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Is historical cost accounting a panacea? Market stress, incentive distortions, and gains trading

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  • Ellul, Andrew
  • Jotikasthira, Chotibhak
  • Lundblad, Christian
  • Wang, Yihui

Abstract

This paper explores the trading incentives of financial institutions induced by the interaction between regulatory accounting rules and capital requirements by investigating insurance companies' trading behavior during the recent financial crisis. According to insurance regulation, life insurers have a greater degree of flexibility to hold downgraded instruments at historical cost, whereas property and casualty insurers are forced to re-mark many of their downgraded securities to market prices. Using firm-level insurance company transaction and position data, we study the implications of this accounting difference, and document direct evidence of ‘gains trading' associated with historical cost accounting during the financial crisis. When faced with severe downgrades among their holdings in asset-backed securities (ABS), life insurers largely continue to hold the downgraded securities at historical cost and instead selectively sell their corporate bond holdings with the highest unrealized gains. This is particularly true for insurers facing regulatory capital constraints and with high ABS exposures. This behavior is largely absent among property and casualty insurers; they instead disproportionately sell their re-marked ABS holdings. Finally, we find that the gains trading among life companies induces significant price declines in the otherwise unrelated corporate bonds that happen to exhibit high unrealized gains.

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  • Ellul, Andrew & Jotikasthira, Chotibhak & Lundblad, Christian & Wang, Yihui, 2012. "Is historical cost accounting a panacea? Market stress, incentive distortions, and gains trading," LSE Research Online Documents on Economics 119197, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:119197
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    More about this item

    Keywords

    regulation; mark to market; historical cost accounting; gains trading; fire sales; asset-backed securities; corporate bonds; insurance companies;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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