Federal Reserve Regulator Hits Principles-Based Accounting

Thomas Hoenig wants the United States to move beyond crisis mode and figure out how to stop the next meltdown.

Warning the crowd at a global banking industry conference not to “misdiagnose the problem,” Thomas Hoenig, president of the Federal Reserve Bank of Kansas City said that the current U.S. banking and supervision structure is not the cause of the credit crisis. The “hard truth” is that many corporate, government, and oversight officials saw the credit crisis coming, but ignored it during the boom years, he said.

Speaking at a breakfast sponsored by the Institute of International Bankers today, Hoenig took the podium after newly-appointed interim assistant secretary of the Treasury Neel Kashkari outlined more details about the government’s Troubled Asset Relief Program (TARP). TARP is the Treasury Department’s program to buy up toxic mortgage assets from troubled banks.

Soon after the breakfast, Treasury Secretary Henry Paulson called a meeting of the top U.S.-based commercial and investment banks — slated for 3 PM today.

Interestingly, Hoenig brought up accounting issues in his talk, noting that he supports a rules-based system, rather than accounting standards based on principles. He criticized principles as being vague and fostering “volumes” of regulatory interpretations. The danger, he explained, is that interpretations are often “worked to circumstances” in an effort to make them “more procyclical.”

Further, he said, any set of accounting rules should have three basic elements: They need to be simple, understandable, and enforceable. Hoenig asserted that the more complex a set of principles and interpretations, the less enforceable they become.

The Financial Accounting Standards Board and the Securities and Exchange Commission have been working over the last several years to address the complex nature of U.S. generally accepted accounting principles — which has mushroomed into 25,000 pages of rules and interpretations. (International Financial Reporting Standards number about 2,500 pages). Part of that effort is to move U.S. GAAP toward what many observers refer to as a more “principles based” system similar to IFRS. According to Hoenig, though, that approach may entail a daunting Catch-22.

Thus, by slowly removing bright-line rules from accounting literature and encouraging financial statement preparers and auditors to use more judgment, FASB and the SEC would likely be called upon to issue more interpretations. Whether they would resist that call from preparers and auditors remains to be seen.

Despite mention of accounting, Hoenig’s remarks generally focused on banking regulation and the part it could play in averting another crisis. Looking ahead, he listed several issues that emerged from the crisis that he believes should be addressed immediately, before another crisis hits.

To that end, Hoenig suggested forming task forces to examine each area. He called the issues “hard and controversial,” but stessed the need to address them sooner, rather than later. For instance, Hoenig said that as banking consolidations continue, there is a need to examine the rise of a financial oligarchy and the ramifications of such concentrated power.

In addition, he said, the government should examine the appropriate degree of intervention by centralized banks to stop failures, the premiums that should be paid by institutions being rescued, and creation of a systematic way to intervene so it is not done in crisis mode.

Hoenig also called for an examination of what the proper level of oversight for hedge and equity funds — which he said would not be “easy or popular — should be. Other areas in need of scrutiny, he said, are what guarantees the government should provide to investors and the “unintended consequences” and “moral hazards” created by extending government safety nets.

The regulator said that the $700 billion rescue plan was an important first step, and that implementation of the plan is critical. And while he fully expects the United States and the global markets to “clear the crisis,” he called on regulators to address and work out the “thorny issues” in advance of the next crisis.

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