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Review of Quantitative Finance and Accounting

, Volume 52, Issue 4, pp 1163–1189 | Cite as

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

  • Ulf Mohrmann
  • Jan RiepeEmail author
Original Research

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.

Keywords

Banking Bank default Fair value accounting Level 3 assets 

JEL Classification

G21 G28 G32 M41 

Notes

Acknowledgements

We want to thank Jannis Bischof, Ralf Elsas, Daniel Foos, Jon Garfinkel, Markus Glaser, Jens Grunert, Andre Guettler, Robert Hodgkinson, Christoph Kaserer, Kalin Kolev, David Oesch, Andreas Pfingsten, Peter Raupach, Zacharias Sautner, Isabel Schnabel, Thorsten Sellhorn, Ulrike Stefani, and Tracy Yue Wang as well as the participants of the 2013 Marie Curie ITN meeting, Konstanz; the 2013 VHB Annual Meeting, Würzburg; the 2013 Münster Banking Workshop; the 2013 IRMC, Copenhagen; the 2013 AFFI Paris December Meeting; the 2014 SGF Meeting, Zurich; and the 2014 EFA Annual Meeting, Pittsburgh, PA, for their valuable comments and insights. We thank Malte Kurz for the excellent research assistance. A previous version of the article circulated under the title “A blind spot of banking regulation.”

Supplementary material

11156_2018_740_MOESM1_ESM.docx (27 kb)
Supplementary material 1 (DOCX 26 kb)

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Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2018

Authors and Affiliations

  1. 1.Chair of Accounting, Department of EconomicsUniversity of KonstanzConstanceGermany
  2. 2.Department of BankingUniversity of TuebingenTübingenGermany

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