Discretionary Measurement of Financial Assets during the 2008 Financial Crisis

Abstract:     
This paper examines whether banks use discretion in loan loss provisions (LLP) and fair value estimates to manage earnings during the 2008 financial crisis. We select the crisis as the investigation period because the market turmoil provides both measurement uncertainties and strong incentives for earnings management. Using a sample of 291 U.S. bank holding companies, we predict and find that banks use discretionary fair value estimates based on unobservable inputs (i.e., Level 3) to smooth earnings. For LLP, we do not find consistent evidence, mainly because better corporate governance mechanisms effectively reduce the use of discretionary LLP to smooth earnings. However, better corporate governance does not reduce measurement discretion in Level 3. We assign this finding to the substantial measurement leeway of Level 3 positions, the little experience with SFAS 157 disclosures, and the increased measurement uncertainty during the crisis.

Number of Pages in PDF File: 60

Keywords: Fair Value Measurement, Earnings Management, 2008 Financial Crisis, Loan Loss Provisions (LLP), Level 3, SFAS 157, Corporate Governance

JEL Classification: G21, M41

working papers series