Confronting High Risk and Banks

Floyd Norris|The New York Times

Did accounting help cause the financial crisis?

A minuet playing out now is showing that the answer is yes — but not in the way the banks want us to believe.

The issue is a couple of new accounting rules that are forcing banks to put back on their balance sheets some strange creations that bad accounting rules had allowed them to shunt aside in the past.

The Federal Reserve headquarters in Washington, DC.

The banks have accepted the inevitability of that change. But they are asking the bank regulators to make the rules easier to live with by phasing them in. Otherwise, the banks say, they would need to raise more capital or cut back lending.

The Federal Deposit Insurance Corporation, one of the regulators, has indicated it would consider that request this week, and Sheila Bair, the F.D.I.C. chairwoman, has voiced some sympathy for the banks’ desire to delay the impact. But she added that those assets should have been on the balance sheets all along, and that banks should have been required to set aside capital in case their value plunged.

Robert Herz, the chairman of the Financial Accounting Standards Board, which wrote both the rules that were used to justify the off-balance sheet shenanigans and the new rules that bar them, thinks banks violated the old rules, in at least some cases. Perhaps so, but auditors signed off, which at a minimum indicates the rules were not well written.

The logic of the off-balance sheet treatment of such things as structured investment vehicles, or SIVs, which banks created in order to get assets off their books, was that the bank did not control them, and so did not have to show the SIV assets, and liabilities, on its own books.

That fiction evaporated early in the financial crisis. Some SIVs were among the first structures to fail, when they could not roll over loans to finance assets that had lost value. The banks chose to, or had to, rescue the SIVs. Maybe they did so to guard their reputations, or maybe they feared they would have been vulnerable to fraud allegations from those who lent to the leaking SIVs. In either case, it turned out there was a black hole that the regulatory rules had ignored in assessing how much capital the banks needed to hold.

There are other examples. Bank holding companies have been allowed to issue something called “trust preferred securities.” The beauty of those securities was that they were really debt that the holding companies could call capital. Having that “capital” meant the bank could take on more debt. A system that lets a bank borrow more money because it has already borrowed money — rather than because it has sold stock — is hardly a wise one.

All this was part of what financial engineers openly called “capital arbitrage,” in which they created securities and structures whose purpose was to let banks slide around the capital rules. Regulators seem to have responded by assuming that everything would be fine.

“Capital arbitrage has been an issue for years,” Ms. Bair told me this week. “Nobody wanted to take away the punch bowl.” She thinks a council of regulators, with an appointed chairman, could monitor the systemic risk created by rising risk levels in the banking system and take away the bowl the next time.

Of course, banks also engaged in regulatory arbitrage, by moving from one regulator to another to seek more lenient treatment. Their route to regulatory success — at least in terms of building an empire — was to spike the punch bowl.

The banks now want to stop FASB from forcing them to mark assets to market, or reveal their current market value. And they have some sympathy from bank regulators, which fear that marking to market can make banks look too healthy in good times and too unhealthy in bad times.

That appalls investors. “The purpose of financial reporting is to convey the results of the company,” said Sandra Peters, the director of financial reporting for the CFA Institute, an investor advocacy group. “It is not to assure the company stays around.”

Mr. Herz, the chairman of the accounting standards board that determines what are “generally accepted accounting principles,” or GAAP, this week proposed further “decoupling” of capital rules and accounting standards. He noted that in some cases the capital rules were already stricter than accounting rules, and said that if bank regulators want to base the capital rules on the original cost of assets, rather than market value, they should at least let investors also see the market value. “Handcuffing regulators to GAAP or distorting GAAP to always fit the needs of regulators is inconsistent with the different purposes of financial reporting and prudential regulation,” he said in a speech.

Ms. Bair sounded hesitant about that when I spoke to her, saying she was concerned that decoupling could lead FASB to stop listening to bank regulators, something Mr. Herz said would not happen.

The Spanish example

She said she would like to see one accounting change that FASB is talking about, which would make it easier for banks to take reserves against loans in good times. “With better reserving methodology,” she said, capital and reserves would have been higher before the current crisis erupted, and banks safer.

The financial crisis showed that regulators should have required banks to hold much more capital than they did. Some regulators figured that out.

In Spain, some smaller banks are in trouble from real estate loans, but the big banks seem to have emerged in good shape. One reason is that Spanish regulators were not fooled by things like SIVs, and insisted that if any bank wanted to create one, it could, but would have to hold reserves anyway. Since there was no business reason — other than capital arbitrage — for a SIV, those banks shied away. Good regulation is not easy. A new paper by Amir E. Khandani and Andrew W. Lo of M.I.T., and Robert C. Merton of Harvard, estimates that repeated “cash-out” refinancings of mortgages led to more than $1 trillion in additional losses in this crisis.

It used to be that people who had owned homes for a longer time were less leveraged than recent purchasers, but the refinancing boom changed that. “A coordinated increase in leverage among homeowners during good times will lead to sharply higher correlations in defaults among those same homeowners in bad times,” they wrote.

But they added that it was hard to imagine any existing regulator acting against any of the causes of the refinancing boom — rising home prices, new mortgage products and low interest rates. Those developments allowed more people to buy homes, made Americans richer, and fueled both economic growth and consumer spending.

“Which politician or regulator would seek to interrupt such a virtuous circle?” they asked. “How could such a maverick accomplish the task?”

Their solution is to create a systemic risk regulator. But it is far from clear that such a regulator, had it been around the last time, would have had the wisdom to take away the punch bowl in time. If it had, it probably would have lacked the power.

Nonetheless, it is a good idea to try such a regulator, and to give the job to someone who is not conflicted by other responsibilities. Expecting any regulator to perform multiple tasks is asking for trouble when goals may conflict. The Fed’s pursuit of economic growth helped to create the refinancing boom that backfired.

That fact is why multiple regulators can make sense. The Securities and Exchange Commission, which supervises FASB, knows that investor protection is its job. Bank regulators have nothing against that, but it is not a primary goal. It is to be hoped that the bank regulators will adopt wise capital standards, but not at the expense of letting investors know what is going on.

Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.