market capitalizations of European banks? Have markets perceived enforcements as being useful? Do
43

market participants believe that banks have actually taken into account enforced provisions and did this attention generated better informing disclosures about financial instruments? These are the research questions. Upon these questions, underlying hypothesis have been computed too. The belief is that the work of ESMA and national enforcers is not useless. More specifically, the supposition is that market participants generally give credit to institutions that work in order to ensure transparency in financial markets and believe that their guidelines are taken into account by entities. Even more so that, if financial institutions wouldnt comply with required quality of disclosures, they would fall afoul of sanctions carried on by watchdogs (the supervisory authorities). So, if this hypothesis is accepted, the result will be that while the perceived values of all instruments disclosed by levels wont however fully reflect the amount recorded in the financial statements (thus, statistically speaking, point estimates of regression coefficients related to such variables wont be equal to 1 for assets and -1 for liabilities), the perceived value of level 3 assets and liabilities will better reflect related recorded values, than level 2 and level 1 do (thus, level 3 coefficient estimates will be more close to 1 and -1). This hypothesis is supported by the fact that the enforcements have special regard to the most opaque, level 3 financial instruments. Before testing this issue, a more general issue has to be once more tested, that is the value relevance of all financial instruments recorded at fair value. The belief is that the result of this preliminary test will be in line with previous literature, since most authors reached this conclusion, and there is no need to think that something has meanwhile changed: in other words, investors actually believe that fair value measurement for financial instruments is value relevant. Finally, within this assumption, is taken for granted that hierarchy disclosures required by IFRS 7 are informative for market participants. Different levels reflect different methods of valuation. This means that across levels, different discounts are supposed to be found, in line with literature.

44

Formally speaking, the preliminary hypothesis is the following: (H1) Even though the perceived value of assets and liabilities differs across levels, all instruments disclosed by levels are perceived to be value relevant. The main hypothesis of this test is the following: (H2) Mark-to-model values present, on average, a lower discount for 2010 and 2011 financial statements compared to discounts previously found in literature, thanks to the recently issued IFRS enforcements concerning the fair value hierarchy.

3.2. Sample and variables description

Data on accounting values were gathered from both 2010 and 2011 consolidated financial statements of banks, closing at December 31st, that are directly downloadable from the entities websites. 36 The sample originally was made of 46 European listed banks, but later some banks were excluded. Three financial institutions didnt provide all necessary information and other 2 banks provided useful information only for one of the two periods, therefore were included only in one of the two yearly data. Finally, for the research purposes, 42 banks were maintained for the year 2011 and 41 banks for the year 2010. Most number of banks were selected from Italy, United Kingdom, Spain (see Table 1 for the distribution of banks across countries). The final sample was computed putting together data for both years. It has 83 observations.

36

Only financial statements of an Italian Mediobanca S.P.A., closes at 31/06.

45

Country Italy Spain UK France Sweden Switzerland Denmark

Banks 8 6 5 4 4 3 3

Country Austria Germany Norway Belgium Finland Portugal Ireland

Banks 2 2 1 1 1 1 1

Table 1. Number of banks by country.

All financial institutions disclosed information about financial instruments recorded at fair value in line with IFRS 7, for both years. Subject of the research are total amounts of fair value financial assets and financial liabilities disclosed by level. This data, along with the amount of total loans (interbank loans + customer loans), of other than intangible assets not recorded at fair value, of customer deposits and of other liabilities, are independent variables in the statistical regressions subject matter of the research. Market capitalization (as of 31/12/2010 and 31/12/2011) is the dependent variable. The results will show to what extent amounts of assets and liabilities of European listed financial institutions in 2010 and 2011 influence the market values of these entities. In Table 2 are displayed average data about percentage of level 1, 2 and 3 assets (liabilities) on total amounts of assets at fair value (liabilities at fair value), and percentage of total assets at fair value (liabilities at fair value) on total amount of assets (liabilities) as of the balance sheet.

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ASSETS Level 1 2010 TOT FV 2011 TOT FV 43% 46% Level 2 50% 32% 53% 32% 4% 12% Level 3 4% Level 1 14%

LIABILITIES Level 2 83% 21% 86% 22% 2% Level 3 3%

Table 2. Shares of fair value assets (liabilities) by level on total fair value assets (liabilities) and shares of total fair value assets (liabilities) on total assets (liabilities) as of the balance sheet.

These data are calculated on an average percentage basis across financial institutions. For example, for the ASSETS - column are displayed percentages of level 1, 2 and 3 on total fair value assets in 2010 and 2011. The same holds for the LIABILITIES column. Tot FV is an average value of total assets recorded at fair value divided by the amount of total assets as of balance sheets for each year. Of note, almost 95% of assets disclosed at fair value are distributed similarly among levels 1 and 2 (level 2 is however prevailing) in both years. Liabilities, instead present an 85% disclosed at level 2, while level 1 accounts for a noticeable smaller share. Level 3 instruments represent a small share of all fair value instruments. In order to point out the high importance of fair value instruments, table 3 presents data on an average basis about the impact of assets and liabilities, disclosed by levels, on the tangible book value (common equity less intangible assets)37.

37

TBV = tangible book value = tangible common equity = common equity intangible assets.

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L1 assets/tbv Min Max Mean 0,28x 11,83x 3,03x

L2 assets/tbv 0,19x 30,83x 5,85x

L3 assets/tbv 0 1,90x 0,30x

L1 liab./tbv 0 7,00x 0,75x

L2 liab./tbv 0,25x 25,83x 5,28x

L3 liab/tbv 0 0,98x 0,13x

Table 3. Instruments disclosed by level divided by tangible common equity (31/12/2011 data).

There is a reassuring evidence of the lower impact of level 3 instruments on tangible common equity, with respect to the impact of other levels: on average, level 3 assets represent 30% of TBV and level 3 liabilities represent 13%. Data for level 2 assets and liabilities are more alarming (level 2 instruments are about 5 times higher than the tangible common equity). The maximum values within the sample are even more critical: level 2 assets represent a maximum value equal to 31 times the TBV, and level 2 liabilities represent a maximum value of 26 the TBV38.

3.3. Statistical regressions

All regression variables are scaled by the tangible book value, otherwise called net tangible assets, to allow for homoscedasticity and not to account for differences of size across different bank. The indicator P/TBV is used, because it reflects the perception of investors about the value of equity. So, if market capitalization is higher than the tangible book value (and the indicator is higher than 1), then if the bank would sell all its assets at a price equal to the assets

38To

make an example, banks which are settled in Italy, Spain, UK, and France (the first three countries by number of banks in the sample) on average, hold level 2 assets/TBV with the following percentages: Italy 150%, Spain 181%, UK 750%, France 1306%. Furthermore, 37% of the sample (computed with 2011 data) have negative level 2 net assets (assets less liabilities).

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value recorded on its balance sheet, would have a gain39. Finally, using the tangible book value provides a more cautious measure with respect to the simple book value40. With these variables initially three regressions were created. One that gathers together results for both years and other two that account for each year separately.

1. The first regression, that controls exclusively for amounts of assets and liabilities is, therefore, the following: Pi/TBVi = + 1*AFV1i/TBVi + 2*AFV2i/TBVi + 3*AFV3i/TBVi +

4*LOANSi/TBVi + 5*OTHAi/TBVi + 6*LFV1i/TBVi + 7*LFV2i/TBVi + 8*LFV3i/TBVi + 9*DEPi/TBVi + 10*OTHLi/TBVi + Where: P is the share price multiplied by the total shares (total market capitalization of the bank). AFV1(LFV1), AFV2(LFV2), AFV3(LFV3) are assets (liabilities) at level 1, level 2, level 3, LOANS are the interbank loans + net loans41, OTHA are other assets (i.e. not disclosed at fair value) excluding the intangible assets, DEP are the total customer deposits, OTHL are remaining liabilities not disclosed at fair value.

2. The second regression, which accounts also for each year separately is:

39

Of note, in the present sample, P/TBV values range between 0.22 and 2.92 in 2011 and between 0.26 and 3.66 in 2010.

This measure gives an advantage in the sense that it can be used also in the future (to determine, e.g. the price of the entity), when the goodwill or the brands wont necessarily have the same value. This implies that it is more difficult for intangible assets to have a precise value, because this value can change easily.
41 Net loans are total loans to customers reduced by possible default losses and unearned interest income.

40

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Pi/TBVi

= +

1*AFV1i/TBVi

+ 2*AFV2i/TBVi

+ 3*AFV3i/TBVi

4*LOANSi/TBVi + 5*OTHAi/TBVi + 6*LFV1i/TBVi + 7*LFV2i/TBVi + 8*LFV3i/TBVi + 9*DEPi/TBVi + 10*OTHLi/TBVi + 11*YEAR + Where YEAR is a dummy variable, that is equal to 0 for the 2010 data, and equal to 1 for the 2011 data.

3. The third regression takes into account the impact of YEAR and of an additional variable (ROTE): Pi/TBVi = + 1*AFV1i/TBVi + 2*AFV2i/TBVi + 3*AFV3i/TBVi +

4*LOANSi/TBVi + 5*OTHAi/TBVi + 6*LFV1i/TBVi + 7*LFV2i/TBVi + 8*LFV3i/TBVi + 9*DEPi/TBVi + 10*OTHLi/TBVi + 10*ROTEi + 11*YEAR + Where ROTE is the Return on Tangible Equity. It measures how well an entity is producing profit with the invested equity, not accounting for intangibles. Investors usually compare similar companies, by comparing their ROTE rates in order to see which one performs better. ROTE is computed with the following formula:

NET INCOME ROTE = COMMON EQUITY INTANGIBLES

Using hypothesis summarized above and the regression equations, testing and accepting the first hypothesis (H1) means that coefficient estimates assigned to assets and liabilities of each level (1, 2, 3, 6, 7, 8) are statistically significant. Testing and accepting the second hypothesis (H2), means that coefficient estimates of level 3 instruments is higher than coefficient estimates of levels 2 and 1 or, at least they have a reasonable lower discount compared with discounts resulting from previous literature. Table 2 summarizes the predicted signs of all the model variables.
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VARIABLE

(1) PREDICTED SIGN

(2) PREDICTED SIGN

(3) PREDICTED SIGN

AFV1/TBV + AFV2/TBV + AFV3/TBV + LOANS/TBV + OTHA/TBV + LFV1/TBV LFV2/TBV LFV3/TBV DEP/TBV OTHL/TBV YEAR ROTE Table 4. Predicted signs of variables.

+ + + + + +/-

+ + + + + +/+

In tables 2 and 3 are presented descriptive statistics of variables. Numbers show that on average the indicator Price to tangible book value (P/TBV) is 66% higher in 2010 compared to 2011. This implies that market participants have put a higher discount on banks during 2011, perhaps due to a global negative view of investors confidence. Standard deviation of this variable is also noticeably higher in 2010. This implies that the indicator varies within the sample more in 2010 than in 2011, and this higher variance could partially explain the increase in investors valuation of banks in 2010. Mean of LFV1/TBV and LFV3/TBV are less than 1 in both years, while on average level 2 liabilities are approximately 5 times higher than the tangible book value (for 2010 the value is equal to 4.68 and for 2011 to 5.28). This gives evidence of the high amount of level 2 liabilities that banks generally hold. As far as concerns assets, amounts of level 2 is also high, but level 1 accounts for a substantial share too (it is not so for liabilities).

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Descriptive statistics*
P/TBV Mean Median StdDev Min Max P1% P99% 0.7823 0.6512 0.5245 0.2216 2.9183 0.23 2.51 LOANS 15.2089 14.1356 6.1889 6.9938 44.1371 7.09 35.67 AFV1 3.0271 2.3844 2.0388 0.2784 11.8343 0.59 10.14 AFV2 5.8543 3.5084 6.2330 0.1912 30.8309 0.22 26.23 AFV3 0.2982 0.1538 0.3800 0.0000 1.9037 0.00 1.64 OTHA 1.0803 1.1330 2.7174 -4.4663 8.7061 -4.36 8.70 DEP 9.1095 8.3652 3.4344 1.8332 21.9468 2.34 19.51 LFV1 0.7498 0.2989 1.2541 0.0000 7.0022 0.00 5.62 LFV2 5.2808 2.7603 5.5312 0.2482 25.8314 0.27 22.95 LFV3 0.1261 0.0216 0.2260 0.0000 0.9832 0.00 0.89 OTHL 7.8750 7.3337 4.6330 1.1702 27.5055 1.35 23.49 ROTE 0.0065 0.0594 0.1570 -0.6019 0.1524 -0,4936 0,1477

Table 5. Descriptive statistics 2011.

P/TBV Mean Median StdDev Min Max P1% P99% 1.1812 1.0931 0.7011 0.2649 3.6599 0.29 3.54

LOANS 15.2009 15.1193 5.7655 6.7298 38.9075 7.28 33.14

AFV1 3.3900 2.6831 2.4170 0.3419 12.7764 0.55 11.60

AFV2 5.3212 2.8473 5.7579 0.2459 29.4672 0.25 23.22

AFV3 0.3092 0.1622 0.4231 0.0000 2.0775 0.00 1.81

OTHA 1.0889 1.0511 3.1607 -7.3681 9.0641 -6.24 8.82

DEP 9.2659 9.4327 3.4189 1.8153 21.8754 2.25 19.55

LFV1 0.9021 0.3360 1.5594 0.0000 8.7825 0.00 7.04

LFV2 4.6752 2.8045 4.9380 0.1711 23.7799 0.19 19.64

LFV3 0.1447 0.0319 0.2573 0.0000 1.2451 0.00 1.01

OTHL 7.8977 7.1075 4.3855 0.2757 23.2499 1.00 20.88

ROTE 0,0880 0,0905 0,0658 -0,1703 0,2091 -0,1096 0,2029

Table 6. Descriptive statistics 2010. *All variables are scaled by TBV.

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On average, level 1 instruments (both assets and liabilities) have decreased from one year to another and interestingly level 2 instruments have increased. Particularly, from 2010 to 2011, level 1 assets decrease by 12% and level 1 liabilities decrease by 20%. Level 2 assets and liabilities increase by 9% and 11% respectively. Evidence of these changes can also be drawn from percentages presented in table 2. Level 3 instruments have basically remained the same. Of note is also that no banks have no level 2 liabilities, while there is at least one bank that has no level 1 (and no level 3) liabilities. Since for the purpose of the test, data are gathered together from both years, descriptive statistics for these data (of note, all variables are still scaled by the tangible book value) as a whole, is summarized in Table 7.

P/TBV LOANS AFV1 AFV2 AFV3 OTHA DEP LFV1 LFV2 LFV3 OTHL ROTE Mean Median Std dev Min Max 0,98 0,87 0,65 0,22 3,66 15,20 14,33 5,95 6,73 44,14 3,21 2,43 2,23 0,28 5,59 3,04 5,97 0,19 0,30 0,16 0,40 0,00 2,08 1,08 1,12 2,93 -7,37 9,06 9,19 8,86 3,41 1,82 0,83 0,34 1,41 0,00 4,98 2,80 5,22 0,17 25,83 0,14 0,03 0,24 0,00 1,25 7,89 7,13 4,48 0,28 27,51 0,05 0,08 0,13 -0,60 0,21

12,78 30,83

21,95 8,78

Table 7. Descriptive statistics all data.

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54

4. RESEARCH RESULTS
A formal statistical regression has been run using Excel 2007. As already mentioned, observations for years 2010 and 2011 were used together in order to enhance the sample size. Firstly, were not made any controls to keep into account for different years. Next, a dummy variable was introduced. Finally, also the return on tangible equity ratio (ROTE) was included in the model. In the following figure, results of (1) are briefly presented.

4.1. Regression results (1)

In the following table, results of the first regression (1) are briefly summarized:

R squared: 23% Adj. R squared:13% VARIABLE Intercept LOANS/TBV AFV1/TBV AFV2/TBV AFV3/TBV OTHA/TBV DEP/TBV LFV1/TBV LFV2/TBV LFV3/TBV Coefficients 0,160 0,546 0,707 0,687 0,778 0,533 -0,582 -0,681 -0,694 -0,983 Signif. 78% 6% 2% 2% 7% 6% 6% 3% 2% 8%

OTHL/TBV -0,623 4% Table 8. Regression results (1).

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First of all, the total fitting of the regression (R2) is not very high: R square is 23% and corrected R square is 13%, even though statistics for the overall significance of the model (F statistics) has a good value (see tables in the appendix for detailed regression results). Moreover, also the individual significance of each variable (with the exception of the intercept) presents good values, with significance values of level 1 and 2 coefficients that perform the best: these estimates are significant at about 98% level. Some preliminary considerations are to be pointed out about coefficients of variable LOANS/TBV (Loans) and DEP/TBV (Customer deposits). Loans present a that is equal to 0.546, lower than the theoretical value of 1, in other words a 50% discount. This implies a lower than dollar-to-dollar pricing of these assets. Loans are recorded at amortized cost, and cannot be devalued unless a default probability arises (the so called non-performing loans). Prerequisite of devaluation is an objective evidence of one or more occurred events after the initial recognition of the asset (IAS 39). If a probability of default arises, the loan value is calculated with a higher interest rate. This higher rate is given by an increased spread and an increased risk. In such a case, the value of the loan would decrease. The loan has to be recorded in the balance sheet, but as already said, it has to be valued at amortized cost (that is a higher value than its fair value calculated with the increased interest rate). Therefore, if dont occur sure events, that imply the probability that the loan could become a non-performing loan, the loan will be recorded at a higher value than its real underlying value. The differential between the amortized cost and the loan fair value has to be recorded in bad debts provision and the value of the certain payable amount is given by the residual part (the difference between amortized cost and the amount in bad debts provision). Concluding, loans are discounted because their book value may be higher than their real value. As far as concerns Customer deposits, the related coefficient estimate is equal to -0,582. These liabilities too, are not priced in line with their book value, therefore market put a discount also upon this category. This is due to the fact that banks have a benefit of gain by paying to customers interest rates on their deposits, that are
56

lower compared to the market interest rate. Thereafter at this latter interest rate, banks do investments (issue loans). That is, financial institutions, in order to obtain a gain, issue loans and invest themselves at a higher rate than the interest rate they remunerate customers for doing business (opening deposits) with them. Market participants perceive the benefit that banks obtain by offering low interest rates on deposits, therefore they price this category with a discount. Focusing on results for coefficients estimates of level 3 instruments (in the regression equation, 3 and 8), remarkable is the highest value of liabilities estimated coefficient, (almost equal to -1) with respect to coefficients of level 2 and level 1. Of note is that level 1 and level 2 liabilities have very similar coefficients (and very similar standard errors), suggesting that level 3 are considered far more different with respect to the first two levels of the hierarchy. As for the asset category (1, 2, 3), differentials between level 1 and 2, and level 3 is smaller. Here coefficient estimates of level 1 and 2 are 0,707 and 0,687 respectively - once again they display very similar values - while level 3 coefficient is higher (0,778) but not so high as for liabilities. Of note is that level 3 standard errors are higher than standard errors of level 1 and level 2, and also the significance test (p-value signif column) shows that estimates of level 3 are significant at a 92% level for liabilities (93% level for assets), with a p-value of 0.08 (0.07 for assets). The good significance level of all coefficients confirms the preliminary hypothesis (H1) within a global 92% confidence level: all fair value instruments are value relevant for investors purposes. Moreover, the predicted negative sign for liabilities and positive for assets is in line with results. Coefficients, as predicted are not equal to their theoretical value of 1 (-1), although level 3 liabilities coefficient is very close to this value. However this proximity with the theoretical value (coefficient of level 3 liabilities is - 0,94) is to be interpreted cautiously, because of the higher standard errors and p-values with respect to other variables. However, this high coefficient estimate for level 3 would lead to not refusing also the second hypothesis (H2). There is evidence of a good improvement in investors
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valuation of level 3 liabilities for the years 2010 and 2011: the coefficient is higher than the coefficient related to level 1 and level 2, and it is close to the theoretical value. Also level 3 assets present a good estimate (0.778), higher than coefficients of level 1 and level 2. This improvement is supposed to be correlated with commitment of ESMA and national enforcers and the issuance of IFRS enforcements, with particular regard to level 3 fair value disclosures. As a consequence of enforcements, entities disclose in detail each component related to level 3 instruments, in order to improve reliability of this category.

4.2. Regression results (2)

Results of the second regression (2), which accounts for different year effects, are briefly summarized below42:

R squared: 29% Adj. R squared: 19% VARIABLE Intercept YEAR LOANS/TBV AFV1/TBV AFV2/TBV AFV3/TBV OTHA/TBV DEP/TBV LFV1/TBV LFV2/TBV LFV3/TBV Coefficients 0,577 -0,326 0,418 0,566 0,550 0,609 0,405 -0,449 -0,546 -0,551 -0,856 Signif. 33% 2% 14% 5% 7% 15% 15% 13% 7% 7% 12%

OTHL/TBV -0,491 9% Table 9. Regression results (2).

42

Of note, YEAR attributes 0 to data gathered from 2010 annual reports, and 1 to data gathered from 2011 annual reports.

58

With the introduction of a dummy variable which accounts for different years, R2 and adjusted R2 of the model improve by 6%. The overall significance (F statistics) improves too. This result implies the benefit of using multiple variable regression: with the inclusion of new variables, total model explaining power is enhanced. However, globally now coefficients are less significant with respect to the first regression. Particularly, only dummy YEAR, level 1 and level 2 and OTHL present significance at a 90% level. Looking at point estimates, coefficients of LOANS and of DEP now present even a higher discount, but their individual significance is lower with respect to the first test (p-values are 0.14 and 0.13 respectively). Dummy YEAR presents a negative value (-0,326), which would imply that, if all other coefficients were equal to 0, value of the dependent variable (P/TBV) would be directly attributed only to the intercept and to this negative value. In other words, in 2011, it is estimated a higher discount of market values of banks, compared to 2010. In this case, no precise conclusions can be drawn, since the intercept is not significant. Coefficients of level 1 and level 2 instruments remain highly significant with respect to other variables, in line with the first regression. Their point estimates remain once more very similar (equal to about 0.55 both for assets and liabilities). Significance of level 3 instruments, instead worsen and also point estimates are lower. Specifically, for level 3 assets difference between related coefficient and level 1 and 2 coefficients is only of 5% (for level 3 liabilities, difference is of 30%).

59

4.3. Regression results (3)

Results of the third regression, which accounts for each year separately, and also for the effects of return on tangible equity, are briefly summarized below:
R squared: 34% Adj. R squared: 23% VARIABLES Intercept ROTE YEAR LOANS/TBV AFV1/TBV AFV2/TBV AFV3/TBV OTHA/TBV DEP/TBV LFV1/TBV LFV2/TBV LFV3/TBV Coefficients 0,456 1,256 -0,231 0,413 0,544 0,511 0,512 0,396 -0,441 -0,511 -0,509 -0,864 Signif. 43% 3% 9% 14% 5% 8% 22% 15% 13% 9% 8% 11%

OTHL/TBV -0,477 9% Table 10. Regression results (3).

Coefficient of ROTE is higher than 1 and its significance level is good (p-value 0.03). This implies that Return on tangible equity is a good indicator for market participants to settle a price on the entity. LOANS and DEP confirm their discounts and present almost identical values of point estimates and significance levels, similarly to regression (2). Dummy YEAR is also significant at 91% level and confirms its negative corrective impact of the intercept. Focusing on results about fair value assets and liabilities, is remarkable the worsening of the significance related to level 3 assets compared to previous regressions: the related p-value is equal to 0.22, thus it cannot be considered significant at a 90% level, like all other fair value instruments. Level 1, level 2 assets and level 3 liabilities have similar estimates and p-values to those found in regression (2). Finally, level 1 and level 2 liabilities present a discount of 50%
60

(higher than in previous regressions) at a 91% and 92% significance level, respectively. Concluding, general results as far as concerns fair value instruments dont change drastically, with the exception of level 3 assets variable which turns to be statistically not significant at a 90% confidence interval. On one hand, introduction of a new variables improve general fitting of the model, on the other hand coefficients (particularly those related to level 3) become individually significant at a lower level.

4.4. Summary of regression results

Summarizing, coefficient estimates of level 1 and level 2 instruments are very close one to each other in all three regressions. In order to gather approximate estimate differentials across the three levels, the following table displays features of coefficients of level 3 instruments, compared to level 1 and level 243.

Regression (1) (2) (3)

ASSETS Difference between L3 and (L1 and L2) Higher than L1 and L2 of ~ 0,08 Higher than L1 and L2 of ~ 0,05 Like L2, lower than L1 (but pvalue=0,22)

LIABILITIES Difference between L3 and (L1 and L2) Higher than L1 and L2 of ~ 0,30 Higher than L1 and L2 of ~ 0,30 Higher than L1 and L2 of ~ 0,36

Table 11. Coefficient approximate differences.

Difference is evident for liabilities, level 3 presents a lower investors discount of about 30% compared to level 1 and level 2 (thus, an improvement of the level 3 impact on market value of banks).
43

Results are presented in absolute values.

61

After the three tests, general conclusions can be drawn: Further variables introduction improves the overall explaining power of the model variance. Precisely, R2 improves by 10% in the third test compared to the first one. Significance of individual variables however, generally performs better when including less variables. Loans and deposits are always discounted and ROTE proves a high positive impact on market values. Dummy YEAR has a negative estimated coefficient, therefore proves a market discount for 2011, compared with 2010. Further precise conclusions cannot be drawn, since the intercept is not significative. Therefore it is not possible to correctly quantify this discount. Level 1 and level 2 instruments have very similar coefficient estimates, with similar standard errors. This result is in line with results found in the study run by Song et al. (2010), and Goh et al. (2009). Level 3 assets have the lowest significance value, suggesting that value relevance of these instruments is lower than value relevance of other levels. However, out of the first test, level 3 assets presented a significance level. With introduction of further variables, related p-value worsened. Level 3 liabilities instead, perform better and present a coefficient estimate very close to its theoretical value (-1). Therefore, this would be evidence of higher heterogeneity in investors valuation of fair value liabilities, than of assets. Putting it differently, valuation of instruments is less similar across levels for liabilities than for assets (although p-value related to the latter is higher). Seems like ESMA and national enforcers have generated (through IFRS enforcements) a positive impact on investors perception about level 3 liabilities, which are supposed to be disclosed more in detail than prior to the issuance of such enforcements. This result is partially in line with results found by De Martino G. (2012). He initially finds value relevance evidence related to level 1 only. Moreover,
62

he even finds a negative impact of level 3 instruments on value of banks. But secondly, with the introduction of a new variable, that accounted for enhanced disclosures about level 3 instruments44, related coefficient turned out to be significant and positive. So, enhanced disclosures about these instruments (which are a direct consequence of IFRS enforcements) decrease the information asymmetry and totally change the final outcome. Regarding the two hypothesis of this research, as far as concerns liabilities, (H1) (concerning the value relevance of fair value instruments) and (H2) (concerning the improvement of investors pricing of level 3 after the issuance of enforcements) are accepted at approximately 90% significance level. Related coefficient estimates are higher than those of level 1 and level 2, and close to 1 (-1). For assets, value relevance of level 3 is not verified in all three tests. An improvement in pricing level 3 assets (H2) with respect to previous literature is seen by looking at coefficient point estimates, but p-values of 0.15 and 0.22 may run against the value relevance of these instruments. A partial explanation for the lower value relevance of level 3 assets45, may be related to the introduction of the new variable Return on tangible equity. ROTE is directly and positively correlated with P/TBV (Bagna, 2012) and perhaps, it incorporates a large share of significance (thus, value relevance) of level 3 assets. In other words, when market participants perceive great importance of ROTE for their economic decisions, it seems like they attribute level 3 assets no additional useful information. Moreover, ROTE already accounts for changes in fair values46. In any case, the high impact of level 3 liabilities (and its relatively good p-value) is still remarkable, both in numerical terms and as far as concerns its economic interpretation. It seems like IFRS Enforcements are a widely helpful instrument for investors.
44

Disclosure regarding the Movements in and out of level 3 category.

45

Is to remember that in the first regression, level 3 assets were even more significant and value relevant than level 3 liabilities. Which, as a remainder, have to be recorded in the profit or loss statement.

46

63

64

CONCLUSIONS
In recent years, fair value accounting has acquired remarkable importance compared to prior the adoption of international financial reporting standards. Particularly, International Accounting Standards Board has judged that enhanced disclosures concerning fair value financial instruments were needed, given their complex nature and their weight, especially on balance sheets and income statements of financial institutions. Starting from November 2009, European entities disclose financial instruments in the notes of consolidated balance sheets, through a three level hierarchy, that classifies fair value assets and liabilities according to the nature of inputs (publicly observable or non observable) used to determine related values. Particularly, top priority is given to observable market prices for identical instruments (level 1). If market evolution cannot be considered regular, determination of fair value is to be done by considering the best available observable assumptions (level 2). Finally, if this is possible neither, private managements information along with internally developed fair value estimates are used (level 3). Literature has generally demonstrated the value relevance of instruments recorded at fair value (that is, they provide useful information to investors for purposes of entity valuation). Reliability of reported values is a more complex issue when dealing with fair value accounting, especially with regard to fair value hierarchy. Therefore, in order to ensure informativeness of reported values, were issued a number of documents stressing the importance of proper disclosures and drawing attention on precision and transparency, especially when disclosing level 3 (the most opaque) assets and liabilities. These documents are the so called IFRS Enforcements. The aim of this thesis was to test whether purposes of IFRS enforcements, concerning disclosures of fair value hierarchy, has had a positive impact on investors valuation of a sample of European banks in 2010 and 2011.

65

This research, however presents some caveats. One element regards the gathering of data. Financial institutions present financial information in many different ways, within the sample. While some banks disclose instruments precisely, for some others for instance, pooling financial instruments in order to classify them within the hierarchy is not straightforward. Another element is given by the reduction of the sample size, because not all banks provided all necessary information. Therefore, increasing the sample size could have provided individual variable significance at a higher confidence interval Nevertheless, three different statistical tests were made and, regarding level 1 and level 2 instruments, results show that their impacts on the market value of banks are similar: both are value relevant and both are discounted by investors, of approximately 30% (out of the first test) and of 50% (out of the second and the third test). As far as concerns level 3 liabilities, were found convergent results too. In other words, the outcome of all three tests is coherent with the research hypothesis: investors perceive level 3 liabilities as being value relevant, and price them with a lower discount than prior to the issuance of IFRS Enforcements (while previous literature found higher discounts of level 3 compared to discounts of the other two levels, in the present research it is found a lower discount for level 3, compared to the other two levels). As far as concerns assets, related value relevance was not fully confirmed in two out of the three tests. This result may partially be attributed to the Return on tangible equity ratio, which accounts for a great share in bank valuations. Thus on the one side, when investors account for this profitability indicator, in pricing of an entity, while they account for level 1 and level 2 assets and liabilities and also for level 3 liabilities, they may not fully account for level 3 assets, despite IFRS enforcements. On the other side, ROTE already incorporates elements of fair value, since gains and losses of fair values have to be recorded in the income statement.

66

REFERENCES
Allen, F., & Carletti, E. (2007). Mark-to-Market Accounting and Liquidity Pricing. Working paper. Altamuro, J. M., & Zhang, H. (2012). Financial reporting of fair value based on managerial inputs versus market inputs: Evidence from Mortgage servicing rights. Working Paper. Bagna, E. (2009). Intangibili e valore nelle banche. Universit degli Studi di Trieste Sede Amministrativa del Dottorato di Ricerca - Tesi di dottorato. Bagna, E. (2012). La valutazione delle banche. Milano: Egea. Barth, M. E., & Landsman, W. E. (2010). How did Financial Reporting Contribute to the Financial Crisis? European Accounting Review. Barth, M. E., Beaver, W., & Landsman, W. R. (1996). Value-Relevance of Banks' Fair Value Disclosures under SFAS No. 107. The Accounting Review, pp. 513-537. Benston, G. J. (2008). The shortcomings of fair-value accounting described in SFAS 157. Journal of Accounting and Public Policy, pp. 101-114. Bosch, P. (2012). Value relevance of the fair value hierarchy of IFRS 7 in Europe How reliable are mark-to-model fair values? Working Paper. Burkhardt, K., & Strausz, R. (2006). The effect of Fair vs. Book Value Accounting on Banks. Working paper. CESR. (2010). Activity Report on IFRS Enforcement 2009. Paris. Consob, Isvap, & Bancad'Italia. (2010). Documento n.4 del 3 marzo 2010. Tavolo di coordinamento fra Banca d'Italia, Consob ed Isvap in materia di applicazione degli IAS/IFRS. pp. 12 - 13. Di Martino, G. (2011). La value relevance del fair value accounting nel settore bancario europeo. Universit degli studi di Trieste - Tesi di dottorato. Eavis, P. (2012, May 25). The dark nooks in JP Morgan's fortress balance sheet. New York Times. Eccher, E. A., Ramesh, K., & Thiagarajan, S. R. (1996). Fair value discolures by bank holding companies. Journal of accounting and economics, pp. 79-117. Ernst&Young. (2005). How Fair is fair value? London.
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ESMA. (2011). Activity report on IFRS enforcement 2010. Paris. Fietcher, P., & Meyer, C. (2011). Pricing of fair values during the financial crisis: International evidence. Working paper. Goh, B. W., Ng, J., & Yong, K. O. (2009). Market Pricing of Banks' Fair Value Assets Reported under SFAS 157 during the 2008 Economic Crisis. Working Paper. ESMA website. Available at:. (http://www.esma.europa.eu/). IASB. (2009). Improving disclosures about Financial Instruments (amendments to IFRS 7 - Financial Instruments: Disclosures). Project Report. IASB. (2009). International Accounting Standard no. 32 - Financial Instruments: Presentation. London, UK. IASB. (2009). International Accounting Standard no. 39 - Financial Instruments: Recognition and Measurement. London, UK. IASB. (2011). International Financial Reporting Standard 13 - Fair value Measurements. IASC Foundation, London., UK. IASC. (2001). Framework for the Preparation and Presentation of Financial Statements. IASB Framework. London, UK. King, A. M. (2006). Fair Value for Financial Reporting. New Jersey: John Wiley & Sons. Kolev, K. (2008). Do investors perceive Marking-to-Model as Marking-to-Myth? Early evidence from FAS 157 Disclosure. Working Paper. New York University. KPMG. (2009). IFRS Practice Issues: Fair Value Hierarchy. KPMG. (2011). First Impressions: Fair Value Measurement. Lanchester, J. (2010). I.O.U. Why everyone owes everyone and no one can pay. In L. J.. New York: Simon and Schuster. Landsman, W. (2007). Is Financial Accounting Information Relevant and Reliable? Evidence from Capital Market Research. Accounting and Business Research, Special Issue: pp. 19-30. Laux, C., & Leuz, C. (2009). The crisis of Fair Value Accounting: making sense of the recent debate. Center for Financial Studies, Working paper. Laux, C., & Leuz, C. (2010). Did Fair Value Accounting contributed to the Financial Crisis? Journal of Economic Perspectives.

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Lev, B., & Zhou, N. (2009). Unintended Consequence: Fair Value informs on Liquidity Risk. Working paper. Liao, L., Morris, R., Tang, Q., & Kang, H. (2010). Information Assymetry of Fair Value Accounting and Loan Loss Provisions during the Global Financial Crisis. Working paper. Martin, R. D., Rich, J. S., & Wilks, T. J. (2006). Auditing Fair Value Measurements: A Synthesis of Relevant Research. Accounting Horizons, (Vol. 23, pp. 287-303). Nelson, K. K. (1996). Fair value accounting for commercial banks: an empirical analysis of SFAS 107. The accounting Review, vol. 71, n. 2, pp. 161-182. Serafiem, G., & Riedl, E. (2011). Information Risk and Fair Values: an Examination of Equity Betas. Journal of accounting research, Vol. 49. Shaffer, S. (2010). Fair value accounting: villain or innocent victim. Exploring the links between fair value accounting, bank regulatory capital and the recent financial crisis. Federal Reserve Bank of Boston. Song, C. J., Thomas, W. B., & Yi, H. (2010). Value Relevance of FAS 157 Fair Value Hierarchy Information and the Impact of Corporate Governance Mechanisms. The Accounting Review. Walton, P. (2007). The Routledge Companion to Fair Value and Financial Reporting. London: Routledge Companion. Whittington, G. (2008). Fair Value and the IASB/FASB Conceptual Framework: an Alternative View. The Accounting Foundation, 139-168.

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70

APPENDIX

(1) P/TBV = + 1*AFV1/TBV + 2*AFV2/TBV + 3*AFV3/TBV + 4*LOANS/TBV +

5*OTHA/TBV + 6*LFV1/TBV + 7*LFV2/TBV + 8*LFV3/TBV + 9*DEP/TBV + 10*OTHL/TBV +

Multiple R Squared R Corrected squared R Std. Error Obs.

0,4837230 0,2339879 0,1275973 0,6036107 83 VARIANCE ANALYSIS

Regression Residual Total VARIABLE Intercept LOANS/TBV AFV1/TBV AFV2/TBV AFV3/TBV OTHA/TBV DEP/TBV LFV1/TBV LFV2/TBV LFV3/TBV

DF 10 72 82 Coefficients 0,160 0,546 0,707 0,687 0,778 0,533 -0,582 -0,681 -0,694 -0,983

SQ MQ F Signif. F 8,013166642 0,801316664 2,199329437 0,027233417 26,23290483 34,24607148 Std. Error 0,582 0,287 0,290 0,300 0,428 0,283 0,301 0,306 0,300 0,558 Stat. t 0,276 1,902 2,439 2,290 1,819 1,884 -1,935 -2,227 -2,311 -1,762 -2,138 Signif. 78% 6% 2% 2% 7% 6% 6% 3% 2% 8% 4% Lower 95% -0,999 -0,026 0,129 0,089 -0,075 -0,031 -1,181 -1,291 -1,292 -2,094 -1,203 Upper 95% 1,320 1,119 1,284 1,285 1,631 1,096 0,018 -0,071 -0,095 0,129 -0,042 0,3643459

OTHL/TBV -0,623 0,291 Table 12. Regression results Equation (1).

71

(2) Pi/TBVi = + 1*AFV1i/TBVi + 2*AFV2i/TBVi + 3*AFV3i/TBVi + 4*LOANSi/TBVi + 5*OTHAi/TBVi + 6*LFV1i/TBVi + 7*LFV2i/TBVi + 8*LFV3i/TBVi + 9*DEPi/TBVi + 10*OTHLi/TBVi + 11*YEAR +

Multiple R Squared R Corrected squared R Std. Error Obs.

0,5428154 0,2946485 0,1853687 0,5832826 83 VARIANCE ANALYSIS

Regression Residual Total

DF 11 71 82

SQ 10,09055 24,15552 34,24607

MQ F 0,917323 2,696276 0,340219

Signif. F 0,00588334

VARIABLE Intercept YEAR LOANS/TBV AFV1/TBV AFV2/TBV AFV3/TBV OTHA/TBV DEP/TBV LFV1/TBV LFV2/TBV LFV3/TBV

Coefficients 0,577 -0,326 0,418 0,566 0,550 0,609 0,405 -0,449 -0,546 -0,551 -0,856

Std. Error 0,587 0,132 0,282 0,286 0,295 0,419 0,278 0,296 0,301 0,296 0,541

Stat t 0,984 -2,471 1,481 1,983 1,862 1,453 1,458 -1,519 -1,818 -1,863 -1,581 -1,713

Signif. 33% 2% 14% 5% 7% 15% 15% 13% 7% 7% 12% 9%

Lower 95% -0,593 -0,589 -0,145 -0,003 -0,039 -0,227 -0,149 -1,038 -1,146 -1,141 -1,935 -1,062

Upper 95% 1,748 -0,063 0,981 1,136 1,138 1,445 0,960 0,140 0,053 0,039 0,223 0,080

OTHL/TBV -0,491 0,286 Table 13. Regression results Equation (2).

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(3) Pi/TBVi = + 1*AFV1i/TBVi + 2*AFV2i/TBVi + 3*AFV3i/TBVi + 4*LOANSi/TBVi + 5*OTHAi/TBVi + 6*LFV1i/TBVi + 7*LFV2i/TBVi + 8*LFV3i/TBVi + 9*DEPi/TBVi + 10*OTHLi/TBVi + 10*ROTEi + 11*YEAR +

Multiple R Squared R Corrected squared R Std. Error Obs.

0,5837667 0,3407836 0,2277751 0,5678980 83 VARIANCE ANALYSIS DF SQ MQ F Signif. F

Regression Residual Total VARIABLES Intercept ROTE YEAR LOANS/TBV AFV1/TBV AFV2/TBV AFV3/TBV OTHA/TBV DEP/TBV LFV1/TBV LFV2/TBV LFV3/TBV

12 70 82 Coefficients 0,456 1,256 -0,231 0,413 0,544 0,511 0,512 0,396 -0,441 -0,511 -0,509 -0,864

11,67049905 0,972541588 3,015556366 0,00187011 22,57557242 0,322508177 34,24607148 Std. Error 0,574 0,567 0,136 0,275 0,278 0,288 0,410 0,271 0,288 0,293 0,289 0,527 Stat t 0,794 2,213 -1,707 1,503 1,953 1,774 1,247 1,463 -1,531 -1,742 -1,763 -1,639 -1,711 Signif. 43% 3% 9% 14% 5% 8% 22% 15% 13% 9% 8% 11% 9% Lower 95% Upper 95% -0,689 0,124 -0,502 -0,135 -0,012 -0,063 -0,307 -0,144 -1,014 -1,095 -1,084 -1,915 -1,034 1,601 2,387 0,039 0,961 1,099 1,085 1,331 0,936 0,133 0,074 0,067 0,187 0,079

OTHL/TBV -0,477 0,279 Table 14. Regression results Equation (3).

73

LEVEL/TOT. FV ASSETS

LEVEL/TOT. FV LIABILITIES

A.L1/TOT A.L2/TOT A.L3/TOT L.L1/TOT L.L2/TOT L.L3/TOT BANK 49,19% 49,79% 1,02% 1,43% 98,40% 0,17% Banca Monte dei Paschi di Siena S.p.A. 0,02% 98,13% 1,85% Banca Popolare dell'Emilia Romagna S.C.A.R.L. 71,99% 15,57% 12,43% 73,11% 19,43% 7,46% 6,13% 90,84% 3,03% Banca Popolare di Milano S.C.A.R.L. 58,14% 40,69% 1,17% 12,49% 87,45% 0,06% Banco Bilbao Vizcaya Argentaria S.A. 75,70% 22,03% 2,28% 0,00% 86,75% 13,25% Banco de Sabadell S.A. 39,02% 59,86% 1,12% 0,00% 100,00% 0,00% Banco Espirito Santo S/A 69,80% 26,72% 3,49% 59,40% 40,60% 0,01% Banco Popolare S.C. 77,75% 13,45% 8,80% 0,68% 62,88% 36,43% Banco Popular Espanol S.A. 49,89% 49,36% 0,75% 11,08% 88,78% 0,14% Banco Santander S.A. 73,79% 25,33% 0,88% 0,00% 96,59% 3,41% Bank of Ireland Ord Stk EUR0.64 11,86% 83,97% 4,17% 5,70% 92,57% 1,73% Barclays PLC 35,96% 60,95% 3,09% 16,69% 78,65% 4,65% BNP Paribas S.A. 18,40% 79,60% 2,00% 9,54% 89,88% 0,58% Commerzbank AG 48,11% 49,85% 2,04% 8,56% 90,34% 1,09% Credit Agricole S.A. 41,08% 50,24% 8,69% 25,47% 67,35% 7,18% Credit Suisse Group AG 37,39% 61,70% 0,91% 65,23% 33,94% 0,83% Danske Bank A/S 11,80% 84,19% 4,01% 6,59% 91,90% 1,51% Deutsche Bank AG 40,40% 35,87% 23,72% 0,00% 99,92% 0,08% DNB ASA 43,53% 55,76% 0,71% 1,23% 98,75% 0,02% Erste Group Bank AG 43,66% 54,60% 1,74% 22,99% 74,57% 2,44% HSBC Holdings PLC 60,93% 37,06% 2,01% 10,04% 88,90% 1,06% Intesa Sanpaolo S.p.A. 50,40% 49,60% 0,00% 46,66% 53,34% 0,00% Julius Baer Gruppe AG 69,87% 29,30% 0,83% 1,77% 98,23% 0,00% Jyske Bank A/S 67,19% 28,22% 4,59% 12,83% 69,68% 17,48% KBC Group N.V. 51,50% 45,51% 2,99% 1,31% 98,31% 0,37% Lloyds Banking Group PLC 59,68% 31,99% 8,33% 19,33% 67,37% 13,31% Mediobanca Banca di Credito Finanziario 28,99% 69,59% 1,41% 0,23% 99,46% 0,30% National Bank of Greece S.A. 32,83% 60,06% 7,11% 16,44% 82,97% 0,60% Natixis 26,10% 70,77% 3,13% 19,66% 79,20% 1,14% Nordea Bank AB 65,48% 31,45% 3,07% 1,17% 96,11% 2,72% Pohjola Bank Plc 52,48% 46,64% 0,88% 16,48% 83,52% 0,00% Raiffeisen Bank International AG 16,60% 81,40% 2,00% 5,53% 93,72% 0,75% Royal Bank of Scotland Group Plc 38,01% 59,96% 2,04% 31,61% 59,49% 8,90% Skandinaviska Enskilda Banken AB 42,83% 54,24% 2,93% 4,16% 89,50% 6,34% Societe Generale 35,85% 62,54% 1,61% 9,64% 89,48% 0,88% Standard Chartered PLC 59,64% 39,18% 1,17% 47,12% 52,78% 0,10% Svenska Handelsbanken A 24,01% 75,91% 0,08% 25,82% 74,17% 0,00% Swedbank AB 4,68% 93,71% 1,62% 0,12% 99,88% 0,00% Sydbank A/S 24,97% 71,50% 3,53% 8,17% 87,47% 4,35% UBS AG 38,61% 56,56% 4,83% 10,38% 86,64% 2,98% UniCredit S.p.A. 80,37% 18,01% 1,62% 18,79% 81,21% 0,00% Unione di Banche Italiane SCpA Table 15. First three columns: shares of level 1, level 2, level 3 assets on total fair value assets. Last three columns: shares of level 1, level 2, level 3 liabilities on total fair value liabilities. (data from 2010 annual reports)

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LEVEL/TOTAL FV ASSETS

LEVEL/TOTAL FV LIABILITIES

BANK 49,55% 49,56% 0,90% 3,70% 96,21% Banca Monte dei Paschi di Siena S.p.A. 75,55% 13,43% 11,02% 0,00% 98,53% Banca Popolare dell'Emilia Romagna S.C.A.R.L. 67,85% 24,21% 7,94% 2,07% 94,99% Banca Popolare di Milano S.C.A.R.L. 49,30% 49,40% 1,30% 10,41% 89,55% Banco Bilbao Vizcaya Argentaria S.A. 77,99% 20,16% 1,85% 3,91% 83,27% Banco de Sabadell S.A. 30,26% 68,27% 1,46% 0,00% 100,00% Banco Espirito Santo S/A 64,73% 32,41% 2,86% 51,30% 48,70% Banco Popolare S.C. 75,63% 15,96% 8,42% 0,00% 93,84% Banco Popular Espanol S.A. 40,76% 58,88% 0,36% 8,39% 91,47% Banco Santander S.A. 69,28% 27,78% 2,94% 0,02% 97,31% Bank of Ireland Ord Stk EUR0.64 46,08% 46,80% 7,13% 1,86% 98,14% BANKIA S.A. 12,44% 83,54% 4,02% 4,30% 93,93% Barclays PLC 27,15% 69,63% 3,22% 14,43% 81,21% BNP Paribas S.A. 64,50% 33,38% 2,13% 15,57% 84,39% CaixaBank S.A. 24,96% 72,81% 2,23% 8,27% 91,02% Commerzbank AG 36,87% 61,08% 2,06% 6,69% 92,76% Credit Agricole S.A. 35,34% 55,93% 8,74% 22,19% 71,82% Credit Suisse Group AG 34,67% 64,05% 1,28% 54,74% 43,83% Danske Bank A/S 9,53% 86,90% 3,57% 4,65% 94,05% Deutsche Bank AG 16,69% 66,29% 17,02% 0,00% 99,94% DNB ASA 42,63% 56,91% 0,47% 0,74% 99,24% Erste Group Bank AG 38,80% 59,44% 1,75% 18,33% 80,01% HSBC Holdings PLC 57,80% 40,16% 2,04% 5,31% 93,48% Intesa Sanpaolo S.p.A. 62,41% 37,59% 0,00% 24,49% 75,51% Julius Baer Gruppe AG 56,26% 42,83% 0,91% 1,05% 98,95% Jyske Bank A/S 61,37% 30,05% 8,57% 13,15% 67,78% KBC Group N.V. 52,94% 43,91% 3,15% 3,85% 95,20% Lloyds Banking Group PLC 61,14% 28,11% 10,74% 38,92% 45,44% Mediobanca Banca di Credito Finanziario S.p.A. 23,32% 72,81% 3,87% 12,29% 87,63% Natixis 23,55% 74,57% 1,88% 14,63% 84,92% Nordea Bank AB 58,22% 39,35% 2,43% 0,69% 96,53% Pohjola Bank Plc 49,87% 49,52% 0,60% 4,84% 94,35% Raiffeisen Bank International AG 14,44% 83,70% 1,86% 4,60% 94,56% Royal Bank of Scotland Group Plc 35,19% 63,94% 0,87% 26,49% 71,50% Skandinaviska Enskilda Banken AB 34,85% 62,86% 2,28% 3,73% 91,05% Societe Generale 29,81% 68,25% 1,94% 6,01% 93,58% Standard Chartered PLC 51,98% 47,47% 0,55% 39,08% 60,89% Svenska Handelsbanken A 23,15% 76,80% 0,05% 27,52% 72,48% Swedbank AB 3,61% 94,86% 1,53% 0,07% 99,93% Sydbank A/S 19,41% 77,08% 3,51% 5,50% 90,70% UBS AG 26,74% 67,93% 5,33% 6,44% 90,42% UniCredit S.p.A. 75,57% 22,72% 1,71% 15,63% 84,37% Unione di Banche Italiane SCpA Table 16. First three columns: shares of level 1, level 2, level 3 assets on total fair value assets. Last three columns: shares of level 1, level 2, level 3 liabilities on total fair value liabilities (data from 2011 annual reports).

A.L1/TOT A.L2/TOT A.L3/TOT L.L1/TOT L.L2/TOT L.L3/TOT

0,09% 1,47% 2,93% 0,04% 12,82% 0,00% 0,00% 6,16% 0,14% 2,67% 0,00% 1,77% 4,36% 0,04% 0,71% 0,55% 5,99% 1,43% 1,30% 0,06% 0,02% 1,65% 1,21% 0,00% 0,00% 19,07% 0,95% 15,64% 0,08% 0,45% 2,77% 0,81% 0,83% 2,00% 5,23% 0,42% 0,04% 0,00% 0,00% 3,80% 3,14% 0,00%

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2010

2011
FVL/TL

FVA/TA FVL/TL FVA/TA BANK 23,04% 25,39% 23,20% Banca Monte dei Paschi di Siena S.p.A. 7,39% 5,30% 8,17% Banca Popolare dell'Emilia Romagna 22,75% 3,73% 20,87% Banca Popolare di Milano S.C.A.R.L. 22,72% 7,86% 22,71% Banco Bilbao Vizcaya Argentaria S.A. 12,33% 1,27% 14,64% Banco de Sabadell S.A. 22,68% 15,70% 22,39% Banco Espirito Santo S/A 13,01% 24,74% 14,44% Banco Popolare S.C. 10,69% 1,68% 9,69% Banco Popular Espanol S.A. 23,88% 18,03% 23,07% Banco Santander S.A. 19,22% 12,75% 16,51% Bank of Ireland Ord Stk EUR0.64 27,10% BANKIA S.A. 46,71% 40,35% 50,95% Barclays PLC 52,97% 38,36% 52,03% BNP Paribas S.A. 22,13% CaixaBank S.A. 39,06% 30,63% 36,63% Commerzbank AG 41,60% 23,95% 43,58% Credit Agricole S.A. 56,52% 42,77% 51,49% Credit Suisse Group AG 53,03% 35,42% 58,15% Danske Bank A/S 61,07% 46,37% 61,62% Deutsche Bank AG 29,12% 30,05% 32,14% DNB ASA 16,34% 4,56% 18,30% Erste Group Bank AG 43,35% 28,15% 42,52% HSBC Holdings PLC 26,78% 12,76% 27,10% Intesa Sanpaolo S.p.A. 45,14% 18,50% 34,70% Julius Baer Gruppe AG 38,57% 17,15% 35,55% Jyske Bank A/S 33,87% 19,69% 28,07% KBC Group N.V. 25,20% 7,30% 25,03% Lloyds Banking Group PLC 32,95% 9,79% 30,05% Mediobanca Banca di Credito Finanziario S.p.A. 15,65% 3,89% National Bank of Greece 42,61% 36,46% 55,99% Natixis 45,58% 35,56% 52,13% Nordea Bank AB 28,27% 6,08% 30,81% Pohjola Bank Plc 13,50% 7,92% 15,56% Raiffeisen Bank International AG 54,08% 46,52% 58,55% Royal Bank of Scotland Group Plc 23,06% 10,67% 22,89% Skandinaviska Enskilda Banken AB 49,38% 33,20% 46,32% Societe Generale 28,23% 14,11% 28,80% Standard Chartered PLC 14,76% 10,04% 13,44% Svenska Handelsbanken A 51,52% 26,44% 47,22% Swedbank AB 46,24% 27,73% 48,19% Sydbank A/S 52,71% 44,86% 50,23% UBS AG 23,25% 14,51% 25,22% UniCredit S.p.A. 10,51% 1,84% 9,34% Unione di Banche Italiane SCpA Table 17. Shares of fair value assets (fair value liabilities) on total assets (total liabilities).

23,15% 7,81% 5,84% 10,01% 1,53% 19,56% 24,60% 2,05% 17,01% 14,11% 9,95% 44,17% 41,34% 5,62% 30,96% 28,33% 40,35% 40,16% 48,94% 33,51% 5,86% 29,14% 13,52% 13,21% 16,25% 21,41% 9,01% 11,84% 47,96% 39,98% 8,92% 10,18% 52,84% 11,35% 34,97% 15,34% 9,29% 22,91% 32,61% 45,42% 15,74% 2,34%

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