Why FAS 166 and 167 Rules Are Wrong

The Financial Accounting Standards Board, whose edicts are enforced by the U.S. government, issued two rules pertaining to off-balance sheet securities which went into effect last year: FAS 166 & 167. These rules ordered financial institutions to place securities previously deemed "qualifying special-purpose entities" back onto balance sheets. They also forced consolidation of an expanded range of "variable interest entities" onto the balance sheet. These rules are significant in the current environment because securitization enables lending, and they have effectively choked off securitization.

The affected securities had initially been allowed off the balance sheet because their complex ownership and obligation structures were not necessarily appropriate to a simple balance sheet recording. The benefit to the banks of this arrangement is that the assets and liabilities associated with these securities do not count against the bank in terms of its regulatory capital requirements under Basel or local regulations.

At first glance, the rules have an indisputable logic behind them. Securities are securities, and they belong on a balance sheet. Banks cannot leave potential liabilities off a balance sheet just because they want to lend more to make more money. These securities should not be special in the eyes of the law. They should have equal status and be placed on the balance sheet just like every other security.

This logic ignores the reality of a fundamentally unjust system. If a bank sees an opportunity to lend, it ought to be able to lend, and it should be able to leverage however much it wants without government interference. As long as there is no fraud involved (as defined by the law, not by leftists), it should be legally accountable only to its shareholders. If it wants to run a leveraging scheme 10 standard deviations from the market average, it should have an absolute legal right to do so. Who can argue with that?

Some undoubtedly will. Their counterargument will be that irresponsible bank policies endanger counterparties and those downstream of the counterparties. This is true, but such an outcome is an aspect of living in a free society. People are responsible for their own economic decisions, including whom they choose to deal with. From those choices, economic winners and economic losers will emerge. The government should not try to protect anyone from the consequences of their decisions. Business is not the business of government.

But banks are insured by the FDIC, they will say, and the taxpayer is on the hook to cover their depositors should they fail, so the government has the right to get into their books and make rules to ensure they behave responsibly. Actually, banks fund the FDIC through fees, and when the system is distressed, those fees go up. But even if the taxpayer were footing the FDIC's bill, the salient question in everyone's mind should be: Why is there an FDIC in the first place?

The government should not be mandating, regulating, or providing insurance of any kind. The FDIC should never have been allowed to come into being, and it should be abolished immediately. The FDIC is the single biggest pretext for government interference in the financial sector. It has been used to justify all manner of government-imposed evils, from capital regimes to accounting regimes to restrictions on what activities an institution can perform. If there were no FDIC, the number one pretext for federal government interference would evaporate, and so would the FDIC's distorting effects on the market.

The same argument applies to TARP and other bailouts. TARP was shamefully imposed on the banks in the fall of 2008. It was an alarming abrogation of individual rights and a breakdown of the rule of law on many levels. It should never have happened. Even if all the banks had approached the government on bended knee, politicians have the authority and the obligation to reject the request - and politicians are constitutionally accountable to the citizenry. Banks are not, nor should they be. Banks cannot compel human beings by means of physical force. Politicians can.

If people do not like market crashes and bailout requests, then they should stop supporting government interventions into the private sector, like procyclical accounting and capital regimes, which cause the market to crash in the first place. Then they should hold their politicians accountable for how they wield power. Blaming bankers for what the government chooses to do is almost as ridiculous and intellectually dishonest as a libertarian who Occupies Wall Street.

But wouldn't irresponsible bank policies also endanger the entire monetary system? After all, banks are leveraging dollars, the public currency. Spectacular losses deflate the currency which everyone uses, and that is true under a gold standard as much as under a baseless monetary regime.

This is actually an argument against public currency. If currency were denationalized, then the fallout from a given bank's bad policies would necessarily be circumscribed. No one would take the consequences except those who were foolish enough to voluntarily transact with them, directly or indirectly. For those who would argue that too many poor or unsuspecting people would be affected by a bank collapse, two words will suffice: Due diligence.

If currencies were private, there would be no need for seeming accounting gimmicks to justify the kinds of things banks need to do to survive and make a profit. Banks could execute whatever strategy they deemed best, and individuals and institutions would be free to take it or leave it.

But what if the existence of off-balance sheet securities heralds a bloated system, one in which there is simply too much securitizing? Those with Austrian School leanings argue that there has been a misallocation of minds and capital into the financial sector and that these resources would best flow into other sectors to fuel genuine economic advances.

There had certainly been a significant influx of MBAs and capital into the financial sector in the last decade, but this observation does not justify government intervention, even on its own terms. The "right" level of leveraging or resource allocations can only be claimed with reference to a market system that is free, and the very existence of rules such as FAS 166 & 167 mean that the system is not free. In a statist system, with a public currency and all manner of government interference, technically, everything is wrong. The entire system is artificial, and each parameter is different from what it otherwise would be in a free market system.

How then to rank the illegitimacy of government interventions?

There are levels of wrongness. A radical government squelching of any parameter, such as lending capacity, is the most obviously wrong because it causes mass pain, disruption, and unnecessary destruction. A rule like FAS 166 does not just entail a reorganization of the books. At the lowest level, it means that farmers cannot get loans and have to plant fewer crops; more and more retailers go out of business; employees get laid off because their companies can no longer expand; retirement accounts lose value because a condition of impaired credit creation results in a general downward pressure on prices.

Such rules are even more wrong in the context of financial or economic distress. These rules went into effect at a time when the banking sector and the economy at large were just recovering from a crash of historic proportions. A rule which contracts lending capacity (i.e., the money supply) further is the most wrong kind.

The Federal Reserve estimated in April 2009 that there were about $900B in off-balance sheet securities affected by these rules. If even 10% of the value of these securities were subsequently written down or were lost in credit creation capacity as a result of new balance sheet dynamics, the loss to the American financial sector from these two rules alone is quadruple what Dodd-Frank is estimated to cost large U.S. banks.

It is also in the same range as the much-hyped credit losses on all U.S. subprime and Alt-A loans during the 2007-2009 financial crisis.

There is no rational case for FAS 166 & 167. Repeal them.