Fair value levels

The negative phase of the financial markets and the difficulties that involved primary financial institutions have forced the supranational and domestic Supervisory Authorities to recommend to the operators maximum transparency towards shareholders and investors in exposing the loan and market risks assumed, in the various forms, in relation to determination of the fair valueⁱ of financial assets and liabilities classified in the categories HFT, AFS and recorded in Fair Valueⁱ Options.

The IAS/IFRSⁱ international accounting standards prescribe valuation at the fair valueⁱ, with a contra entry to the income statement, for the financial instruments classified in the trading bookⁱ. The existence of official share prices in an active market¹ constitutes the best evidence of the fairvalue; these share prices therefore represent the effective market quotes for the valuation of the financial assets and liabilities in the trading bookⁱ.

In the absence of normal functioning of the market, it is nevertheless necessary to abandon a direct reference to market prices and resort to other valuator methods, including the application of theoretical models that, by making more use of observable market parameters, can determine an appropriate fair valueⁱ of the financial instruments.

In the case where valuations of the returning financial instruments are unavailable from sources considered as reliable (even if the said prices are not to be to connoted as effective market quotes), the fair valueⁱ can be determined by utilising valuation techniques aimed at establishing, in the last analysis, what price could the instrument have had, at the valuation date, in a free exchange motivated by normal commercial considerations. Such techniques include:

• reference to market values indirectly con nected to the instrument to be valued and deduced from instruments that are similar by risk characteristics (comparable approach);
• valuations made utilising - even only partially- inputs not deduced from parameters observable on the market, for which recourse is made to estimates and assumptions made by the analyst (Mark-to-Model).

The aforesaid methods must be applied in a hierarchic order: if, specifically, a price expressed by an active market is available, one of the other valuation approaches cannot be used.

In the current context of financial turbulence, the accounting bodies have intervened to regulate the market situations in which very many financial instruments have prices altered by conditions of strong illiquidity. The IASB, in common with the equivalent United States Body (FASB), issued an application guide on the theme that underlines the possibility of using "dislocated²" market figures or internal inputs in place of the prices recorded on distorted markets.

In summary, this refers to no longer valuing some financial instruments on the so-called "level 1" (effective market quotes) basis, but on the "level 2" (comparable approach) or "level 3" (mark to modelⁱ approach) basis.

As described above, the hierarchy of the valuation models, that is of the approaches adopted for the determination of the fair valueⁱ, attributes absolute priority to the official prices available on active markets for the asset and liability to be valued (effective market quotes) and, in their absence, to the valuation of assets and liabilities based on indicative prices or else by referring to similar assets and liabilities (comparable approach). Finally, as a residual matter, valuation techniques based on non-observable inputs can be utilised and, therefore, are mostly discretional (Mark-to-Model Approach).

The Banca Carige Group has made an analysis of the various levels of fair valueⁱ used for the valuation of its financial assets and liabilities held for trading as at 31 December 2008 and a summary is shown below:

• Effective market quotes - Level 1 of Fair Valueⁱ. The valuation is the market price of the financial instrument that is to be valued, obtained on the basis of prices expressed by an active market.
• Valuation Techniques (Comparable Approach) - Level 2 of Fair Valueⁱ. The valuation is not based on significant prices of the financial instrument that is to be valued, but on indicative valuations available from reliable info providers or else on prices determined by utilising an appropriate calculation method (pricingⁱ model) and observable market parameters, including loans and advances spreads deduced from the official prices of substantially similar instruments in terms of risk factors. Should the calculation methods (pricingⁱ models) be used in the comparable approach, these allow reproduction of the prices of financial instruments listed on active markets (calibration of the model) without including discretional parameters - that is parameters whose value cannot be deduced from prices of financial instruments on active markets or else cannot be fixed on levels such as to replicate prices on active markets - such as to influence the final valuation price in a determining manner.
• Valuation Techniques (Mark-to-Model Approach) - Level 3 of Fair Valueⁱ. The valuations are made by utilising various inputs, not all directly deduced from observable market parameters and therefore lead to estimates and assumptions by the analyst.

Specifically, this approach envisages that the valuation of the financial instrument is conducted by utilising two different methods:

• with reference to the profit-sharing of the Bank of Italy, the fair valueⁱ was determined as an amount equal to the corresponding fraction of the shareholders' equity at 31/12/2007 (last approved financial statements). This valuation Is a significant approximation of the fair valueⁱ of the investment;
•  a calculation method (pricingⁱ model) that is based, amongst other things, on specific hypotheses regarding:

-    the development of future cash flows, possibly conditioned by future events which can be attributed to probabilities deduced from historic experience or on the basis of behaviour hypotheses;

-    the level of determined input parameters in securities unlisted on active markets, for which estimates are in any event privileged by the information acquired from prices and spreads observed on the market. When these are unavailable, recourse is made to historical data of the specific underlying risk factor or specialised research on the matter (for example, reports from ratingⁱ agencies or primary players of the market).

It is specified that, with the exclusion of the above, Level 3 of Fair Valueⁱ was only utilised in relation to the valuation of capitalisation policies.

Summarised in the following table are the values and the respective percentages of the various Fair Valueⁱ levels utilised by the Banca Carige Group for the valuation of the financial instruments classified in the categories held for trading, available for sale and recorded as Fair Valueⁱ Options:

FAIR VALUEⁱ LEVELS UTILISED