Monday, September 22, 2008

Irish Credit Crisis Worsens

As reported in the Irish Independent ("Banks prepare to write off billions in bad debts under stricter new rules on accounting," 09/18/08), International Financial Reporting Standards ("IFRS") have, since 2005, prohibited banks from building up an allowance for doubtful accounts ("bad debts") in excess of expected write-offs in the short term.

Thus, over the past couple of years, write-offs were low, and banks booked significant profits. Unfortunately, Allied Irish Banks, the Bank of Ireland, and the Anglo Irish Bank — the country's three largest publicly-listed financial institutions — are now looking at write-offs in 2009 and 2010 of approximately €6.5 billion, an increase of more than 200% from two years ago. Added to the recent crises in housing, jobs, education, and the list of usual suspects, Ireland may be looking at a rerun of what's been going on in the United States over the past couple of weeks, as we've noted on this blog.

From an accounting point of view, the new rules are correct, an application of the "matching principle," which states that revenues and expenses are to be recognized in the period in which they are incurred. Taking an overall systems approach, however, and considering current financial institutions, their interrelationships, and the way the system is being egregiously misused and manipulated, forbidding financial institutions to prepare for a rainy day is sheer insanity from an accounting or any other point of view. The accounting profession appears once more to be taking an unfair share of blame for the results of bureaucratic tinkering and political interference with a banking and finance system that should be self-adjusting and regulating.

As we will explain in future postings, the whole money, credit, and insurance system is interrelated, but (consistent with accounting principles of internal control) relies for its stability and soundness on specialization, separation of function, and a careful avoidance of allowing institutions to assume incompatible functions. For example, the regulatory body (the State, which defines and sets standards for weights and measures, including the currency) should never — repeat, never — have the power to create the very money it regulates. Further, the body that authorizes expenditures — such as the State — should never, ever have the power to create money.

It's obvious what happens when the State, with its monopoly over the instruments of coercion, seizes total operational control of a nation's money and credit system, and manipulates it to its own advantage — which it inevitably does. Combining incompatible functions such as deciding what money is, spending money, creating money, and insuring all risks, is a short road to financial chaos and total disaster in a single company, and to complete social meltdown and anarchy throughout society when a State does it. Permitting insurance companies to invest premiums in speculative or risky ventures or (worse) in the very thing they are insuring is to allow insurance companies both to assume risk and spread it around at the same time — another incompatible function. In light of that,

• Banks must be required to maintain 100% reserves of hard assets against their loans and demand deposits, and fractional reserve banking abolished.

• Commercial bank reserves must be in the form of cash, government securities (until all government debt is paid off), or liens on insured hard assets, not unsecured corporate debt instruments or equity shares.

• All commercial bank loans for capital formation must either be discounted at the central bank, or maintained at the commercial bank with 100% reserves, not factored or sold to other financial institutions via commercial paper, CDs, or any form of financial "derivative."

• Insurance companies must insure all loans for capital formation up to 80% or so of the face value of the loan — and be strictly prohibited from investing in anything other than government securities and "blue chip" secured debentures. When any government debt is fully repaid, the reserves must be in the form of sound, secured corporate debentures.

• Any loan that does not qualify for capital credit insurance cannot be made by a commercial bank.

• Commercial banks must maintain "unloanable" reserves in cash or government securities equal to the uninsured principal of their outstanding loans.

• The State must be forbidden absolutely from creating money for public sector operations through its central bank, and restricted to borrowing existing pools of savings (or, better, living within its means and meeting all expenditures out of taxes).

• Central banks must be restricted to acting as depositories for State funds from taxes and user fees for government services, and as banks of issue (banks that create money) for commercial banks which will use the newly-created money for productive private-sector purposes, not government programs.

• Investment banking and commercial banking must be separated.

• Deposit banking and issue ("circulation") banking must be separated.

• Extension of consumer credit not backed by existing accumulations of savings must be curtailed. All future consumer credit must be collateralized, either by clearly identified existing assets that have been accurately appraised, or with "consumer credit insurance," with premiums set by the market-determined rate of risk, and paid by the lender out of the risk premium included in the interest rate charged to the consumer. Insurance companies making consumer credit loans must be forbidden to invest in anything other than government securities or "blue chip" secured debentures.

• Extension of self-liquidating, capital credit must be expanded on a democratic basis to every person.

While this list is far from complete, it does outline the sort of "internal controls" the financial system must embody. It cannot continue to rely on State oversight of incompatible functions, hoping that infinitely clever humanity won't find a way around the near-infinite number of contradictory regulations that attempt to correct individual flaws in the system without looking at the system itself. The system must regulate itself. There must be a structural check on the possibility that an unaccountable elite could seek to gain total power over society by combining centralized control over and access to the money and credit system with the necessarily centralized power of the State over all instruments of coercion. Such power is inherently totalitarian and corrupt.

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