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

Author

Listed:
  • Andrew Ellul

    (Indiana University)

  • Chotibhak Jotikasthira

    (University of North Carolina)

  • Christian T. Lundblad

    (University of North Carolina)

  • Yihui Wang

    (Fordham University)

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.

Suggested Citation

  • Andrew Ellul & Chotibhak Jotikasthira & Christian T. Lundblad & Yihui Wang, 2014. "Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading," CSEF Working Papers 375, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  • Handle: RePEc:sef:csefwp:375
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    File URL: http://www.csef.it/WP/wp375.pdf
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    References listed on IDEAS

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    Cited by:

    1. Michele Fabrizi & Elisabetta Ipino & Michel Magnan & Antonio Parbonetti, 2016. "Real Regulatory Capital Management and Dividend Payout: Evidence from Available-for-Sale Securities / Gestion du capital réglementaire et politique de dividende : Le cas des valeurs mobilières disponi," CIRANO Working Papers 2016s-57, CIRANO.

    More about this item

    Keywords

    Regulation; Mark to market; Historical cost accounting; Gains trading; Fire sales; Asset-backed securities (ABS); Corporate bonds; Insurance companies.;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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