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

Ellul, Andrew, Jotikasthira, Chotibhak, Lundblad, Christian and Wang, Yihui (2012) Is historical cost accounting a panacea? Market stress, incentive distortions, and gains trading. Financial Markets Group Discussion Papers (701). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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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.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 2012 The Authors
Divisions:	Financial Markets Group
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice; Investment Decisions G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency; Event Studies G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation G - Financial Economics > G2 - Financial Institutions and Services > G22 - Insurance; Insurance Companies
Date Deposited:	26 Jun 2023 14:54
Last Modified:	16 Sep 2023 00:01
URI:	http://eprints.lse.ac.uk/id/eprint/119197

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