Mark-to-Market Rules and Capital Reserve Ratios

There was talk of repealing the April changes in the mark-to-market laws at the FASB meeting in July. This is significant news for the debate on capital reserve ratios. Back in April, the rule change allowed for banks to avoid having to mark down their asset values in temporary economic dips. This remedied a problem that exacerbated financial institution troubles in the fall of 2008 and early 2009 as asset prices dipped causing banks to scramble for cash to stabilize their balance sheets.

Sure, the price of any good is what someone will give you for it. But if you have a good that you don’t plan on selling for sometime and the price has dropped recently because of an abnormal flood of similar products into the market temporarily increasing supply and lowering price, that shouldn’t mean financial institutions should immediately mark down all of their assets. The immediately forced mark down in an illiquid economy was a significant problem for banks, and might have helped stave off Morgan Stanley, Wachovia, or WaMu’s breakups (I say that not knowing all the details of those firms troubles, so I understand there is more to it than just this).

The April rule change I think was prudent. It allows for firms to hold constant their valuing of assets in terms of figuring out how much reserve cash to hold on hand relative to debt. Of course, such a scenario is not designed to be permanent. And once an illiquid market or extraordinary situation is passed, if the supply of the asset remains high, pushing down the asset values, then banks will need to mark them down. But according to notes from the July FASB meeting, has highlighted by this Atlantic piece, the prudent steps may be reversed.

Now, here is why this matters for the capital reserve ratio debate. Banks (I use that term broadly) were clearly caught with their pants around their ankles when the market dropped. That is due in part to problems of euphoria over gains, bets from traders that they could pull out before the ships sunk (and some did), and moral hazard created from previous bailouts of financial institutions considered too interconnected to fail. But a key element underpinning a lot of that was that banks over leveraged themselves, took on too much debt and did not hold on to enough cash relative to their debts. When overnight lending ceased, and capital became impossible to raise with freezing markets, some banks didn’t have enough money to pay the bills. (An oversimplification, yes, but basically accurate.) If banks had kept more capital (cash) available, then there would have been less concern about the health of banks, less people would have been pulling out of investments, there wouldn’t have been as much of a perceived “need” to bailout the market, etc. etc. There is a chain of events that largely stems from reserve ratios.

So most people think we need to raise those reserve requirements. But with the mark-to-market law change, this isn’t as necessary. When the value of assets a bank holds goes down it decreases the value of the collateral they are holding relative to the debt they are carrying elsewhere. They have to make up the different in reserve cash. However, since banks don’t have to do that in a crisis as of April, many firms would be okay until the crisis clears. There are some banks that would have gone down anyway, simply becoming insolvent (Bear Stearns was one of those, Lehman was too, but AIG wasn’t necessarily, they were over leveraged on insurance contracts from other firms that went under.) Thus, there might not be as much of a need to change this—unless the FASB reverts its rule change.

Even still, I wonder how much of capital reserve ratio laws strike at the personal responsibility of banks. The President’s plan for Wall Street regulations, now in the hands of Congress, puts reserve ratios into the new systemic risk management three tier system. Firms deemed too big to let fail will be labled Tier 1 and, among other things, be subject to the highest standards for keeping cash around in the case of another economic downturn.

But here is the thing: all the talk around increasing reserve ratios is couched in an assumption that the government should have some role in regulating risk. And the only reason that the government would feel the need to do that is to protect other actors in the market from the misdeeds of another. But shouldn’t banks take the potential failure of rivals, and the subsequent hit to the market, into consideration when thinking about one’s own risk? Its like speed limits. On the Autobahn, you know there are no speed limits. You know there is the possibility of another crashing into you, and you take this into consideration as you maneuver on the road. Or when you pick the car you choose to drive on the Autobahn. (I suggest against the Yugo.) So maybe, firms should just be held responsible for their actions.