Friday, 25 July 2008

Ship, meet iceberg

Loath though I am to quote from a Murdoch publication - just look at the sad decline of the WSJ to see what being owned by him does to a paper - I do want to comment on something by Anatole Kaletsky yesterday. Fortunately it is an utterly wrong-headed piece which misunderstands fair value accounting. First the good bit:
the whole point of a bank is to exchange short-term, liquid, fixed-value liabilities for long-term, illiquid assets whose value is hard to gauge - this liquidity and maturity transformation is, in fact, the main social function that a banking system provides.
Agreed. But here's the thing. Banks can only do that if people have the confidence to give them their money to lend to someone else. That depends, for the retail investor, on deposit insurance; and for the wholesale depositor, on credit quality. Both of those in turn rely on the bank being well capitalised: regulators demand it to reduce moral hazard, and market counterparties need it as part of their risk assessment.

Now how can we tell if a bank is well capitalised if it is allowed to pretend nothing is wrong until it actually suffers losses? That is what accrual is all about - the fiction that all is well while the ship steers at full speed towards the iceberg. At least fair value shows you what is ahead.

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