By William Isaac, Published by Forbes

Government leaders seem surprised that bank lending is in a downward spiral. But the only surprise is that it is taking so long for us to understand that government policies are a big part of the problem.

In economic downturns banks tighten lending standards, and bank examiners become increasingly critical about loan quality. Government needs to mitigate these forces–and to some extent it is. The Federal Reserve in particular is providing unprecedented liquidity to stabilize and stimulate the financial sector. Unfortunately, the left hand of government is pressing down on the financial sector while the right hand is trying to lift it.

For about a quarter of a century, our accounting system required banks to exclude trillions of dollars of securitized loans from their balance sheets, thus avoiding capital requirements. This allowed excessive expansion of credit and risk in the financial system and needed correction.

The Financial Accounting Standards Board (FASB) abruptly reversed course during a worldwide recession. Instead of phasing in the new rules over time, it ordered that securitizations be returned to banks’ books in 2010. As a result, banks must allocate scarce capital to loans they made in prior years instead of new loans. Adding insult to injury, many of the loans had been sold to other banks, and now both the originating and the purchasing banks are required to maintain capital and loss reserves against the same loans.

The Treasury and the Fed promoted the Basel capital regime, which relied on highly pro-cyclical mathematical models and on forms of capital (for example, preferred stock) inferior to tangible equity. This, too, allowed excessive expansion of credit and risk.

Bank regulators demanded immediate changes in 2009 instead of phasing in new rules. Many of the 19 stress test banks were ordered to increase their tangible equity at the worst possible time.

Banks cannot allocate capital to new loans if they are required to increase their capital ratios and if the markets are not receptive to large issuances of new capital. The alternative to raising more equity is to shrink loans, and many banks are being forced to do just that.

Exacerbating these problems is our inexplicable unwillingness to order FASB to eliminate mark-to-market accounting, except for trading accounts. President Franklin D. Roosevelt and his Treasury Secretary ordered bank regulators in 1938 to abandon MTM in favor of historical cost accounting because MTM was inhibiting lending and prolonging the Depression.

The FASB re-instituted MTM beginning in the early 1990s over strong objections from the Fed, Federal Deposit Insurance Corp. and Treasury. The agencies feared that MTM would create intense credit crunches since temporary declines in asset prices would result in immediate reductions in capital and inevitable retrenchments in lending.

Their worst nightmare came true in 2008. MTM forced banks to mark mortgage-backed securities and other financial assets to fire-sale prices when the financial markets collapsed. This destroyed some $500 billion of capital and nearly $5 trillion of bank lending capacity.

FASB is a major culprit in the crisis of 2008. Rather than returning to historical cost accounting, which values assets at their true economic value based on projected cash flows, FASB desperately seeks to justify MTM accounting while trying to cobble ways to limit its systemic impact.

FASB Chairman Robert Herz’s latest very bad idea is that FASB continue MTM but that regulators ignore it in determining capital adequacy in banks and thrifts. This is precisely what happened in the 1980s when the savings and loan regulator, at Treasury’s urging, decided to mask S&L problems by applying regulatory accounting principles instead of generally accepted accounting principles (GAAP).

The decision to ignore GAAP accounting, now being urged by Herz, cost taxpayers $150 billion in the S&L debacle (about $450 billion in today’s terms). We need an accounting system that works, not one we must ignore.

It is past time for the Obama administration to determine its No. 1 priority and throw the full force of government policy behind it. My top priority would be turning around the economy and putting the country back to work.

A growing economy will make it much easier to get America’s financial house in order. It will help reduce budget deficits and enable banks to return to the equity markets to strengthen their financial condition.

We are not going to get the American economy growing until bank lending opens up. Small businesses need access to credit, and consumers need financing for purchases of homes, appliances and autos.

None of this is going to happen until the left and right hands of government work together instead of against each other.

William M. Isaac, chairman of the Federal Deposit Insurance Corporation during the banking crisis of the 1980s, is chairman of LECG Global Financial Services, based in Washington, D.C.

Original Article Located Here.