Abstract
Financial instruments in levels 2 and 3 for accounting purposes are complex and opaque products and their evaluation is problematic. The amount of these assets held by banks in Europe is exceptionally high (€3 trillion in 2019) and there is no empirical evidence as to the extent, if at all, to which investors perceive them as risky instruments. Focusing on stock price crash risk, we provide evidence of a significant difference in the relationship between these instruments and risk depending on whether they are classified as levels 2 or 3. Specifically, level 3 assets and liabilities appear positively linked to bank risk, while there is no similar evidence for level 2 instruments. Our results are robust to various risk measures, including value-at-risk and expected shortfall. A key implication that emerges from this study is that stability requires more defined boundaries between level 2 and level 3 financial instruments and a reduction of the opportunities for managerial discretion.
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