have the unintended reverse impact during a panic, tying up cash that banks need to pay out in order to stem the panic

From Econlog:

Mark to Market

David Henderson

Economist Jeff Hummel sent out the following to a large e-mail list. I'm reprinting the whole thing here and appending my comments.

Jeff's e-mail:

Mark-to-market accounting has received a lot of criticism during the
current financial crisis. But a recent email from Less Antman, a CPA and
financial planner, offers the best explanation I've seen of why
government-mandated capital requirements are the real source of the
problem. Economists now realize that reserve requirements, designed to
make banks more LIQUID, have the unintended reverse impact during a panic,
tying up cash that banks need to pay out in order to stem the panic. As a
result, reserve requirements are fast disappearing as a tool of bank
regulation. Similarly, capital requirements, designed to make banks more
SOLVENT, also have the reverse impact during a crisis. What follows is
Less's analysis:

"Any discussion of mark-to-market accounting must differentiate between
the beneficial effects of honestly reporting assets at what they are
actually worth and the destructive impact of inflexible regulations that
utilize the principle. Current discussions have blurred the distinction.

"(1) The Financial Accounting Standards Board (FASB) determined that
securities held by a company which it intends to sell when funds are
needed for another purpose ought to be reported at fair market value
rather than historical cost. This seems eminently sensible to me.

"(2) The FASB allowed an exception for debt securities which would
eventually mature at a fixed price, and which the company had the positive
intent and ability to hold to maturity. Mark-to-market accounting is
specifically not required when the company elects to classify the security
as one to be held to maturity.

"(3) In spite of ignorant comments to the contrary, 'market' doesn't mean
that the last trading price of a security must always be used, nor that a
security whose market has virtually disappeared due to unusual
circumstances must be valued at zero or near zero. The FASB EXPLICITLY
permits the use of alternative market measures in such circumstances, such
as the complicated derivative pricing model known as Black-Scholes. For
instance, Berkshire Hathaway (Warren Buffett's company) has $8.1 billion
(at cost) of derivatives on its books, all carried under mark-to-market
accounting, but none of them currently priced based on the non-existent
market for those derivatives.

"I am fully supportive of the use of mark-to-market accounting on balance
sheets. It is clearly the most honest way to report derivatives. So what's
the problem with mark-to-market accounting? I see the following
government-created problems associated with them:

"(1) Mark-to-market was adopted by regulators as the basis for determining
minimum capital requirements. Creating an inflexible regulation based on
an inherently volatile measure was always an accident waiting to happen.

"(2) While foresighted bank executives might have chosen to maintain
capital in excess of regulatory requirements so that a decline in value
wouldn't trigger a crisis, it would have made no business sense to do so,
since it would have reduced their lending income and ability to pay
competitive rates on deposits or offer other benefits to attract
customers. In a free market, they would have been able to do so, since
they would have gained a reputation advantage from their greater safety,
but with FDIC insurance protecting all deposits, customers don't shop
based on safety, as they assume they are protected by the government from
the loss of their deposits. Thus, only the rates and benefits offered by a
bank matter to a customer, not the reliability of the bank, thanks to the
FDIC."

(JRH interjecting: I might add that Less's point here is well supported by
the historical record. Prior to government deposit insurance, U.S. banks
voluntarily maintained capital-asset ratios in the neighborhood of 10 to
20 percent, way above current mandated levels.)

"(3) With banks thus always seeking to keep only the minimum required
capital, the problem was further exacerbated by the Basel capital
requirement formula, which requires less than half the capital if kept in
the form of AAA securities compared to high quality individual mortgages
(as I discuss in my article on Credit Default Swaps, forthcoming in the
April 2009 issue of THE FREEMAN). This caused an explosive increase in the
worldwide demand for AAA securities as a result of the needs of regulatory
arbitrage.

"(4) With capital of virtually every international bank invested as
heavily as possible in AAA securities critical to the financial
competitiveness of the bank, the problem was further exacerbated by the
ratings cartel created by the SEC in 1975, which effectively mandated that
companies obtain a rating from Moody's, S&P, or Fitch, who were thus
effectively insulated from the destructive effects of reputational damage
by a system that made it impossible for them to be put out of business by
more accurate upstart rating services. This also prevented better methods
of risk measurement (such as Credit Default Swaps) from replacing ratings.

"(5) Fannie and Freddie fed the supply by creating AAA securities in
gigantic sums, initially from the securitization of high-quality
mortgages, then from lower-quality mortgages that had components
artificially improved in quality from the creation of 'tranches,' and
finally from lower tranches artificially improved in quality as a result
of Credit Default Swap protection from AAA-rated companies such as AIG
(also discussed in my CDS article). AAA ratings that were, in many cases,
undeserved.

"(6) It is also possible, although I haven't thought this through, that
the mortgage lending boom itself was stimulated by the need for AAA
securities to satisfy regulatory arbitrage needs worldwide, and once it
was clear that low-quality mortgages could be turned into AAA securities,
the lowering of lending standards was inevitable, even absent the CRA and
FHA mandates.

"So, thanks to various government interventions, banks operated with the
minimum capital required by the mark-to-market application of the law,
consisting almost entirely of artificially created AAA securities
benefiting from artificially high market pricing resulting from sloppy
ratings. And then reality bit, and an honest revaluation of these
securities based on mark-to-market accounting, linked to inflexible
government regulations, brought down the banking industry. And that is the
extent to which I believe mark-to-market accounting can be blamed for this
crisis. "

David's addition:
Jeff's comment above reminded me of George Kaufman's article. "Deposit Insurance," in the first edition of The Concise Encyclopedia of Economics. Note the following statement in the article:

In the thirties, before deposit insurance, banks held capital of almost 15 percent of assets. (Capital, which consists of money put up by shareholders, is the "cushion" to absorb losses.) Moreover, bank owners had personal double liability. They were liable not only for the amount of their investment, but also for an additional amount up to the par value--the price at which the shares were initially offered--of their shares. By the late seventies bank capital ratios had fallen to only 6 percent of assets and double liability had been abolished.

CATEGORIES: Finance , Monetary Policy"

Me:

Don the libertarian Democrat writes:

I need some help with this. Maybe I'm missing the point.

The point of adding capital as a bank is essentially downgraded is to keep people from attacking the bank for money. As long as they're adding money as they go down, there's no panic.

If I hear that, as my bank is getting worse and worse off, its reserves are going down, I'm immediately heading to that bank, since the bank definitely cannot fulfill all claims.

The only problem arises when they can't get any more capital, at which point they will indeed have problems. You might keep your money in a bank bleeding capital, but count me out.

The problem of the Calling Run is based on uncertainty. Since no one knows what the assets are worth, investors call in the money, if they can, before the business goes bust. Again, in a Calling Run, you might be willing to value assets based on a predicted future, but count me out. I want to know what we can get now.