108 Pages Posted: 23 Jan 2012 Last revised: 15 Apr 2015
Date Written: February 18, 2015
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