Financial disclosures in the European banking sector -An analysis of the Level 3 hierarchy

Abstract

Background: The large reorganisation of financial instruments in the US banking sector prior to the recent financial crisis and the effects related to the crisis, raise concerns of similar accounting disclosures in Europe. The valuation of the Level 3 financial instruments is based on unobservable inputs and the instruments shall be valued at their fair value, in which information asymmetry may present itself through the subjectivity in the valuation mechanism. Research scope: The study is built on the notion that a high amount of Level 3 financial instruments results in a higher cost of capital. In relation to the main objective we have included control variables representing an overview of a bank’s business. The control variables are also subject to an in depth analysis. Research design: The correlation between Level 3 instruments and the cost of capital is examined through a statistical research, using CDS as a proxy for the cost of capital. The study consists of approximately 50 listed banks actively operating in the European Union, reflecting a large proportion of the asset base within the banking sector. The Level 3 variable as well as the control variables is examined through a linear regression analysis. Limitations: The study is limited to banks within the European Union as they are subject to the same economic regulation. The amendments to IFRS 7 were implemented in January of 2009 and as such the study encompasses both of the available years in order to establish a sound base of analysis. Empirical findings: We find no significant relationship between the amount of Level 3 financial instruments and the banks cost of capital. However, for 2010 the multiple regression analysis present depicts a significant relationship regarding the control variables as well as exhibiting a correlation to the cost of capital. Further research: We propose that future research include information observed over a longer period of time as well as examines an extended economical area due to the difference in the results received.