Center For The Study of Financial Regulation

Summer 2013 - Issue NO.11

Mark-to-Market Accounting Market Stress and Incentive Distortions

by Andrew Ellul, Chotibhak Jotikasthira, Christian T. Lundblad and Yihui Wang

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A very contentious issue raised during the recent financial crisis has been the role played by mark-to-market (MTM) accounting in creating or exacerbating the impact of the crisis on financial institutions and asset prices.  In a September 2008 letter to the SEC, the American Bankers Association stated: “The problems that exist in today’s financial markets can be traced to many different factors. One factor that is recognized as having exacerbated these problems is fair value accounting.”  An alternative to MTM accounting is historical cost accounting (HCA), and it is precisely this variant that has been proposed as a better accounting method for financial institutions, at least to avoid amplifying systemic risk during a crisis.  

Most of the theoretical literature that links the propagation of systemic risk to accounting (Allen and Carletti (2008), Plantin, Sapra and Shin (2008), and Sapra (2008)) argues that the specific nature of MTM accounting leads to a “fire-sale externality problem” whereby additional selling pressure by financial institutions arises during market stress because of feedback effects between asset prices and financial institutions’ capitalization.  They argue that HCA, in contrast, may limit such downward spirals by avoiding these feedback effects. 

In our recent papers (Ellul et al. (2012, 2013)), we argue that a crucial issue in the debate, and one that has been largely ignored thus far, relates to the interaction between the accounting regime and the institutional framework.  In particular, the accounting treatment cannot be viewed separately from regulatory capital requirements. Our work explores the trading incentives of financial institutions induced by this interaction.

Before proceeding, let us first explain how the use of MTM and HCA can influence financial institutions’ capital positions. Consider securitized assets (referred to as ABS) that experienced substantial downgrades during 2007-2009. Because of risk-based capital requirements, the severe downgrades of ABS, often from investment to speculative grades, significantly increased the regulatory capital requirements of various financial institutions holding these downgraded instruments. Moreover, these instruments also suffered significant price declines. Each affected institution faces a stark decision: either keep the downgraded instruments and raise additional equity capital, quite difficult during a crisis, or sell the downgraded instruments to reduce the risk-based capital requirement by swapping for low risk assets like Treasuries.  This is where the accounting rules used for these instruments should have a first-order effect on trading incentives.

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Consider the case where an institution holds the downgraded assets at market values. In this case, the price decline is automatically reflected in the balance sheet, and the loss would directly reduce the institution’s equity capital.  While the institution will be indifferent between keeping the assets on its balance sheet and selling them from a purely accounting point of view, selling the downgraded assets for cash or lower-risk assets will reduce the required risk-based capital and hence improve the financial health as measured by the risk based capital (RBC) ratio (defined as the amount of equity capital divided by the risk-weighted capital requirement).  In this case, one institution’s desire to satisfy regulatory constraints by selling the distressed assets may create negative externalities for other institutions holding the same assets, and thus MTM may lead to a downward spiral of prices.  Consider another case where the institution holds the downgraded assets at historical cost: in this case, the price decline will not affect its equity capital but will elevate its required risk-based capital, leading to a deterioration of its RBC ratio.  This institution may try to avoid selling the downgraded assets and realizing losses, but it cannot escape the fact that it needs to improve its RBC ratio to recover its previous measurement of financial health.  One option is to engage in the so-called gains trading, where an institution selectively sells other risky assets on its balance sheet to recognize gains and increase its capital (Laux and Leuz (2009, 2010)).

We use the insurance industry as a laboratory to explore the impact of accounting rules since the accounting treatments used in determining the required regulatory capital for holding speculative-grade assets differ significantly for life and for property and casualty (P&C) insurers.  Prior to 2009, when an asset held by insurance companies is downgraded from investment to speculative grade, P&C insurers have to immediately recognize the asset value as the lower of the book value (based on HCA) and the market price (or model price, in case no market price is available).  On the other hand, life insurers can continue to hold the downgraded asset under HCA except in the extreme case when it is classified as ‘in or near default’. 


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Using position-level data provide by the National Association of Insurance Commissioners (NAIC), we investigate how the significant downgrade of ABS securities held by the two groups of insurers affected their behavior during the 2007-09 crisis. In Ellul et al. (2012), we find a number of important results. Life firms (generally booking the downgraded securities under HCA) largely keep the downgraded ABS in their balance sheet whereas P&C firms (generally marking to market the downgraded securities) disproportionately sell their downgraded ABS holdings. This evidence is consistent with the idea that MTM can lead to fire sales and potentially downward spiral in prices. In contrast, we find that life insurers disproportionately sell otherwise unrelated corporate bonds that have the highest level of unrealized gains, confirming the gains trading behavior induced by HCA: because most corporate bonds are held at historical cost, it is only by selling that these unrealized gains can be recognized. This trading behavior is disproportionately conducted by life insurers that have (a) large exposures to downgraded ABS booked under HCA, and (b) low risk-based capital ratios.

The question then becomes whether such gains trading generates distortions in financial institutions’ portfolio allocations and engenders price pressures in the market for the assets with unrealized gains. Our analysis shows that the answer is yes. Life insurers, particularly those that are relatively capital-constrained, maintain sizeable allocations to significantly underperforming and risky ABS whereas P&C insurers significantly cut their ABS allocations. We also find that gains trading by life insurers induces price declines for the otherwise unrelated corporate bonds that happen to exhibit high unrealized gains.  HCA does not completely avoid illiquidity spillovers.

In Ellul et al. (2013), we investigate the trading behavior of the two groups of insurers in the years leading up to the crisis. We find that P&C insurers, subject to MTM in the case that their assets are downgraded to speculative grades, are significantly more prudent in their portfolio choice in the period prior to the crisis.  In sharp contrast to life insurers, P&C insurers do not increase as much their portfolio allocation to ABS securities, many of which are eventually downgraded during the crisis, and choose similarly-rated corporate bonds that are safer (as evidenced by their lower market yields and better performance during the crisis). This prudent behavior reduces the need for P&C insurers to engage in fire sales of downgraded assets and hence dampens the potential adverse effects of MTM.

Overall, these results show that the interaction between the accounting treatment and capital regulations can alter financial institutions’ portfolio allocations, yielding distortions in key regulatory metrics and creating unintended consequences.  In particular, the incentives associated with HCA can engender “reaching-for-yield” behavior during normal times and price distortions during market stress for assets that are completely unrelated to the original downgraded securities.


1) Allen F., and E. Carletti, 2008, Mark-to-market accounting and cash-in-the-market pricing, Journal of Accounting and Economics 45, 358-378.

2) Ellul, A., C. Jotikasthira, C. Lundblad, and Y. Wang, 2012, Is historical cost accounting a panacea? Market stress, incentive distortions, and gains trading, Working Paper.

3) Ellul, A., C. Jotikasthira, C. Lundblad, and Y. Wang, 2013, Mark-to-Market Accounting and Systemic Risk in the Financial Sector, Working Paper

4) Laux, C., and C. Leuz, 2009, The crisis of fair-value accounting: Making sense of the recent debate, Accounting, Organizations and Society 34, 826–834

5) Laux, C., and C. Leuz, 2010, Did fair-value accounting contribute to the financial crisis? Journal of Economic Perspectives 24, 93–118.

6) Plantin, G., H. Sapra, and H. Shin, 2008, Marking-to-market: Panacea or Pandora's box? Journal of Accounting Research 46, 435-460.

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