Wednesday, September 17, 2008

Relaxation of Regulatory Capital Rules

(Credit Slips) The Fed seems to be knocking down every firewall that exists in banking regulation in an effort to stanch the current crisis. The danger, of course, is that by demolishing prudential firewalls, the crisis could grow even bigger. The latest casualty: accounting standards. Banks will now be permitted to count goodwill toward their Tier I capital requirements.

Goodwill is a very problematic asset--it doesn't have much (if any) liquidation value and can't be sold by itself. No one will lend against goodwill. If capital requirements are really about ensuring that there is a solid fundamental core of assets backing lending operations, counting goodwill is quite questionable. The most troubling part of this is that we've been here before--in the S&L crisis, when the Federal Home Loan Bank Board (now OTS) permitted thrifts to count goodwill toward regulatory capital. The results weren't pretty, as counting goodwill toward capital masked institutional insolvency and permitted thrifts to get even more leveraged relative to real assets. (See U.S. v. Winstar, 518 U.S. 839 (1996) for a concise discussion of the goodwill problem with thrift accounting).

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