Agency Conflicts, Prudential Regulation, and Marking to Market∗

We develop a theory of how agency conflicts between the shareholders and debt holders of a financial institution, accounting measurement rules, and prudential capital regulation interact to affect the institution’s capital structure and project choices. We show that, relative to a benchmark historical cost regime in which assets and liabilities on the institution’s balance sheet are measured at their origination values, fair value or mark-to-market accounting could mitigate asset substitution, but exacerbate under-investment arising from debt overhang. The optimal choices of the accounting regime and the prudential solvency constraint balance the inefficiencies due to asset substitution and under-investment that move in opposing directions. Under fair value accounting, the optimal (value-maximizing) solvency constraint declines with the institution’s marginal cost of investment in project quality, and with the excess cost of equity capital relative to debt capital. Fair value accounting dominates historical cost accounting provided the solvency constraints in the respective regimes take their optimal values. If the solvency constraint in the fair value regime is sub-optimally set to be too tight, however, historical cost accounting dominates fair value accounting. ∗We thank Patrick Bolton, Pingyang Gao, and workshop participants at Emory University, Georgia State University, Temple University, University of Houston, and University of Minnesota for valuable comments. Haresh Sapra is grateful to the University of Chicago Booth School of Business for financial support.