Agency Conicts, Prudential Regulation, and Marking to Market

We develop a theory to show how mark-to-market accounting and shareholder–debt holder agency con‡icts interact to a¤ect the prudential regulation of a …nancial institution. We demonstrate that, relative to a benchmark historical cost regime, mark-to-market accounting could alleviate the ine¢ ciencies arising from asset substitution, but exacerbate those arising from the incentives to choose lower quality projects due to debt overhang. The ine¢ ciencies due to debt overhang and asset substitution work in opposing directions. An increase in the propensity for asset substitution mitigates the debt overhang ine¢ ciency, and this tradeo¤ is especially pronounced for highly levered …nancial institutions. The optimal choices of the accounting measurement regime and the prudential solvency constraint balance the con‡icts between shareholders and debt holders. From a policy standpoint, our results suggest that a uniform capital requirement across institutions could be sub-optimal. In fact, if the solvency constraint is too tight (i.e., the capital requirements is too strict), historical cost accounting dominates mark-to-market accounting. Our results therefore sound a note of caution given the recent proposals to require both markto-market accounting and stricter capital requirements in the Basel III accords. We thank Patrick Bolton, Pingyang Gao, Frank Gigler, Christopher Hennessy, Robert McDonald, and workshop participants at the 2011 Western Finance Association Meetings (Santa Fe, New Mexico), the 2011 C.R.E.D.I.T Conference on Stability and Risk Control in Banking, Insurance, and Financial Markets (Venice, Italy), the Fifth Interdisciplinary Accounting Symposium held by the Danish Center for Accounting and Finance (Copenhagen, Denmark), Emory University, Georgia State University, London School of Economics, Northwestern University, Stanford University, Temple University, University of Houston, University of Minnesota, University of North Carolina at Chapel Hill, and Washington University at St. Louis for valuable comments. Haresh Sapra is grateful to the University of Chicago Booth School of Business for …nancial support.