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Level 3 Assets: Booking Profits and Concealing Losses

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  • Konstantin Milbradt

Abstract

Fair value accounting forces institutions to revalue inventory whenever a transaction occurs. An institution that faces a balance sheet constraint may have incentives to suspend trading in Level 3 assets (traded on opaque over-the-counter markets) in order to avoid such marking-to-market. This keeps the book valuation artificially high, relaxing the balance sheet constraint. But, the institution loses direct control of the risk of its position. Solving this "real options" problem, the institution will report profits as they occur but delay reporting losses. A regulator trying to control risk imposes fines for balance sheet manipulation and capital requirements. Both these tools can increase risk-taking and balance sheet manipulation. Audits in comparision generally decrease risk-taking but may be costly to the regulator. The model provides predictions on the distribution of a bank's trading gains in illiquid markets. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Suggested Citation

  • Konstantin Milbradt, 2012. "Level 3 Assets: Booking Profits and Concealing Losses," The Review of Financial Studies, Society for Financial Studies, vol. 25(1), pages 55-95.
    • Handle: RePEc:oup:rfinst:v:25:y:2012:i:1:p:55-95
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    File URL: http://hdl.handle.net/10.1093/rfs/hhr112
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    Cited by:

    1. Greenwood, Robin & Landier, Augustin & Thesmar, David, 2015. "Vulnerable banks," Journal of Financial Economics, Elsevier, vol. 115(3), pages 471-485.
    2. Alex Edmans & William Mann, 2019. "Financing Through Asset Sales," Management Science, INFORMS, vol. 65(7), pages 3043-3060, July.
    3. Laura Blattner & Luisa Farinha & Francisca Rebelo, 2017. "When Losses Turn Into Loans: The Cost of Undercapitalized Banks," 2017 Papers pbl215, Job Market Papers.
    4. He, Zhiguo & Kelly, Bryan & Manela, Asaf, 2017. "Intermediary asset pricing: New evidence from many asset classes," Journal of Financial Economics, Elsevier, vol. 126(1), pages 1-35.
    5. Yaron Leitner, 2012. "Contingent capital," Business Review, Federal Reserve Bank of Philadelphia, issue Q2, pages 11-18.
    6. Bond, Philip & Leitner, Yaron, 2015. "Market run-ups, market freezes, inventories, and leverage," Journal of Financial Economics, Elsevier, vol. 115(1), pages 155-167.
    7. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1289-1361, Elsevier.
    8. Black, Dirk & Neururer, Thaddeus, 2024. "Do analysts provide information about other comprehensive income in book value forecasts for financial firms?," Advances in accounting, Elsevier, vol. 64(C).
    9. Couch, Robert & Thibodeau, Nicole & Wu, Wei, 2017. "Are fair value options created equal? A study of SFAS 159 and earnings volatility," Advances in accounting, Elsevier, vol. 38(C), pages 15-29.

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