Seminar

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

Andrew Ellul (University of Indiana)

May 21, 2012, 12:30–14:00

Room MF 323

Paul Woolley Research Initiative Seminar

Abstract

We provide new empirical evidence concerning the contentious debate over the use of historical cost versus fair value accounting in regulating financial institutions. These accounting rules, through their interactions with capital regulation, alter financial institutions’ optimal portfolio choice and trading behavior. The insurance industry provides a natural laboratory in which to explore these interactions. First, there exist significant differences in regulatory accounting rules; life insurers have greater flexibility to hold speculative-grade instruments at historical cost than property and casualty insurers. Second, within an insurer’s investment portfolio, detailed data are available on transactions, positions, and, most importantly, the regulatory accounting treatment for each security. 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, inducing significant price declines. This is particularly true for life 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. Historical cost accounting creates an altered incentive environment in which constrained financial institutions sell assets to realize gains. Insofar as this behavior transmits shocks across potentially unrelated markets, historical cost accounting is not a panacea.