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The link between the share of banks’ Level 3 assets and their default risk and default costs

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  • Ulf Mohrmann

    (University of Konstanz)

  • Jan Riepe

    (University of Tuebingen)

Abstract

We empirically explore the risk relevance of Level 3 fair value estimates. Thereby we focus on banks’ default risk as well as banks’ 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 an association between banks’ share of Level 3 estimates and higher volatilities as well as lower market values. Both factors add up to much higher default risks in bank-quarters with a larger share of Level 3 estimates. The association remains strong even after controlling for the systematic information risk in Level 3 estimates. Furthermore, we find a strong association between the share of 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.

Suggested Citation

  • Ulf Mohrmann & Jan Riepe, 2019. "The link between the share of banks’ Level 3 assets and their default risk and default costs," Review of Quantitative Finance and Accounting, Springer, vol. 52(4), pages 1163-1189, May.
    • Handle: RePEc:kap:rqfnac:v:52:y:2019:i:4:d:10.1007_s11156-018-0740-7
    DOI: 10.1007/s11156-018-0740-7
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    References listed on IDEAS

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    More about this item

    Keywords

    Banking; Bank default; Fair value accounting; Level 3 assets;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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