Abstract

http://ssrn.com/abstract=1972027
 
 

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


Andrew Ellul


Indiana University - Kelley School of Business - Department of Finance

Chotibhak Jotikasthira


University of North Carolina Kenan-Flagler Business School

Christian T. Lundblad


University of North Carolina Kenan-Flagler Business School

Yihui Wang


Fordham University

May 6, 2014


Abstract:     
We provide new empirical evidence concerning the contentious debate over the use of historical cost versus mark-to-market accounting (HCA vs. MTM) in regulating financial institutions. These accounting rules, through their interactions with capital regulations, alter financial institutions’ portfolio decisions and trading behavior. The insurance industry provides a natural laboratory in which to explore these interactions since significant differences exist in regulatory accounting rules: (1) life insurers have greater flexibility to hold speculative-grade instruments under HCA than property and casualty (P&C) insurers, which are required to use MTM, and (2) the degree to which life insurers have to recognize market value through impairment significantly differs across U.S. states. In the context of the sizeable downgrades of asset-backed securities (ABS) during the financial crisis of 2007-2009, we show that insurers facing greater degrees of market value recognition (i.e., MTM) are more likely to sell the downgraded ABS than insurers holding these securities under HCA. Instead, insurers facing HCA disproportionately resort to gains trading, selectively selling their corporate and government bond holdings with the highest unrealized gains, to improve their capital positions. Finally, we demonstrate that the trading incentives induced by the interplay between HCA and capital regulations alter financial institutions’ portfolio allocations, potentially engender distortions in key regulatory metrics, and transmit shocks across otherwise unrelated markets.

Number of Pages in PDF File: 99

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

JEL Classification: G11, G12, G14, G18, G22

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Date posted: December 14, 2011 ; Last revised: May 28, 2014

Suggested Citation

Ellul, Andrew and Jotikasthira, Chotibhak and Lundblad, Christian T. and Wang, Yihui, Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading (May 6, 2014). Available at SSRN: http://ssrn.com/abstract=1972027 or http://dx.doi.org/10.2139/ssrn.1972027

Contact Information

Andrew Ellul
Indiana University - Kelley School of Business - Department of Finance ( email )
1309 E. 10th St.
Bloomington, IN 47405
United States

Chotibhak Jotikasthira (Contact Author)
University of North Carolina Kenan-Flagler Business School ( email )
Chapel Hill, NC 27599-3490
United States

Christian T. Lundblad
University of North Carolina Kenan-Flagler Business School ( email )
Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-8441 (Phone)

Yihui Wang
Fordham University ( email )
33 West 60th Street
New York, NY 10023
United States
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