In banking and finance, pretending that risky things aren’t risky is a formula for disaster. History teaches this lesson repeatedly, including our recent history in the financial crisis of 2007-2009. “Those who don’t learn from history are doomed to repeat it,” the saying goes. Sadly, we may want to consider if our financial market policymakers, including accounting standard setters, may be repeating our mistakes of the past.
On December 7, the Governmental Accounting Standards Board will vote on its proposal to exempt Local Government Investment Pools (a cash management tool for many state and local governments) from new SEC regulations calling for some money funds to cease using amortized cost accounting, and begin to adopt “floating” values for shares in the fund.
The new SEC regulations could well be a step in the right direction. In our money markets, including basic bank deposit accounts, history is sadly replete with examples of massive dislocation arising from distorted views of the value of “money,” including assumptions of fixed values for money assets offered by institutions with varying credit quality.
After the Panic of 1907, the U.S.A. created a new solution for banking instability – a central bank, the Federal Reserve System. Twenty years later, despite (or because of) this new source of stability, the country endured the then-worst banking crisis in our nation’s history.
So we added new government corporations to the mix – deposit insurance from government corporations like the FDIC and FSLIC. They and the Fed moved forward in their efforts to inspire confidence in money. For several decades, things worked more or less OK, at least on the surface -- altho rising inflation in the 1970s certainly undermined some of that confidence, with significant economic consequences. But we really had our lunch handed to us again in the late 1980s in the savings and loan and deposit insurance crisis, costing taxpayers somewhere in the hundreds of billions of dollars.
Lessons were available, but sadly unlearned. Moral hazard issues raised by the government’s safety net for financial markets led risk-taking to bubble and boil, under the surface. A longer story, of course, but one that culminated in perhaps the worst financial crisis in our nation’s history, in 2007-2009.
Maybe we can trace an important source of the problem to a simple accounting issue. On the balance sheet, “cash,” or, interestingly, “cash and cash equivalents,” is at the top. They are the most “liquid” assets, by fiat. And they are traditionally accounted for at face value – even if they (like uninsured deposits) are risky.
To repeat, pretending that risky things aren’t risky is a recipe for disaster. Especially if the pretending is driven in part by expectations for government bailouts.
In the latest GASB proposal, we appear to be moving in that direction – in important part because GASB is also choosing to rely on some of the same institutions that got us into our latest and greatest disaster for deciding what is or is not an acceptable instrument for “par value” accounting – ratings by ratings “agencies.” You can see GASB’s exposure draft on this proposal here. Search on the term “NRSRO” to get a feel for how many times these references arise. “NRSRO” stands for “Nationally Recognized Statistical Rating Organization,” applied to those firms granted recognition for their ratings for regulatory purposes. Among other places, regulatory reliance on NRSRO ratings in bank capital regulation proved to be a central point of failure in our woefully-undercapitalized banking system, heading into the 2007-2009 meltdown.
Granted, as backers of the proposal – including large money market mutual fund companies – have argued, many local governments operate under rules restricting their investments in “floating NAV” (net asset value) instruments. But maybe those rules themselves are also at fault.