Regulatory Obfuscation and Accounting Gimmickry Have Been the Preferred Approaches of Central Banking with Respect to Capital Inadequacy in Banking

Today [June 1990], many large banks are operating with capital ratios below 5 percent. But even these ratios overstate capital adequacy in the banking system because banks do not adjust the value of their loan portfolios to reflect market values. The resort to accounting gimmickry to mask weakness in the banking system is not new, although it is accelerated when that weakness becomes widespread. One economist noted that “indeed, the use of book value accounting in banking was promoted by regulators in the 1930s to deliberately mask the banks’ poor financial condition . . . . It appears that opposition to market value accounting comes less from banks themselves than from the regulators.” The practical difficulties of marking loans to market value are starting to be overcome with the rise of a secondary market for bank loans. But this market is simultaneously providing evidence of how far bank loan values are overstated. For example, most banks have written down loans to Latin American countries by 25 percent, carrying them in effect at 75 cents on the dollar. Yet the secondary market for such debt shows its market value to be approximately 25 cents (as of late 1989) and declining rapidly, from 65 cents only 1 year earlier. Many money center banks would wipe out their equity cushion by recognizing the market value of these loans alone. The market for bank stocks has reflected this fact better than bank accountants and regulators (who should know better), as investors discount bank stock prices in relation to book values. Capital adequacy also has been overstated to the extent that banks have moved a significant amount of their liabilities off the balance sheet in the form of credit commitments, interest rate swaps, and standby letters of credit. The most important point is that regulatory obfuscation and accounting gimmickry, not genuine reform, have been the preferred approaches of central banking with respect to capital inadequacy in banking. 

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 65-66.