'The banks will need bailing out again, but with public finances overstretched and markets for government debt battered the money won't be there.'<blockquote>
'In the event, instead of taking all assets at par, the Basel regulators came up with an increasingly elaborate structure, by which certain types of assets, such as mortgages, should be weighted less in calculation of capital requirements. Inevitably, this drove banks into acquiring those types of assets, and produced innumerable political games between the various categorizations. Unforgivably, the regulators rated debt of Organisation for Economic Co-Operation and Development (OECD) governments at zero, thus perpetuating the myth that it was risk-free and allowing banks to indulge in infinite leverage with anything that carried a government guarantee.
Naturally, this produced endless new refinements by which banks sought to profit by playing yield curve games with government debt, thus taking on massive interest rate risk – but with monetary managers like Ben Bernanke, the Bank of England's Mervyn King and the Bank of Japan's Haruhiko Kuroda in charge, they were given a free license to do so with very little risk that monetary policy would ever revert to normal.
..
You can thus see the mechanism by which asset price booms and bubbles make banks more aggressive, allowing them to purchase more assets and thereby intensifying the boom/bubble. The combination of tight capital regulations and mark to market accounting increases the amplitude of business cycles, making the economy less stable and more prone to wild booms and devastating crashes. Add in the effect of Bernankeist monetary policies, which intensify up-cycles in asset prices, and you have a recipe for a very unpleasant denouement indeed in the next few years. The asset bubble will burst and the cycle will go into reverse with the world's major banks marking their assets to an ever-decreasing market, panic sales of depreciated stocks, bonds and real estate and bank capital melting away to zero. The banks will need bailing out again, but with public finances overstretched and markets for government debt battered the money won't be there.'</blockquote>
Bank accounting and regulation worsen bubblesBy Martin Hutchinson
December 30, 2013
SourceSince 2008 there has been a huge tightening of bank regulation, attempting to prevent a repeat of the meltdown.
Capital requirements have been greatly increased, although a number of the regulatory loopholes in the previous system have been left open. However not enough attention has been paid to the interaction between the new regulatory standards and revised “mark to market” bank accounting rules that came into effect on Nov. 15, 2007, just before the crash. In the euphoric market action of 2013 there are already signs that the two immensely complex sets of regulations interact with each other—and that interaction is enlarging the current bubble.
In a traditional banking system, the main control on bank leverage was the reputation of the bank among its large depositors. If the bank had a reputation for sound, conservative lending and undertaking only high-quality business, it could leverage itself rather more than a bank that engaged in more speculative lending or dealt with the financial center's known bad hats.
Needless to say this system was impossible to regulate, except through the old London method of self-enforced good behavior through a market "club" the Accepting Houses Committee. It is not a coincidence that the Basel system of banking regulation was invented within only a few years of the demise of the AHC; regulators strongly felt the need to quantify the previously subjective market parameters about capitalization and client quality.
Being public-sector bureaucrats advised by academics, however, they made a mess of it. To be fair, they had a number of possible alternatives, none of them ideal. One was to adopt a simple ratio of capital to assets, which would have pushed banks towards riskier assets. Another would have been to use a rating system, which would have pushed banks towards less risky assets but would have given the rating agencies altogether too much power.
A third alternative, which would probably have been best, would have been to delegate the banks to rate each other, so that a bank that took too many risks would be downgraded by bank analysts at its competitors. Banks panned by their competitors would then be subjected to enhanced scrutiny and arm-twisting by the regulators themselves. However that would have smacked altogether too much of a recognition that the private sector knows best, not something the average regulator is prepared to admit, except under duress.
In the event, instead of taking all assets at par, the Basel regulators came up with an increasingly elaborate structure, by which certain types of assets, such as mortgages, should be weighted less in calculation of capital requirements. Inevitably, this drove banks into acquiring those types of assets, and produced innumerable political games between the various categorizations. Unforgivably, the regulators rated debt of Organisation for Economic Co-Operation and Development (OECD) governments at zero, thus perpetuating the myth that it was risk-free and allowing banks to indulge in infinite leverage with anything that carried a government guarantee.
Naturally, this produced endless new refinements by which banks sought to profit by playing yield curve games with government debt, thus taking on massive interest rate risk – but with monetary managers like Ben Bernanke, the Bank of England's Mervyn King and the Bank of Japan's Haruhiko Kuroda in charge, they were given a free license to do so with very little risk that monetary policy would ever revert to normal.
The arithmetical standards for bank capital have tightened since 2008, the calculations by which assets are written down for capital calculations have been made more complex and arcane, and the scrutiny the regulators give capital ratios has vastly increased, with various futile "stress tests" being adopted. However the security of the banking system has not significantly increased, indeed it may even have diminished, because of the effect of mark to market accounting.
Traditionally, banks held assets on their books at cost, with the occasional write-down for obvious value impairments. If one of the London merchant banks had a bad year, and wanted to make its results look prettier, it would find some ancient asset it had acquired in 1926, whether shares or real estate, and sell it in the open market, realizing a large profit and offsetting any hiccups in its loan portfolio, for example. Analysts would indulge in arcane calculations of "hidden reserves" in banks' balance sheets – assets that had been bought decades earlier and could be sold in this way – thus suggesting that the merchant banks were more valuable than appeared on the surface.
This only went wrong once, in the very deep bear market of 1974, in which real estate became unsaleable and stocks declined to the value they had held 20 years earlier, wiping out the possibility of creating profits to offset the unexpected losses that were all too prevalent that year. This failure caused accountants to question the time-honored wisdom of cost-based accounting, especially in trading operations. Thus by the 1980s brokers and traders were revaluing their positions daily on a "mark to market" basis and paying out bonuses annually based on their value at the end of the year.
This caused two kinds of silly games. First, it caused market-makers to trade small quantities of illiquid assets at unrealistic prices close to year-end, in order to establish a more attractive valuation for the books. Second, for assets in which no real market existed, increasingly common with the spread of arcane derivatives, traders would value the position by reference to a mathematical model – which normally bore little resemblance to reality.
Mark to market accounting was partially adopted for banks in 1993 and spread more widely with new accounting rules that came into effect in November 2007. Its initial effect was to increase the panic level in the market collapse of 2008, since it revealed the extent to which balance sheets of operations like Lehman and Bear Stearns consisted of illiquid assets for which there was no real market. It thus contributed significantly to the depth of panic in September 2008. Indeed its more draconian requirements were suspended for a period after September 2008, to prevent the market from spiraling to destruction.
Still, it's not really fair to blame the new accounting technique for a crash that was already baked into the cake at the time of its adoption. While confidence would have maintained itself better if the capital bases of the investment banks were not self-destructing in the downturn, the foolish decisions that made them vulnerable had been taken prior to the new rule's adoption and were unrelated to it. In a sense, mark to market accounting only forced the financial sector to recognize an unpleasant reality.
The real danger of mark to market accounting, however, comes in a bull market, not a bear market, and it relates to the Basel capital rules. If asset prices increase, mark to market accounting allows banks to recognize these gains as they occur, whether or not the assets have been sold, or indeed could be sold at the prices indicated by the market. Naturally, brokers and their bosses are all too happy for this to occur, since even a restrained portion of these gains, leveraged as they are perhaps 20 to 1, provides some very nice bonus pools indeed.
However, every $1 billion extra that mark to market accounting produces in the bank's books allows the bank to acquire another $20 billion of assets. In a prolonged bull market therefore, the bank can take on more assets as the market rises, taking on which itself tends to push the market up further. The cycle is self-perpetuating.
We can see the effect of this in the current market. Equity prices are up some 28% since the beginning of 2013, almost entirely based on richer valuations, since profits, already at record levels in terms of GDP, have been relatively sluggish and economic growth is growling along at well under 3% for the year as a whole. Real estate also has risen sharply, with house prices up 12%.
To the extent that banks own equities and real estate their capital will correspondingly have increased in 2013, and they will be able to take on more assets in 2014. Given banks' recent activities, those assets are unlikely to include many loans to small businesses, the most useful part of banks' portfolios. Instead they are likely to focus mainly on mortgage bonds and other assets enabling them to profit from the artificial gap between short-term and long-term interest rates. Oh, and more equities and real estate, in the hope of surfing the market wave for another year.
You can thus see the mechanism by which asset price booms and bubbles make banks more aggressive, allowing them to purchase more assets and thereby intensifying the boom/bubble. The combination of tight capital regulations and mark to market accounting increases the amplitude of business cycles, making the economy less stable and more prone to wild booms and devastating crashes. Add in the effect of Bernankeist monetary policies, which intensify up-cycles in asset prices, and you have a recipe for a very unpleasant denouement indeed in the next few years. The asset bubble will burst and the cycle will go into reverse with the world's major banks marking their assets to an ever-decreasing market, panic sales of depreciated stocks, bonds and real estate and bank capital melting away to zero. The banks will need bailing out again, but with public finances overstretched and markets for government debt battered the money won't be there.
Free marketers decry regulation, claiming markets would be stabler and economies more prosperous without it. In theory, competent regulators might make the banking system safer. However regulators seem unable to avoid poisonous combinations like that between tight capital ratios and mark to market accounting. Thus the free-market case will soon make itself.
Let us only hope that when the inevitable crash comes the free-market road is taken, rather than piling on the banks yet more self-contradictory encyclopedias of damaging restrictions.
Context<blockquote>
(Banking Reform - English/Dutch) '..a truly stable financial and monetary system for the twenty-first century..'</blockquote>