The Link between the Share of Banks’ Level 3 Assets and their Default Risk and Default Costs
45 Pages Posted: 10 Apr 2013 Last revised: 31 Jul 2018
There are 2 versions of this paper
The Link between the Share of Banks’ Level 3 Assets and their Default Risk and Default Costs
The Link between the Share Level 3 Assets of Banks and Their Default Risk and Default Costs
Date Written: February 28, 2017
Abstract
We empirically explore the link between Level 3 fair value estimates and banks’ default risk as well as default costs. Both variables are especially important to banks’ creditors and the regulatory authorities that rely on the information in financial statements. In a fixed-effects panel model, we find a link between Level 3 estimates and higher volatilities as well as lower market values. Both factors add up in much higher default risks in bank-quarters with more Level 3 estimates. The link remains strong even after controlling for the systematic information risk in Level 3 estimates. Furthermore, we find a strong link between Level 3 estimates and banks’ default costs in transactions with low information risk. Combining the different pieces of evidence, our results show the presence of two underlying estimation errors in Level 3 assets: information risk and overvaluation. Our results point towards the benefits of complementing the information in financial statements with capital market information for bank creditors and bank regulators.
Keywords: Banking, Bank Default, Fair Value Accounting, Level 3 Assets
JEL Classification: G21, G28, G32, M41
Suggested Citation: Suggested Citation
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