Abstract
Statement of Financial Accounting Standard No. 157 states that "unobservable inputs [management-developed estimates of Level 3 fair-values] shall be used to measure fair-value to the extent that observable inputs are not available". The discretion afforded to managers by allowing them to develop their own estimates of fair-value creates a moral hazard that allows managers to engage in capital and/or earnings management. This study investigates whether bank managers are using Level 3 fair-value estimates in an opportunistic manner in order to meet capital adequacy requirements and/or earnings expectations. I find evidence suggesting bank managers choose the fair-value estimates of Level 3 instruments in order to report current earnings that are positive and more than prior quarter earnings. While previous work has shown that quoted values from illiquid markets contain unwanted noise, the results of this study suggest that allowing managers to use Level 3 estimates can have similar drawbacks if managers choose to use their private information in an opportunistic fashion. My findings support recent efforts by regulators to expand SFAS 157-related disclosures (FASB 2009) in an effort to increase transparency with respect to Level 3 instruments.