International accounting principles define a hierarchy for fair valued instruments according to the availability of market data. Financial instruments classified as 'Level 2' and 'Level 3' (L2 and L3) are subject to a certain degree of valuation uncertainty. This paper investigates the correlation between the amount of L2, L3 and non-performing loans held by banks, on the one hand, and selected financial vulnerability indicators (CDSs, Z-scores and Price-to-Book ratios), on the other hand.
The research, carried out across a large sample of Significant Institutions, shows that an increase in asset and liabilities classified as L2 or L3, or in non-performing loans, tends to be associated with worse financial vulnerability indicators. It detects a positive correlation between L2 and CDS spreads; L3 and non-performing loans show positive correlations with default risk (as measured by Z-scores) and negative correlations with Price-to-Book ratios.
