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

Abstract:     
We provide new empirical evidence concerning the contentious debate over the use of historical cost versus mark-to-market accounting in regulating financial institutions. These accounting rules, through their interactions with capital regulations, alter financial institutions’ optimal portfolio choice and trading behavior. The insurance industry provides a natural laboratory in which to explore these interactions since significant differences exist in the accounting rules imposed by regulators: life insurers have greater flexibility to hold speculative-grade instruments at historical cost than property and casualty (P&C) insurers. Using detailed data on insurers’ transactions and portfolio positions, including the regulatory accounting treatment for each security held, we show that life and P&C insurers respond differently to the observed massive 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 to improve their capital positions. This so-called “gains trading” is particularly widespread among those life insurers that face regulatory capital constraints and that are heavily exposed to ABS. For the most part, P&C insurers do not engage in gains trading; they instead sell their re-marked ABS holdings. In sum, the trading incentives induced by the interplay between historical cost accounting and capital regulations alter financial institutions’ portfolio allocation, potentially engender distortions in key regulatory metrics, and transmit shocks across otherwise unrelated markets.

Number of Pages in PDF File: 57

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

working papers series