Abstract
Bank defaults adversely impact rival banks, the financial system, and the economy as a whole. Given the criticism of banks’ fair value accounting for the managerial discretion embedded in mark-to-model estimates and its consequences on bank risk taking, it is surprising that the link between model-based valuations and aspects of bank default received little attention in the empirical literature so far. Our study fills this gap by focusing on Level 3 assets whose fair values are estimated in the absence of reliable market prices. Based on quarterly data of 737 international banks from 2008 to 2012, we document a robust link between the share of Level 3 assets and banks’ default risk. Looking at asset liquidation transactions, Level 3 assets seem to contain hardly any value in the case of bank default. Several robustness checks support the results.
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