Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading

Andrew Ellul, Chotibhak Jotikasthira, Christian T. Lundblad and Yihui Wang
Additional contact information
Andrew Ellul: Indiana University
Chotibhak Jotikasthira: University of North Carolina
Christian T. Lundblad: University of North Carolina
Yihui Wang: Fordham University

CSEF Working Papers from Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy

Abstract: We provide new empirical evidence concerning the contentious debate over the use of historical cost (HCA) versus mark-to-market (MTM) accounting in regulating financial institutions. These accounting rules, through their interactions with capital regulations, alter financial institutions’ trading behavior. The insurance industry provides a natural laboratory to explore these interactions since significant differences exist in regulatory accounting rules: (1) life insurers have greater flexibility to hold speculative-grade assets under HCA than property and casualty insurers, which are required to use MTM, and (2) the degree to which life insurers have to recognize market value through impairment differs across U.S. states. In the context of the sizeable downgrades of asset-backed securities (ABS) during the 2007-2009 financial crisis, we show that insurers facing MTM are more likely to sell the downgraded ABS than insurers holding these assets under HCA. To improve their capital positions, insurers facing HCA disproportionately resort to gains trading, selectively selling their corporate and government bond holdings with the highest unrealized gains. This trading behavior transmits shocks across otherwise unrelated markets.

Keywords: Regulation; Mark to market; Historical cost accounting; Gains trading; Fire sales; Asset-backed securities (ABS); Corporate bonds; Insurance companies. (search for similar items in EconPapers)
JEL-codes: G11 G12 G14 G18 G22 (search for similar items in EconPapers)
Date: 2014-10-14
New Economics Papers: this item is included in nep-acc and nep-ias
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Citations: View citations in EconPapers (1)

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