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

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  • Andrew Ellul

    ()

  • Chotibhak Jotikasthira
  • Christian T. Lundblad
  • Yihui Wang

Abstract

This paper explores the trading incentives of financial institutions induced by the interaction between regulatory accounting rules and capital requirements by investigating insurance companies’ trading behavior during the recent financial crisis. According to insurance regulation, life insurers have a greater degree of flexibility to hold downgraded instruments at historical cost, whereas property and casualty insurers are forced to re-mark many of their downgraded securities to market prices. Using firm-level insurance company transaction and position data, we study the implications of this accounting difference, and document direct evidence of ‘gains trading’ associated with historical cost accounting during the financial crisis. When faced with severe downgrades among their holdings in asset-backed securities (ABS), life insurers largely continue to hold the downgraded securities at historical cost and instead selectively sell their corporate bond holdings with the highest unrealized gains. This is particularly true for insurers facing regulatory capital constraints and with high ABS exposures. This behavior is largely absent among property and casualty insurers; they instead disproportionately sell their re-marked ABS holdings. Finally, we find that the gains trading among life companies induces significant price declines in the otherwise unrelated corporate bonds that happen to exhibit high unrealized gains.

Suggested Citation

  • Andrew Ellul & Chotibhak Jotikasthira & Christian T. Lundblad & Yihui Wang, 2012. "Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading," FMG Discussion Papers dp701, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp701
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    References listed on IDEAS

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    Cited by:

    1. Ralph S. J. Koijen & Motohiro Yogo, 2015. "The Cost of Financial Frictions for Life Insurers," American Economic Review, American Economic Association, vol. 105(1), pages 445-475, January.
    2. Ellul, Andrew & Jotikasthira, Chotibhak & Lundblad, Christian T. & Wang, Yihui, 2013. "Mark-to-market accounting and systemic risk: evidence from the insurance industry," LSE Research Online Documents on Economics 60968, London School of Economics and Political Science, LSE Library.
    3. Ralph S. J. Koijen & Motohiro Yogo, 2016. "Shadow Insurance," Econometrica, Econometric Society, vol. 84, pages 1265-1287, May.
    4. Justin Chircop & Zoltán Novotny-Farkas, 2014. "The economic consequences of including fair value adjustments to shareholders’ equity in regulatory capital calculations," IEHAS Discussion Papers 1426, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
    5. repec:oup:rcorpf:v:5:y:2016:i:1:p:76-101. is not listed on IDEAS

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