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Mark-to-market accounting and systemic risk: evidence from the insurance industry

Ellul, Andrew and Jotikasthira, Chotibhak and Lundblad, Christian T. and Wang, Yihui (2013) Mark-to-market accounting and systemic risk: evidence from the insurance industry. SRC Discussion Paper (No 4). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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Abstract

One of the most contentious issues raised during the recent crisis has been the potentially exacerbating role played by mark-to-market accounting. Many have proposed the use of historical cost accounting, promoting its ability to avoid the amplification of systemic risk. We caution against focusing on the accounting rule in isolation, and instead emphasize the interaction between accounting and the regulatory framework. First, historical cost accounting, through incentives that arise via interactions with complex capital adequacy regulation, does generate market distortions of its own. Second, while mark-to-market accounting may indeed generate fire sales during a crisis, forward-looking institutions that rationally internalize the probability of fire sales are incentivized to adopt a more prudent investment strategy during normal times which leads to a safer portfolio entering the crisis. Using detailed, position- and transaction-level data from the U.S. insurance industry, we show that (a) market prices do serve as ‘early warning signals’, (b) insurers that employed historical cost accounting engaged in greater degrees of regulatory arbitrage before the crisis and limited loss recognition during the crisis, and (c) insurers facing mark-to-market accounting tend to be more prudent in their portfolio allocations. Our identification relies on the sharp difference in statutory accounting rules between life and P&C companies as well as the heterogeneity in implementation of these rules within each insurance type across U.S. states. Rather than promoting a shift away from market-based information, our results indicate that regulatory simplicity may be preferred to the complexity of risk-weighted capital ratios that gives rise, through interactions with accounting rules, to distorted risk-taking incentives and potential build-up of systemic risk.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.systemicrisk.ac.uk/
Additional Information: © 2013 Systemic Risk Centre, The London School of Economics and Political Science
Divisions: Systemic Risk Centre
Subjects: 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
Sets: Research centres and groups > Systemic Risk Centre
Date Deposited: 18 Feb 2015 10:06
Last Modified: 11 Dec 2017 13:04
Projects: ES/K002309/1
Funders: Economic and Social Research Council
URI: http://eprints.lse.ac.uk/id/eprint/60968

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