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Accounting standards shouldn’t be left to the accountants

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The SEC and FASB are at it again with a plan requiring banks to forecast and book “current expected credit losses” over the life of loans without even a credit for expected interest income. Bank regulators are dutifully moving forward with plans to implement the new accounting standards.

The impact could be very negative for most banks, but particularly those that hold mortgages and other longer-term loans. A typical community bank might have as much as half of its balance sheet in residential mortgage loans. Forecasting and booking losses over the life of a 30-year mortgage is highly speculative at best — and requiring it to be done would probably sound the death knell for long-term mortgages.

Unfortunately, this is not our first experience with the Securities and Exchange Commission and its partner, the Financial Accounting Standards Board, trying force banks out of the business of longer-term lending. Mark-to-market (sometimes called “fair value”) accounting was imposed by them in the 1990s and led directly to at least $500 billion loan write-downs for insured depository institutions in the U.S. during the financial debacle of 2008-2010.

That fiasco produced a lost decade in the economy, a badly bloated Federal Reserve balance sheet that the Fed is still trying to unwind, nationalization of Fannie Mae and Freddie Mac, the misguided $700 billion TARP legislation and imposition of the smothering Dodd-Frank legislation on banks.

Things got so bad that Congress held oversight hearings at which bank regulators, the SEC, FASB and others (including yours truly) were invited to testify. Congressional leaders admonished the SEC and FASB to reverse course or Congress would legislate a solution. Mark-to-market accounting was brought to an end, but too late as the damage was already inflicted.

During the debate over mark-to-market accounting, then SEC Chairman Christopher Cox wrote: “Accounting standards should not be viewed as a fiscal policy tool to stimulate or moderate economic growth, but rather as a means of producing objective measurements of the financial performance of public companies. Accounting standards aren’t just another financial rudder to be pulled when the economic ship drifts in the wrong direction. ... [E]ffective standards require a dispassionate arbiter ... [a] standard setter must be independent ... from the political process ... .”

Nice words, but utterly divorced from history and economic reality. The SEC’s leadership in the 1990s theorized that the S&L crisis would not have gotten out of hand had S&Ls been required to mark their assets to market values. The SEC crammed down FASB’s throat market value accounting despite strenuous objections from the Treasury secretary, the chairman of the Federal Reserve, the chairman of the Federal Deposit Insurance Corp. and leading accounting firms.

Opponents of market value accounting felt that marking to market only a portion of the asset side of bank balance sheets would not capture the totality of the business and would produce misleading accounting. They also believed it would inhibit banks in performing their critical function of converting short-term deposits into longer-term loans.

Critics also complained that market value accounting would be highly procyclical, would produce extreme volatility in bank earnings and capital, and would lead to severe credit contractions — each of which came to pass. Finally, opponents noted that bank regulators abandoned market value accounting in 1938 because they found it was discouraging bank lending and preventing recovery from the Great Depression.

Chairman Cox went on: “Financial reporting is intended to meet the needs of investors. While financial reporting may serve as a starting point for other users, such as prudential regulators, the information content provided to investors should not be compromised to meet other needs.”

Speaking of protecting investors, recall that the SEC in 1999 inhibited banks from creating adequate loan loss reserves because it might lead to “earnings management”; allowed investment banks to massively increase their leverage in 2004, leading to the collapse and near collapse of that industry’s leading firms; eliminated restrictions on short sellers that had been in place since the Great Depression; and failed to notice the largest Ponzi scheme in history, Bernard Madoff.

Congress needs to establish a much better system for setting accounting standards. If the FASB remains the standards setter, it should be overseen by the Federal Reserve and the FDIC, the two agencies whose primary function is to maintain stability in our economy and financial system. Accounting rules are much too important to be left to an anonymous board of accountants and an SEC that does not understand prudential regulation.

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Accounting methods CECL Policymaking Financial regulations FASB SEC
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