Banks’ Opacity and Crash Risk

The opacity of the banking business has been identified as a main source of stock crash risk. Level 3 financial instruments are particularly opaque products, as their fair value is neither directly available nor measurable using market prices. Focusing on Europe, we find robust evidence that L3 positions significantly affect the risk of a banks’ stock price crash, creating a “stigma effect” among investors. We also show that investors do not consider L3 assets and liabilities as offsetting instruments, but as complementary sources of risk, because they do not have enough information about hedging strategies within banks’ portfolios