is about to share his ignorance on banking, banking regulation, accounting, And accounting standards all in one post.
You know the end is near when ordinary people get interested in accounting standards.
A wide variety of politicians have decided that the problem with the US financial system is Mark to Market Accounting. It is tempting to argue that this is equivalent to arguing that closing our eyes will make the problem go away. However, there is one way in which accounting standards can create a crisis. It is through the interaction of accounting standards and capital requirements. Capital requirements are a way in which the numbers written on a balance sheet have real effects even if everyone knows they are made up.
So one could argue that the problem might be mark to market accounting if one were ready to argue that the problem is due to capital requirements. I’d say that is crazy. For one thing US investment banks didn’t long survive the relaxation of capital standards for US investment banks (held out about 4 years IIRC). For another its crazy.
However, there is a particular way in which mark to market times capital requirements can create a crisis. Paul Krugman called it a systemic margin call.
When the value of assets held by banks falls, the difference assets minus debt declines. Capital requirements imply that banks must reduce their total debt by selling assets and paying it off. Thus when the price of assets owned by banks declines banks sell those assets. This creates a downward sloping supply curve for the assets which can make multiple equilibria possible with one in which the capital controls are binding and prices are low and one in which they are not binding and the asset prices are high. The first equilibrium is Pareto inferior to the second and we seem to be in it.
So what is to be done ? I don’t think that eliminating capital controls or making them depend on made up prices is a solution. They were introduced because the same thing can happen at assets minus debt equals zero and then bankruptcy. A purpose of capital controls is to allow regulators to seize banks when the cost of liquidating them is still small. Notably investment banks have capital requirements on the REPO accounts of their clients (typically 2% I think but the investment bank knows what’s happening even before the client does). You’d have to be an idiot not to.
I think the problem is that banks decided to go close to the limit ignoring the risk in new instruments. Basically, I see a problem with allowing a bank to get as close to a line that it must not cross or it might be seized and liquidated while the CEO is in an airplane (al la WaMu even though that was triggered by liquidity requirements not capital requirements).
So I think there should be multiple levels of punishment for bad capital ratios. At a ratio of notionally 8% the bank can be seized. But if the ratio falls below 10% during a year no dividends or bonuses can be paid that year. This is painful enough that banks will try to stay well above 10% but they won’t go into a liquidation vicious cycle if they hit 10%.
The idea of no bonuses is that the dollar value of all payment for services under contingent contracts must be equal to the lowest possible value which means for example, if people are paid in shares or options they get $0 worth of shares or options.
The idea is a punishment so bad that bankers will act so as to make the subjective probability negligible (which we now know corresponds to an objective probability way higher than we should accept) but not so horrible that they will drive the bank bankrupt if they touch the line.
Maybe no bonuses is enough that the bankers will just blow up the bank in rage. If this is a concern a 70% tax on bonuses would probably work fine.
update: Hilzoy has an excellent discussion of the issues and (minds think a like) concludes that, if there is to be reform, there should be reform of capital requirements not accounting standards. She is a bit casual about relaxing capital requirements given what happened the last time that was done (2004 for institutions called “investment banks” which now don’t exist).