Managerial Overconfidence and the Use of Level 3 Estimates Evidence from the Banking Industry

Abstract

This project explores the link between managerial overconfidence and banks’ asset valuation behavior in the aftermath of the 2007 financial crisis. Using intra-bank variations, it provides empirical evidence that banks with overconfident CFOs rely more heavily on valuation models designed for inactive markets only, known as Level 3 fair value estimates. More external governance and more experienced auditors mitigate the effect, pointing toward an inappropriate use of those models by overconfident managers. Endogenous manager selection as a reaction to illiquid markets, as well as signaling or the use of private information do not drive the results. Overall, the paper provides a new channel through which managerial overconfidence impacts firm reporting behavior.