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

See all articles by Ulf Mohrmann

Ulf Mohrmann

University of Konstanz - Department of Economics

Jan Riepe

University of Tuebingen - Department of Banking

Multiple version iconThere are 2 versions of this paper

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

Mohrmann, Ulf and Riepe, Jan, The Link between the Share of Banks’ Level 3 Assets and their Default Risk and Default Costs (February 28, 2017). Available at SSRN: https://ssrn.com/abstract=2247536 or http://dx.doi.org/10.2139/ssrn.2247536

Ulf Mohrmann

University of Konstanz - Department of Economics ( email )

Universitaetsstr. 10
Konstanz, D-78457
Germany

Jan Riepe (Contact Author)

University of Tuebingen - Department of Banking ( email )

Nauklerstr. 47
72074 Tuebingen, Baden Wuerttemberg 72074
Germany

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