Discretionary Measurement of Level 3 Fair Values During the 2008 Financial Crisis
51 Pages Posted: 15 Dec 2009 Last revised: 26 Aug 2016
Date Written: February 1, 2011
In the absence of quoted prices in active markets, the measurement of fair values is complex and difficult to verify. Prior literature finds that investors discount fair value estimates based on unobservable inputs (i.e., Level 3). However, these value relevance tests cannot discern whether the discount is attributable to managerial opportunism or illiquidity concerns. This paper examines whether banks use Level 3 fair value estimates to manage earnings during the 2008 Financial Crisis. Based on a sample of 329 U.S. banks, we find that banks with earnings management incentives (i.e., low earnings, negative change in earnings, small negative earnings, and low Tier 1 capital) recognize lower-than-necessary losses on Level 3 positions. Our inferences are robust to alternative specifications including the use of bank fixed effects, placebo tests with Level 3 gains or losses recognized in other comprehensive income (OCI), and benchmarking against discretionary loan loss provisions (LLP).
Keywords: Level 3 fair values, earnings management, Financial Crisis, loan loss provisions (LLP), other comprehensive income (OCI)
JEL Classification: G21, M41
Suggested Citation: Suggested Citation