Discretionary measurement of Level 3 fair values during the 2008 financial crisis

Abstract

The measurement of fair values, particularly in the absence of quoted prices in active markets, is complex and difficult to verify. This paper examines whether banks use fair value estimates based on unobservable inputs (i.e., Level 3) to manage earnings during the 2008 financial crisis. Using a sample of 291 U.S. bank holding companies, we find that banks use discretionary Level 3 gains or losses to smooth earnings. We benchmark our findings against loan loss provisions (LLP), but we do not find consistent evidence that banks use LLP to smooth earnings, mainly because better corporate governance mechanisms effectively reduce discretion. However, better corporate governance does not reduce measurement discretion in Level 3. This finding suggests that monitoring mechanisms prevent excessive discretion for loans—which are measured at amortized cost—but have yet to develop to prevent similar discretion for investments that are measured at fair value.