Lemon Banking

Munich – After the 1982 debt crisis, the Savings & Loan crisis in the United States in the late 1980’s, and the Asian financial crisis of 1997, the sub-prime mortgage crisis is the fourth major banking crisis since World War II, and by far the biggest. According to the IMF, the total loss in terms of balance sheet write-offs will be nearly $1 trillion worldwide, of which the lion’s share probably will be borne by US financial institutions. Given that the combined equity capital stock of all US financial institutions is roughly $1.2 trillion dollars, this is a breathtaking sum.

Why do banking crises happen? Are bank managers ignorant? Why do they underwrite risks that drive their banks to the brink of bankruptcy? The answer lies in a combination of a bad accounting system and various moral-hazard effects that were not contained by existing regulatory systems.

The bad accounting system is the International Financial Reporting Standards (IFRS), which is now used by big companies throughout the world. The deficiency of IFRS is that it does not mitigate systemic contagion resulting from asset price movements. When asset prices move, firms that own these assets are forced to revalue them on their balance sheets quarter by quarter. The timely reporting of non-realized capital gains and losses makes the shares of the company that holds them volatile, sending shock waves through the financial system.

An alternative would be a precautionary accounting system, like the one that all German companies used before the transition to IFRS began. In Germany’s traditional system, a company’s assets were evaluated according to the “lowest value principle”: the lower of an asset’s historical price and its current market price must be used for accounting purposes. This allowed managers to pursue more long-term goals and proved effective in blocking contagion effects. Indeed, it was a major reason for the German financial system’s stability.