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

59 Pages Posted: 2 Mar 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); University of Naples Federico II - CSEF - Center for Studies in Economics and Finance

Chotibhak Jotikasthira

Southern Methodist University (SMU) - Finance Department

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: March 2015

Abstract

We provide new empirical evidence concerning the contentious debate over the use of historical cost (HCA) versus mark-to-market (MTM) accounting in regulating financial institutions. These accounting rules, through their interactions with capital regulations, alter financial institutionsÂ’ trading behavior. The insurance industry provides a natural laboratory to explore these interactions since significant differences exist in regulatory accounting rules: (1) life insurers have greater flexibility to hold speculative-grade assets under HCA than property and casualty insurers, which are required to use MTM, and (2) the degree to which life insurers have to recognize market value through impairment differs across U.S. states. In the context of the sizeable downgrades of asset-backed securities (ABS) during the 2007-2009 financial crisis, we show that insurers facing MTM are more likely to sell the downgraded ABS than insurers holding these assets under HCA. To improve their capital positions, insurers facing HCA disproportionately resort to gains trading, selectively selling their corporate and government bond holdings with the highest unrealized gains. This trading behavior transmits shocks across otherwise unrelated markets.

Keywords: asset-backed securities (ABS), corporate bonds, fire sales, gains trading, historical cost accounting, insurance companies, mark to market, regulation

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 (March 2015). CEPR Discussion Paper No. DP10450. Available at SSRN: https://ssrn.com/abstract=2572428

Andrew Ellul (Contact Author)

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 )

London
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

Southern Methodist University (SMU) - Finance Department ( email )

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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