ERM: Law of Unintended Consequences [1]

From Neil Bodoff

Accounting on the basis of Historical Cost turned out to cause lots of problems in the 1980’s when banks made loans at low interest rates and then interest rates shot up. Ironically, however, the rules requiring Historical Cost were first required after discovering the abuses leading up to the Great Depression; thus there was a consensus to impose the “more conservative” accounting of Historical Cost. So the crusaders who during the 1930s thought they had fixed financial reporting and prevented crises by imposing “more conservative” accounting had, unwittingly, planted the seeds of a banking crisis that would blossom 40 years later. Lesson: be wary of using measurements that are more conservative or more liberal than they ought to be – strive for accuracy. Broader lesson: beware of unintended consequences.

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Explore posts in the same categories: Financial Crisis, Interest Rate Risk, Mark to Market

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