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

We provide evidence concerning the use of historical cost (HCA) versus mark-to-market (MTM) accounting in regulating financial institutions. Accounting rules, through their interactions with capital regulations, alter financial institutions’ trading behavior. The insurance industry provides a laboratory to explore these interactions: life insurers have greater flexibility to hold speculative-grade assets at HCA than P&C insurers, and the degree to which life insurers recognize market values differs across U.S. states. During the financial crisis, we show that insurers facing HCA are less likely to sell significantly downgraded asset-backed securities than those facing MTM. To improve their capital positions, the insurers facing HCA disproportionately resort to gains trading, selectively selling otherwise unrelated bonds with the highest unrealized gains, thereby transmitting shocks across markets