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.
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Notes
The US-GAAP and IFRS recognizes temporary fair value changes of non-trading fair value assets in the other comprehensive income, which does not affect the regulatory capital because of prudential filters (see SFAS 115 combined with FDIC 325 Ap. A).
Note that there are different interpretations of the results of risk relevance studies. On the one hand, a positive link between risk measures and accounting data might indicate higher risk [this is the interpretation of Riedl and Serafeim (2011)]. On the other hand, a positive link between risk measures and accounting variables might indicate a better ability of financial statements to reflect the inherent risk [this is the interpretation of Hodder et al. (2006)]. Based on the discussion in Beatty and Liao (2014), we follow the first view.
Altamuro and Zhang (2013) use the example of mortgage servicing rights to show the superiority of Level 3 estimates over Level 2 estimates. However, because the market for mortgage servicing rights has some very specific features, Hendricks and Shakespeare (2013) point towards the limits to generalize these results for other financial assets.
Lambert et al. (2007) show that whenever information risk is non-diversifiable, it increases the discount factor. Thereby, information risk on the one side decreases the firm’s asset value, but on the other side increases the value of equity. Whereas for healthy firms with a large distance to default and low volatility, the effect of information risk on the asset’s value dominates, there might be situations for very risky firms, in which the second effect dominates. To a firm’s creditors, both effects work in the same direction and reduce the value of their claims.
Lambert et al. (2007) also discuss a potentially indirect effect of information risk on the real investment choices of the firm.
In their recent study, Arora et al. (2014) only obtain CDS data on 16 banks and 20 diversified financial firms with sufficient data quality. Furthermore, they question the comparability of CDS information before and after March 2009, which again makes the Merton PD and the default costs the preferred measures for the study at hand.
A bid-ask spread is not available for 233 bank quarters in Datastream. We set the value to zero and control for these missing observations by using a dummy variable that takes the value of one for all missing observations. The results remain qualitatively unchanged when dropping all observations with a missing bid-ask spread.
Although the costs to the FDIC are always positive and, therefore, our dependent variable is restricted to zero at the lower bound, unreported evidence shows that the linear prediction yields no inconsistent (negative) values.
According to FFIEC 031 and FFIEC 041, banks only have to file Schedule RC-Q if they report total assets of more than $500 million as of the beginning of their fiscal year. Furthermore, banks that report financial instruments or that service assets and liabilities at fair values under the fair value option and banks that file Schedule RC-D (Trading Assets and Liabilities) also have to file Schedule RC-Q.
When winsorizing the share of Level 3 assets, the coefficients for the Level 3 assets are inflated, as it results in a reduction in the share of Level 3 assets from 93% to around 15%, while the costs to the FDIC remain largely unaffected. Because we are interested in using an especially conservative approach, we decided to drop this observation from our main regression.
From 0.61% (1.12%) to 1.03% (1.81%).
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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.”
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Appendices
Appendix A: Sample composition
Panel 1: This table shows the sample composition of quarterly observations by primary four digit SIC code. The SIC code 6021 refers to “National Commercial Banks”, 6022 to “State Commercial Banks”, 6029 to “Commercial Banks, NEC”, 6035 to “Savings Institutions, Federally Chartered”, 6036 to “Savings Institutions, Not Federally Chartered”, and 6712 to “Offices of Bank Holding Companies”
Quarter\SIC | 6021 | 6022 | 6029 | 6035 | 6036 | 6712 | Total |
|---|---|---|---|---|---|---|---|
2008 Q2 | 113 | 188 | 8 | 58 | 13 | 10 | 390 |
2008 Q3 | 114 | 197 | 7 | 59 | 12 | 10 | 399 |
2008 Q4 | 119 | 208 | 9 | 74 | 17 | 12 | 439 |
2009 Q1 | 125 | 232 | 10 | 79 | 22 | 13 | 481 |
2009 Q2 | 115 | 209 | 7 | 70 | 22 | 10 | 433 |
2009 Q3 | 119 | 210 | 8 | 67 | 18 | 11 | 433 |
2009 Q4 | 130 | 212 | 10 | 67 | 21 | 9 | 449 |
2010 Q1 | 119 | 214 | 7 | 73 | 24 | 10 | 447 |
2010 Q2 | 122 | 203 | 7 | 69 | 24 | 7 | 432 |
2010 Q3 | 118 | 203 | 9 | 73 | 22 | 9 | 434 |
2010 Q4 | 122 | 201 | 8 | 76 | 22 | 10 | 439 |
2011 Q1 | 116 | 206 | 8 | 74 | 24 | 11 | 439 |
2011 Q2 | 112 | 199 | 7 | 74 | 23 | 11 | 426 |
2011 Q3 | 109 | 189 | 7 | 66 | 18 | 12 | 401 |
2011 Q4 | 111 | 191 | 8 | 69 | 20 | 10 | 409 |
2012 Q1 | 110 | 189 | 6 | 73 | 21 | 11 | 410 |
2012 Q2 | 109 | 186 | 7 | 73 | 19 | 14 | 408 |
2012 Q3 | 107 | 184 | 8 | 71 | 22 | 13 | 405 |
2012 Q4 | 105 | 184 | 8 | 63 | 22 | 13 | 395 |
Total | 2195 | 3805 | 149 | 1328 | 386 | 206 | 8069 |
Appendix B: Variable definition and data source
Variables | Definition |
|---|---|
Analyst coverage | Number of analyst, which provided a RoE 1 year forecast for the bank on I/B/E/S |
Bid ask spread | Quarterly average of the spread between bid and ask price at the end of each trading day normalized by the mid-price |
Book leverage | The amount of total common equity to total assets |
Costs to FDIC | Updated costs to the FDIC scaled by the bank’s total assets at default |
Deposit ratio | Amounts in customers’ banking deposits; any accounts subject to federal banking deposit insurance, including any portions in jumbo deposits that are not insured but subject to the FDIC deposit regulations scaled by Total Assets at the beginning of the quarter |
Junior claim | Share of assets which are junior to the insured deposits in case of default |
Ln total assets | Natural logarithm of total assets |
Loan ratio | The ratio of total loans and leases to total assets |
Loss | Dummy taking the value of one if the bank’s net profit is smaller than zero |
Loss sharing agreement | Dummy taking the value of one if the asset liquidation agreement involves a loss sharing agreement |
Market value of equity (MVE) | Market value on Worldscope is the share price multiplied by the number of ordinary shares in issue. The amount in issue is updated whenever new tranches of stock are issued or after a capital change |
Non-performing assets | Share of non-performing assets to total assets |
Merton DD | Merton Distance of Default is based on the Black–Scholes formula of option pricing, where equity is treated as a call option on the firm value |
Mortgage risk | Sensitivity of a bank’s stock returns to the investment graded (AAA) collateralized mortgage backed securities index of the Barclays bank taken from Datastream. The sensitivity is calculated for each bank quarter separately using a rolling window of the last year (four quarters) |
Net profits | Net profits after taxes, minority interests, and extraordinary and other after-tax items |
No bid ask spread | No bid ask spread for that bank quarter from Datastream |
Operating performance | Operating expenses scaled by operating profits |
Purchase and assumption | Purchase and assumption of all deposits |
Return on assets (RoA) | The net income prior to default scaled by total assets at default |
Return on equity (RoE) | Net profit scaled by the market value of equity at the beginning of the quarter |
Share of brokered deposits | The deposits obtained through the mediation or assistance of a deposit broker scaled by total assets |
Share of Level 1 FVA | Level 1 fair value assets scaled by total assets at the end of the quarter. |
Share of Level 2 FVA | Level 2 fair value assets scaled by total assets at the end of the quarter |
Share of Level 3 FVA | Level 3 fair value assets scaled by total assets at the end of the quarter |
Share of transaction accounts | The amount transaction account deposits scaled by total deposits |
Share of non-performing assets | Non-performing assets scaled by total assets |
Tier 1 capital ratio | Tier 1 capital as a percentage of total risk-adjusted assets. For European banks, this excludes transitional capital adjustments when available |
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Mohrmann, U., Riepe, J. The link between the share of banks’ Level 3 assets and their default risk and default costs. Rev Quant Finan Acc 52, 1163–1189 (2019). https://doi.org/10.1007/s11156-018-0740-7
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DOI: https://doi.org/10.1007/s11156-018-0740-7