Nov 10, 2021
Review of Pacific Basin Financial Markets and Policies
The paper investigates the impact of fair value accounting for illiquid assets (so-called ‘Level 2’ and ‘Level 3’ assets by accounting rules) on banks’ valuation and focuses on the change in relative weight of Level 3 (the most opaque and illiquid assets) with respect to Level 2 assets. The boundary between Level 3 and Level 2 assets is blurred and less clear than the one between Level 1 and Level 2 assets. Such unclear borderline entails corporate governance issues and provides room for opportunistic behavior by managers to opt for less transparent instruments. The paper proposes the change in Level 3-to-Level 2 assets ratio as a new measure to capture deviations in the opacity of bank assets and suggests a negative relationship between this ratio and bank’s price-to-book value. The rationale behind this relationship is that market participants interpret growth in Level 3-to-Level 2 assets ratio as an increase in bank’s opacity, since Level 3 assets might be as illiquid as Level 2 assets with the benefit of a less transparent model-based valuation technique. Based on a sample of 33 European banks from 2009 to 2018, I find that an increase of 100[Formula: see text]bps in Level 3-to-Level 2 assets ratio is linked to a decrease of about 74[Formula: see text]bps in the price-to-book value. Results are robust for different measures of firm relative valuation and using a different measure of illiquidity in fair value assets holdings (Level 2-to-Level 1 assets ratio).