Working Paper: CEPR ID: DP10450
Authors: Andrew Ellul; Chotibhak Jotikasthira; Christian T. Lundblad; Yihui Wang
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.
Keywords: Asset-Backed Securities; Corporate Bonds; Fire Sales; Gains Trading; Historical Cost Accounting; Insurance Companies; Mark to Market; Regulation
JEL Codes: G11; G12; G14; G18; G22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| mark-to-market accounting (G18) | likelihood of selling downgraded asset-backed securities (G32) |
| historical cost accounting (M41) | gains trading behavior (G41) |
| capital constraints (D24) | gains trading behavior (G41) |
| gains trading behavior (G41) | transmission of shocks across unrelated markets (E44) |