Agency Conflicts, Prudential Regulation, and Marking to Market

53 Pages Posted: 13 Jan 2011  

Tong Lu

University of Houston

Haresh Sapra

University of Chicago - Booth School of Business

Ajay Subramanian

Georgia State University

Date Written: January 4, 2011

Abstract

We develop a theory of how agency conflicts between the shareholders and debt holders of a financial institution, accounting measurement rules, and prudential capital regulation interact to affect the institution’s capital structure and project choices. We show that, relative to a benchmark historical cost regime in which assets and liabilities on the institution’s balance sheet are measured at their origination values, fair value or mark-to-market accounting could mitigate asset substitution, but exacerbate under-investment arising from debt overhang. The optimal choices of the accounting regime and the prudential solvency constraint balance the inefficiencies due to asset substitution and under-investment that move in opposing directions. Under fair value accounting, the optimal (value-maximizing) solvency constraint declines with the institution’s marginal cost of investment in project quality, and with the excess cost of equity capital relative to debt capital. Fair value accounting dominates historical cost accounting provided the solvency constraints in the respective regimes take their optimal values. If the solvency constraint in the fair value regime is sub-optimally set to be too tight, however, historical cost accounting dominates fair value accounting.

Suggested Citation

Lu, Tong and Sapra, Haresh and Subramanian, Ajay, Agency Conflicts, Prudential Regulation, and Marking to Market (January 4, 2011). Chicago Booth Research Paper No. 11-05. Available at SSRN: https://ssrn.com/abstract=1739164 or http://dx.doi.org/10.2139/ssrn.1739164

Tong Lu

University of Houston ( email )

Houston, TX 77204
United States

Haresh Sapra (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Ajay Subramanian

Georgia State University ( email )

Depts. of Finance & Risk Management and Insurance
P.O. Box 4050
Atlanta, GA 30303
United States
404-413-7483 (Phone)

HOME PAGE: http://robinson.gsu.edu/profile/ajay-subramanian/

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