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Discussion Paper Details

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

Author(s): Andrew Ellul, Chotibhak Jotikasthira, Christian T Lundblad and Yihui Wang

Publication Date: March 2015

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

Programme Area(s): Financial Economics

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 institutions? 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.

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Bibliographic Reference

Ellul, A, Jotikasthira, C, Lundblad, C and Wang, Y. 2015. 'Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10450