The congressional hearings on "market-to-market accounting" are scheduled to begin in a few hours. I shudder at the prospect of financially-illiterate congressmen becoming putty in the hands of savvy lobbyists bearing gifts.
My concern was piqued by Steve Forbes' latest error-filled epistle sans data, which the Wall Street Journal rashly deigned to publish last Friday. I fear that it is a microcosm of what will unfold in the hearings: that mark-to-market accounting will become the scapegoat for practically the entire financial crisis.
"Mark-to-market accounting is the principal reason why our financial system is in a meltdown," writes Forbes. But unlike Congress, who will welcome the suggestion of a convenient scapegoat to keep its constituents at bay, I give Forbes credit for being sufficiently informed to know the real reason; and which lately seems to be fading to the background: DERIVATIVES!
The Forbes critique of mark-to-market accounting for banks and other financial institutions goes something like this:
Writing down investments will reduce a bank's "regulatory capital," which will in turn cause to reduce lending.
Reduced lending by banks triggers a vicious cycle: lack of investment begets higher unemployment, which in turn begets higher loan default rates, which causes the fair value of bank investments to decline even further.
The current accounting rules implementing fair value exacerbate the situation by applying an illiquidity discount to "subprime securities and other suspect assets" even if there has been no direct evidence of impairment.
Forbes believes that President Obama should end "the most destructive policy of the Bush administration" (though I find it curious that he's waited until after Bush has left office to say it) by mandating historic cost for bank assets unless and until there is direct evidence of impairment. I am quite sure that FASB Chair Bob Herz, when he testifies at the hearings, will eloquently and fully describe the many shortcomings of this approach as they bear upon the quality of financial reporting, investor interests and public confidence in the capital markets.
But, Bob's testimony on mark-to-market v. historic cost should be no more than a side show compared to the real problem: derivative financial instruments have rendered the current approach to banking regulation obsolete. Capitalization ratios based on U.S. GAAP, if they ever were reliable, were reduced to white noise when derivatives hit bank balance sheets in a big way. Neither Steve Forbes nor anyone else can provide a solution framed as a change in accounting policy to change that critical fact. And, channeling democrat FDR's banking policies during the depression, which Forbes is wont to do even as he holds his nose, doesn't get us anywhere today; FDR didn't have the DERIVATIVES problem.
Take as a simple example, a financial institution (it could be a bank or an insurance company) that holds only one "investment." Let's say that investment is an interest rate swap with a notional amount of $50 billion dollars; the historic cost of entering into the swap was nil, and its current fair value is $1 billion dollars. Further assume that the bank has liabilities of $0.5 billion dollars. With a debt/asset ratio of 50%, is this bank well capitalized? Technically, yes, but effectively, not on your life. If interest rates were to move slightly in the wrong direction, a $1 billion asset could become a $10 billion liability; and the probability of that occurring could be 50% or more.
Forbes also contends that
"…although banks have twice the amount of cash on hand that they did a year ago, they lend only under duress, or apply onerous conditions…. This is because they know that every time they make a loan or an investment there is a risk of a book write-down, even if the loan is unimpaired."
The existence of derivatives suggests a much more plausible reason: the bankers know that they are going to need every penny of their cash if their derivatives positions go south as a result of, say, a slight increase to mortgage loan default rates. Stated another way, even though their cash position has doubled, they are still way short of capital.
The problem that we really want to resolve is how to restore the banks to a sound financial footing. Even granting that financial reporting to investors could play a role (and I don't), tweaking accounting rules that cover a surprisingly small percentage of assets that banks mark-to-market is hardly the job of Congress. Any solution must radically restructure bank regulation. Throw away any notion of capital adequacy based on capitalization ratios. Stress testing of future cash inflows and outflows is where it's at, and that has nothing to do with financial reporting. For a bank without derivatives, a strong correlation between a static capitalization ratio (based on some set of accounting rules) and the probability of future insolvency might be obtainable; but for banks holding loads of derivatives, we have learned through hard experience that Congress should acknowledge, that any correlation must be spurious.
Finally, although I consider this to be out of my area of expertise, I would like to offer one more suggestion. I believe that federal deposit insurance played a significant role in creating a sense of confidence in the soundness of our financial system. Like prudential regulation, however, it needs to be radically restructured.
Financial soundness of our economy is about whether the failure of one financial institution will damage the entire system. Getting back to deposit insurance, the government should not just limit its exposure to an account (e.g., $100,000 per account), but also to a financial institution. Following the example of Japan in its heyday, a conventional wisdom emerged in the U.S. that our banks would not be able to achieve the economies of scale and scope that would allow them to compete with their international rivals unless they, too, morphed into behemoths. Not only has that strategy failed from taking on too much risk, but U.S. banks along with their Japanese counterparts became "too big to fail," which has now become synonymous for "too big to exist."
I do not advocate that we issue a mandate to banks to break themselves up into smaller pieces, but we should reign in the perverse incentives that encouraged them to become too big in the first place. One way to do that would be to limit the amount of deposit insurance per bank. Any bank that is too large by the new standard will break itself up without any further prompting, and one would hope the result will be more efficient than what would occur via government fiat.
Basically, I think it's a good idea for Congress to hold hearings related to financial reform. I just hope that they come to an understanding that regulatory modernization that adequately addresses the singular risks to the financial system posed by derivatives must be an integral part of any legislative response to the economic crisis.
Accounting rules, no matter how you regard the current batch, are purportedly established to benefit investors. These rules have have nothing to do with what everyone agrees is much needed reform of the rules that regulate the activities of financial institutions. Fixating on the accounting rules is not unlike choosing to buffing the scratches out of a car that won't start, instead of opening up the hood to diagnose the real problem.
Note: I am indebted, as is often the case, to Jim Noel for comments he made when discussing the idea for this post with him.