Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?

Merrill, Craig; Nadauld, Taylor D.; Stulz, René M.; Sherlund, Shane M.

doi:10.2139/ssrn.2115537

Cited by 28 publications

(33 citation statements)

References 34 publications

Supporting

Mentioning

Contrasting

Order By: Relevance

“…The fact that life insurers (under HCA) rather than P&C (facing MTM for speculative-grade bonds) exhibit larger realized, as well as unrealized, losses is inconsistent with the notion that systemic risk is always amplified by the fire-sale feedback problem associated with MTM. To be clear, P&C insurers do sell downgraded securities (see Ellul et al (2012) and Merrill et al (2012)), but this evidence suggests that, on average, the implications for realized losses were actually relatively less pronounced for P&C firms than for life firms.…”

Section: Evolution Of Rbc Ratios Before and During The Crisismentioning

confidence: 99%

“…Indeed, when an institution's RBC ratio falls below certain thresholds, it is put on a regulatory watch and immediate action must be taken. It is important to note that both types of accounting rules, MTM and HCA, have important effects on the calculation of the RBC ratio (see Ellul et al (2012) and Merrill et al (2012)) because they may directly or indirectly impact both the numerator (equity capital) and the denominator (required capital) of this-ratio. The accounting rules governing the recognition of portfolio assets (or book values) have clear implications for equity capital.…”

mentioning

confidence: 99%

See 1 more Smart Citation

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

Ellul

Jotikasthira²,

Lundblad³

et al. 2014

Econ Policy

View full text Add to dashboard Cite

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 marketbased 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.JEL classification: G11, G12, G14, G18, G22

show abstract

Section: Evolution Of Rbc Ratios Before and During The Crisismentioning

confidence: 99%

mentioning

confidence: 99%

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

Ellul

Jotikasthira²,

Lundblad³

et al. 2014

Econ Policy

View full text Add to dashboard Cite

show abstract

“…Our work is also related to the literature on financial and regulatory frictions on the supply side of insurance markets. In particular, some recent papers show that capital regulation and accounting rules, when they interact with financial frictions, affect investment behavior on the asset side of the balance sheet (Merrill, Nadauld, Stulz, and Sherlund (2012), Becker and Opp (2013), Becker and Ivashina (2015), Ellul, Jotikasthira, Lundblad, and Wang (2015)). Our work complements this literature by showing that a set of capital regulation and accounting rules on the liability side has a profound impact on reinsurance activity and pricing behavior in the retail market (Koijen and Yogo (2015)).…”

Section: Introductionmentioning

confidence: 99%

Shadow Insurance

Koijen¹,

Yogo²

2016

Econometrica

114

View full text Add to dashboard Cite

APPENDIX A: STYLIZED EXAMPLES OF CAPTIVE REINSURANCE WE ILLUSTRATE THE BALANCE SHEET MECHANICS of how an operating company can increase statutory capital by ceding reinsurance to an unauthorized captive. We offer three examples to illustrate the three main types of reinsurance: coinsurance, coinsurance with funds withheld, and modified coinsurance. 1 The latter two types differ from coinsurance in that the ceding company retains control of the assets, so the captive does not need to establish a trust fund. The examples show that the three types of reinsurance can achieve the same economic outcomes. We refer the reader to Loring and Higgins (1997) and Tiller and Tiller (2009, Chapters 4-5) for further details.

show abstract

“…In parallel, other studies have shown that securitised and structured finance products, such as Collateralised Debt Obligations (CDOs) and subprime Residential Mortgage Backed Securities (RMBS), were responsible for the intensification and severity of the recent crisis. 4 As downgrades of these structured securities spiked in 2007 their prices plunged, while the buy side almost disappeared (for losses on RMBS, see, Merrill et al, 2012). The RMBS market has been shown to be the origin of contagion during the crisis and so represented a source of considerable risk for banks relating to increasing risk aversion and market illiquidity (Fender and Scheicher, 2009;Longstaff, 2010).…”

Section: Introductionmentioning

confidence: 99%

The determinants of bank risks: Evidence from the recent financial crisis

Leung

Taylor

Evans

2015

Journal of International Financial Markets, Institutions and Mo

View full text Add to dashboard Cite

a b s t r a c tWe investigate whether US bank holding company fundamental characteristics are related to bank risk over a period that covers the recent 2007-09 financial crisis. We extend prior studies to consider bank equity risk exposure to market-wide default risk, the structured finance market, and the asset-backed money market in a variance decomposition. Four important results emerge: (1) the risk in bank opaque assets is not accurately priced;(2) banks with lower earnings have higher risk; (3) a positive relationship between nonperforming loans and bank risk increased threefold during the crisis and (4) banks with a larger buffer of Tier 1 capital have lower risk and lower exposure to shocks in market-wide default risk and the structured finance market in particular. These results highlight the importance to investors of studying fundamentals, while from a bank regulatory perspective, effective management of regulatory capital may manage risks arising from contagion stemming from structured finance markets and funding illiquidity.

show abstract

Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?

Cited by 28 publications

References 34 publications

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

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

Shadow Insurance

The determinants of bank risks: Evidence from the recent financial crisis

Contact Info

Product

Resources

About