Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading
Indiana University - Kelley School of Business - Department of Finance
Southern Methodist University (SMU) - Edwin L. Cox School of Business; University of North Carolina Kenan-Flagler Business School
Christian T. Lundblad
University of North Carolina Kenan-Flagler Business School
February 18, 2015
Journal of Finance, Forthcoming
We provide evidence concerning the use of historical cost (HCA) versus mark-to-market (MTM) accounting in regulating financial institutions. Accounting rules, through their interactions with capital regulations, alter financial institutions’ trading behavior. The insurance industry provides a laboratory to explore these interactions: life insurers have greater flexibility to hold speculative-grade assets at HCA than P&C insurers, and the degree to which life insurers recognize market values differs across U.S. states. During the financial crisis, we show that insurers facing HCA are less likely to sell significantly downgraded asset-backed securities than those facing MTM. To improve their capital positions, the insurers facing HCA disproportionately resort to gains trading, selectively selling otherwise unrelated bonds with the highest unrealized gains, thereby transmitting shocks across markets.
Number of Pages in PDF File: 108
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
Date posted: December 14, 2011 ; Last revised: June 15, 2016
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