Agency Conflicts, Prudential Regulation, and Marking to Market

Abstract

We develop a model of a financial institution to show how prudential capital regulation and mark-to-market accounting interact to affect the institution’s project choices in the presence of shareholder—debt holder agency conflicts. We demonstrate that, relative to a benchmark “pure historical cost” regime in which assets and liabilities on an institution’s balance sheet are measured at their origination values, mark-to-market or fair value accounting could alleviate the inefficiencies arising from asset substitution, but exacerbate t arising from underinvestment due to debt overhang. The inefficiencies due to underinvestmen t and asset substitution work in opposing directions. An increase in the propensity for asset substitution mitigates underinvestment, and this tradeoff is especially pronounced for highly levered financial institutions. The optimal choices of the accounting measurement regime and prudential solvency constraint balance the conflicts between shareholders and debt holders. Under fair value accounting, the optimal solvency constraint declines with the institution’s marginal cost of investment in project quality and the excess cost of equity capital relative to debt capital. The optimal solvency constraint is institution-specific, which suggests that a uniform solvency constraint could be sub-optimal. In fact, if the solvency constraint in the fair value regime is sub-optimally chosen to be tighter than a threshold, historical cost accounting dominates fair value accounting.