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

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

Andrew Ellul

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

Chotibhak Jotikasthira

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

Yihui Wang

Fordham University

Multiple version iconThere 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

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

Andrew Ellul

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

University of Naples Federico II - CSEF - Center for Studies in Economics and Finance ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

Chotibhak Jotikasthira (Contact Author)

Southern Methodist University (SMU) - Edwin L. Cox School of Business ( email )

P.O. Box 750333
Dallas, TX 75275-0333
United States

University of North Carolina Kenan-Flagler Business School ( email )

Chapel Hill, NC 27599-3490
United States

Christian T. Lundblad

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-8441 (Phone)

Yihui Wang

Fordham University ( email )

33 West 60th Street
New York, NY 10023
United States

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