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

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.