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Fight casino capitalism


The sinking of Silicon Valley Bank and Credit Suisse have rocked financial markets around the world. Prof. Hans-Werner Sinn urgently advocates a rapid change in the accounting rules.

The sinking of Silicon Valley Bank and Credit Suisse have rocked financial markets around the world.

Prof. Hans-Werner Sinn urgently advocates a rapid change in the accounting rules.

Munich - The bankruptcy of the Silicon Valley Bank, which collected deposits from start-ups and invested them in securities, is reminiscent of the so-called founder's crash of 1873, which emanated from the German-speaking countries and gripped the whole world.

At that time, the most important start-ups came from the manufacturing industry, for example from the railway, electrical and chemical sectors.

However, many new banks and financial companies also drifted with the tide.

In fact, it was companies like this that got out of hand after the bursting of a huge economic bubble and caused a banking crisis.

As a reaction to the crisis, there was an important reform of accounting law in Germany, which could also be groundbreaking today.  

Under the protection of stock corporation law, which exempted company founders from personal liability, many new investment banks were founded in the German and Austro-Hungarian empires in the second half of the 19th century, which collected deposits in order to purchase securities.

The stock market upturn that also resulted from this ultimately turned out to be an economic bubble.

The bubble burst in May 1873, a few days after the Österreichische Creditanstalt, the most important bank in Austria-Hungary at the time, parted with a very large portfolio of securities due to rumors of bankruptcy.

The stock market crash on “Black Friday” May 9th and a wave of bankruptcies of unprecedented proportions were the result.

In Austria-Hungary and Germany, a significant proportion of the newly founded stock corporations in the financial sector went bankrupt.

Adele Spitzeneders Bank, which operated exactly the same business as later Charles Ponzi or Bernard L. Meadows in the USA, is only representative of the shaky business of many new financial institutions of those days.

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The central banks' lax interest rate policy leads to a valuation bubble

The parallels to today's crisis are of course limited, because history is known to never repeat itself exactly.

In fact, the new banking crisis was not only caused by an irrational exaggeration of the markets, but also by the foreseeable consequences of a valuation bubble that had emerged as a result of the zero and negative interest rate policies of the central banks.

The unprecedented expansion of the money supply, which the central banks caused through the purchase of government securities, had generated fantastic value increases in older government securities already on the market and also in stocks for a good decade.

These increases in value attracted more and more investors.

In the wake of the pandemic and escalating government debt, there was very strong inflation, which the central banks want to curb with a drastic interest rate hike.

The previously inflated market values ​​of long-term securities then collapsed.

That broke the neck of Silicon Valley Bank and a few days later of Credit Suisse, one of the largest banks in the world.

In the USA, as in Germany at the time, the valuation of investments at market values ​​(mark-to-market or fair value principle) contributed to overheating and the formation of bubbles.

This valuation method made balance sheets volatile and amplified cycles.

During the upswing, there are increases in the value of the companies' investments, which mathematically suggest an increase in equity.

The growing balance sheet stock of equity pretends that the companies' creditworthiness is increasing, which puts them in a position to take deposits and loans in order to pay dividends.

Of course, there is a lack of equity in the amount of the dividends when the bubble bursts and the values ​​of the investments return to the normal level.

The ups and downs in prices systematically lead to companies being undermined, thereby increasing the risk of bankruptcy.  

Banks: privatization of profits, socialization of losses

In conjunction with the limitation of liability of stock corporations, the mark-to-market principle also causes companies in the financial sector to dare excessively risky business models.

In the hope that prices will rise, they buy bonds and other financial products during the upswing.

When the hoped-for profits materialize, they are distributed to shareholders.

And when the bubble bursts, in the worst case you only lose what little equity you were allowed to operate with thanks to lax regulation.

Today, one also rightly hopes to be saved from bankruptcy by government bail-out campaigns.

From the privatization of the profits when the bubble builds up and the socialization or at least the transfer of the losses to third parties when they burst, a business profit arises over time even if

In 1874, Germany reacted to the casino capitalism generated by the mark-to-market method by introducing the lowest value principle into its accounting law (cf. Sinn, Casino Capitalism, Oxford University Press 2010, Chapters 5 and 7).

According to this principle, companies are obliged to always take the lowest possible valuation of their assets: either the current market value or the historical purchase price, whichever is lower.

The lower of cost or market principle has meant that companies have hidden reserves in their balance sheets after an upswing, with which losses in the downturn could be cushioned.

In principle, it has given the German banking system a high degree of stability.

The lowest value principle versus casino capitalism

In German commercial law, the lower of cost or market principle still applies to public limited companies and other corporations that are not traded on a stock exchange.

However, since 2004 it has been successively replaced for corporations by the regulations of the International Financial Reporting Standard (IFRS) with its mark-to-market method as a result of EU resolutions.

In the United States and many other Western countries, the mark-to-market or fair value method is generally accepted as a central element of the general accounting principles (GAAP) for all types of companies.

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Revise accounting rules urgently

In view of the new start-up crisis, it is advisable to replace the valuation method based on market values ​​with the lowest value principle.

At the same time, measures could be taken to strengthen the disclosed equity.

Consideration should be given to relating the regulatory minimum ratios for capital to simple total assets rather than to the sum of risk-weighted assets.

The risk-weighted assets are usually only a fraction of the real balance sheet total, because many investments are only recorded very insufficiently.

For example, government bonds are not included at all, although they have proven to be particularly susceptible to interest rate risks in the current crisis.

This would cut the bottom out of casino capitalism.

Such reforms would make financial crises less likely, and governments would be less likely to resort to expensive bail-outs.

Economic development would be smoother and more sustainable.

It would be easier for the defenders of the market economy to convince their critics of the blessings of this form of economy.

About the author: Prof. Hans-Werner Sinn, retired professor of economics and public finance at the Ludwig-Maximilians-University in Munich, was President of the Munich ifo Institute for Economic Research and advisor to the German Ministry of Economic Affairs.

His latest book is entitled: The miraculous increase in money: National debt, negative interest, inflation, Herder, Freiburg 2021.

Source: merkur

All news articles on 2023-03-30

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