Did the bank regulators respond to the 2008 acute phase of the Great Financial Crisis by engaging in accounting control fraud?  I’ll let you be the judge.

Accounting control fraud was introduced into the academic literature by George Akerlof and Paul Romer.  They observed stock options gave bank managers an incentive to delay fully accounting for expected losses.  The result of this delay is more robust profits.  Profits that result in a higher stock price and therefore more money to the bank managers as they exercise their stock options.

Now let’s look at some of the ways bank regulators responded in 2008.  They suspended mark-to-market on securities and substituted mark-to-management’s wildest dreams.  They created zombie firms by letting banks avoid writing off the loans these firms could never repay and instead letting banks engage in “extend and pretend”.  In short, bank regulators delayed fully accounting for expected losses in an effort to inflate the stock price of the banks.

Sounds a lot like accounting control fraud doesn’t it?

Both the bank managers’ and the bank regulators’ version of accounting control fraud requires opacity to boost the stock price.  If investors can see the actual amount of losses coming they won’t boost the stock price as a result of the accounting delay in recognizing the losses.

The next question is should regulators be allowed to engage in what looks like accounting control fraud?

The design of the financial system is suppose to prevent this.

Why?

Banks and other financial institutions are suppose to disclose all the information investors need in order to know what they own.  If banks provided this level of disclosure, everyone would know the magnitude of the losses and there would be no reason to engage in accounting maneuvers to try to hide these losses.

Unfortunately, banks and other financial institutions don’t provide this level of disclosure.  As a result, bank regulators continue* to opt for their version of accounting control fraud.

*Bank regulators previously engaged in their version of accounting control fraud with the Savings & Loans in the 1980s.