Last semester I had the pleasure of taking Law for Finance with the renowned Professor Prentice. It was incredibly helpful to learn how our work as accountants flows through a regulatory framework that seeks to create a level playing field for companies issuing securities and their investors. As auditors we’re most familiar with Sarbanes-Oxley and GAAP/GAAS, but these are only a few pieces of the puzzle that contribute to the rational accumulation and allocation of capital so critical to economic growth.

It’s also important to look at what policymakers call “macroprudential regulation”. These are regulations which seek to mitigate the damage done by the emotional swings among financial intermediaries from exuberant optimism to irascible pessimism, also known as systemic risk or the boom-bust cycle. The Dodd-Frank Act was an important new addition to the macroprudential regulatory framework by requiring the trading of derivatives to be on exchanges and prohibiting banks from gambling with depositors’ money in financial markets. Accountants are instrumental in implementing these regulations and monitoring for continued compliance. Likewise, through the calculation of the Allowance for Loan and Lease Losses (ALLL), accountants must be familiar with the credit risk models mandated by Basel II, an international accord between central banks designed to minimize systemic risk.

During my Big 4 internship I examined credit risk models for a large retail bank to verify that their ALLL was properly calculated. This ALLL feeds into the next pillar of Basel II, capital adequacy standards that help the banking system through downturns and protect deposit insurers like the FDIC.  In light of the 2008 financial crisis, regulators made the capital adequacy guidelines more stringent with the introduction of Basel III. However, few are optimistic that this will prevent future economic bubbles.

Academics have argued that this patchwork of regulations around depository institutions is a case of the doctors treating symptoms instead of the underlying disease. In accounting terms, the disease is that depositors do not have an investing cash outflow when they deposit their money, whereas depository institutions have a financing cash inflow. No other transaction in the economy has this accounting asymmetry, which is commonly known as fractional reserve banking. Professor Jesús Huerta de Soto, from Rey Juan Carlos University in Spain, wrote a book in 2005 (PDF) detailing how this shaky accounting creates systemic risk in the banking system. Most recently, Michael Kumhof, a professor at Stanford University and one of the top economists at the IMF, published a paper (PDF) detailing how a financial system could simultaneously transition from fractional reserve banking to 100% reserves, reduce excessive leverage, and prevent the boom-bust cycle.

I had the honor of meeting Professor Kumhof at the Association for the Study of Peak Oil & Gas’ annual conference which was co-hosted by the University of Texas. He was optimistic that policymakers will come around to what is called the “Chicago Plan”, originally devised by a group of economists at the University of Chicago.

In a nut shell, the plan would have depository institutions finance their investing activities from private investors and loans from the government rather than lending out deposits. Deposits would be much like segregated accounts in a trading house or bailments; the bank is a custodian of the funds but is not allowed to lend them out. This would prevent excessive credit creation since banks would have to borrow real savings, much like a mutual fund or a securitization deal that issues bonds.

Perhaps the most fascinating aspect of the plan is that depository institutions in the United States would have to borrow 180% of GDP from the government to meet the 100% reserve requirement. This would mean that the Federal Government would have a negative level of net debt. Similarly, this would immediately solve the European sovereign debt crisis.

To prevent deflation, the government would have to create and spend new money at a rate of 2 or 3% per year, which would help reduce the budget deficit. This nominal money growth would be one aspect of macroprudential policy under the Chicago Plan. The amount and riskiness of credit creation would still be controlled by capital adequacy rules like Basel III and interest rates would be set by how much the government (or an independent central bank) charges financial institutions for additional liquidity needed to finance large productive investments.

Professor Kumhof estimates that changing the regulation of deposits would result in a 10% boost to GDP growth. This is why he is most optimistic that the Chicago Plan will, over the coming years, become a cornerstone of financial reform. Here is his presentation of the paper he published in August:

Accountants will play an important role in advising depository institutions with restructuring their balance sheet and revising their internal controls to reflect the new accounting treatment of deposits. That said, the greatest benefit for us will be that the manic instability of financial markets will be give way to steady real economic growth.

What benefits or drawbacks do you see from the Chicago Plan?