Basel III and Mark to Market Accounting
The Basel III capital adequacy standards are designed to build a minimum level of stress resistance into the financial system and to provide a tool for regulators to monitor the financial condition of individual banks and the system as a whole. The standards consist of a minimum level of equity capital that, combined with other buffer securities, serves as a cushion for protecting creditors and preventing financial failures. As a monitoring tool, a company’s reported level of Basel III capital is a simple form of stress test. The common equity foundation of the Basel III standards is defined (in the US) by generally accepted accounting principles, or GAAP. That is an unstable foundation for reasons discussed below, but primarily because reported GAAP equity is a trailing indicator of financial stress. Effective regulation needs a leading indicator of stress.
As a window into financial stress, GAAP has been deluding financial regulators and financial markets for most of the past century, but it got out of control with the proliferation of securitizations and derivative financial instruments in the decade of the 1970’s and thereafter. Bank regulators and the Securities and Exchange Commission have continued to rely on GAAP numbers through crisis after crisis without seeming to question the suitability of GAAP for alerting markets and regulators well before a crisis becomes a catastrophe. GAAP does not report the effects of most price changes until they are realized through a cash transaction. Most significantly, it does not report price changes that signal potential future losses that are early warning signs of future financial stress. That omission is compounded by the fact that the two most basic risk indicators, earnings and financial leverage, are legally manipulable under GAAP. Thus, the more stressful a company’s financial condition becomes, the more the company is motivated to sweeten its reported earnings and leverage ratios by engaging in legal accounting gimmickry. So, GAAP is not only deficient as an early detector of financial stress, it is actually a facilitator of stress cover-up. GAAP is a shaky foundation for a stress detection system.
The Basel III capital standards deal with stress detection by specifying a hierarchy of percentages of total capital that banks should maintain in regulatory capital form - common equity of four and a half percent is the core. Both GAAP assets and liabilities are risk weighted before the capital percentages are calculated. Risk weighting modifies the level of stress protection, but the core of the Basel III standards is still made of GAAP equity. And since GAAP is always late to report losses, when a bank’s equity approaches the technical insolvency level - GAAP liabilities exceed GAAP assets, risk weighted or not - it is a virtual certainty that the bank’s real net worth is much deeper in the red, whether measured on a liquidation basis or a going concern mark to market basis. By the time regulators discover that a large part of a bank’s GAAP equity has evaporated, it will often be too late to prevent the bank’s failure and a possible domino reaction through interconnected companies.
Financial regulators need to come to grips with the fact that today’s GAAP is incapable of coping with today’s fast moving and risk filled economy. Risk is the fountain of financial failure. GAAP is not risk sensitive. So, financial crises develop while GAAP looks in the rear view mirror at historical prices and regulators tolerate manipulation of GAAP earnings and leverage to mask financial stress. Although the most recent national crisis centered on banking, banks are not the only problem. The Enron’s of the world need better risk reporting too. Accounting reform is badly needed.
The basics of needed reform are simple: First, all assets and liabilities should be on company balance sheets - no more off balance sheet liabilities or special purpose financing entities whose only purpose is to obfuscate and mislead. Second, all assets and liabilities should be measured at fair market value, marked to market. If informed by mark to market accounting, the capital markets would be the best evaluator of the relative risk of companies’ failure and the best motivator, through differential share prices and borrowing costs, for companies to take corrective action in response to early warning signs of stress.
With an accounting system built on market values, regulators could build capital adequacy standards on the bedrock of economic value. That is because the net sum of marked to market assets and liabilities is the real value – the economic value - of common equity capital. From a bank regulator’s point of view, a substantial amount of economic net worth is the ultimate cushion for protecting creditors. Shrinking economic net worth is the ultimate leading indicator of financial stress. Early reaction to shrinking economic net worth – first by the capital markets and then, if necessary, by the financial regulators - is the ultimate way to protect taxpayers and to guard against systemic failure.