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

Ellul, Andrew; Jotikasthira, Chotibhak; Lundblad, Christian T.; Wang, Yihui

doi:10.2139/ssrn.1989490

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

Journal of Finance, Forthcoming

Kelley School of Business Research Paper No. 2014-40

108 Pages Posted: 23 Jan 2012 Last revised: 15 Apr 2015

See all articles by Andrew Ellul

Andrew Ellul

Indiana University - Kelley School of Business - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); - Centre for Studies in Economics and Finance (CSEF)

Chotibhak Jotikasthira

Southern Methodist University (SMU) - Finance Department

Christian T. Lundblad

University of North Carolina (UNC) at Chapel Hill - Finance Area; University of North Carolina (UNC) at Chapel Hill - Frank Hawkins Kenan Institute of Private Enterprise

Yihui Wang

Fordham University

There are 3 versions of this paper

Date Written: February 18, 2015

Abstract

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.

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

Suggested Citation: 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 (February 18, 2015). Journal of Finance, Forthcoming, Kelley School of Business Research Paper No. 2014-40, Available at SSRN: https://ssrn.com/abstract=1989490 or http://dx.doi.org/10.2139/ssrn.1989490