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Market-Based Solutions to Vital Economic Issues
Research
Dec 1, 2015

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

Abstract

Accounting rules, through their interactions with capital regulations, affect financial institutions’ trading behavior. The insurance industry provides a laboratory to explore these interactions: life insurers have greater flexibility than property and casualty insurers to hold speculative-grade assets at historical cost, and the degree to which life insurers recognize market values differs across U.S. states. During the financial crisis, insurers facing a lesser degree of market value recognition are less likely to sell downgraded asset-backed securities. To improve their capital positions, these insurers disproportionately resort to gains trading, selectively selling otherwise unrelated bonds with high unrealized gains, transmitting shocks across markets.

Note: Research papers posted on SSRN, including any findings, may differ from the final version chosen for publication in academic journals.


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