The Federal Reserve

One of the most common causes of banking problems is when privately owned banks are used as a source of finance for their owners, other insiders and related enterprises. That has been and still is a problem in the banking system and that it will take some years before prudential regulations, in line with best practice, have been fully phased in. Negligence in the past cannot be corrected overnight but at least an effort has been made. It is believed and agreed upon that the banking system is sound and resilient despite this.

Quality of data is a special problem for banks because most of their assets are loans, which are not traded and have no objectively determined market value. The value of the underlying collateral might also be difficult to determine, particularly if there is no functioning market for it. The valuation of bank assets is principally the responsibility of its managers and without proper accounting and provisioning rules, capital adequacy analysis becomes more or less meaningless. In this area a lot of progress has been made worldwide.

Specific provisions are tax deductible, rules on loan classification and provisioning requirements are in line with best practice, new accounting rules in line with international accounting standards have been declared and issued. These rules will be fully implemented before the end of the year 2006. The prolonged operation of unsound banks makes them even more insolvent and inefficient, which in the end increases the cost to be imposed on the taxpayers, creating an environment of mistrust among them.

Insolvent banks existence and practice, particularly pricing, will distort market functions greatly but this will only keep them alive for a few more months. Many banking sectors have learned from experience that the financial condition of weak banks always is much worse than their financial statements indicate and that the cheapest way of keeping a banking system sound is to force the early and regulated exit of nonviable banks. However, to work properly, such a policy requires a system of prompt corrective action.

References:

Baker, D. (2005). The Federal Reserve Board - The Most Important Source of Poverty in the United States Center for Economic and Policy Research Economics Seminar Series. Baumol, W. and Blinder, A. (2006) Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, United States Epstein, L. and Martin, P. (2003). The Complete Idiot's Guide to the Federal Reserve. Alpha Books. United States Mishkin, F. (1995) The Economics of Money, Banking, and Financial Markets, New York, Harper Collins. United States.