... and why does this matter for government accounting?

The financial crisis in recent years challenged many widely-held assumptions, including an assumption of innocence for ‘cash and cash equivalents.’   The fearful crowd lost confidence generally, and rationally, given the leverage in the system, resulting in a widespread run on the bank.  But we aren’t in Kansas anymore, Dorothy.  This isn’t Jimmy Stewart’s banking system.

The complexity and breadth of ‘cash’ instruments has blossomed with financial market innovation in recent decades -- not always for the good.

When is a buck a buck?  When it’s in the mattress, for one thing.  Insured deposits, depending on how well they are insured, are other good candidates.  But in a world that was stretching for yield, many sophisticated and complex investment vehicles designed as ‘cash equivalents’ proved quite unstable in the financial crisis – even traditional money market funds.

The SEC has chosen to address the instability, in part, in a proposal to require money market funds and similar instruments to report their daily values, with some exceptions, on a floating net asset value.  This means that many money market funds would no longer be structured to be worth – at least in principle -- a fixed $1 per share.  The SEC, and others, have argued that fixing the value on top of a pool of underlying investments of varying value left the sector vulnerable to runs, like those that can be experienced in banks.

State and local governmental units have a unique version of this issue.  These can team up with one another and share theoretically liquid resources in ‘local government investment pools.’   These pools are structured like money market funds, but are exempt from much mutual fund regulation.  The excluded regulations include some designed (in theory) to promote liquidity and maintain a stable net asset value (NAV).

In recent months, government leaders have shown growing resistance to the new SEC proposals, concerned that they may end up effectively including these pools.  Earlier this week, the National Association of State Treasurers testified to Congress that the SEC’s recent proposals may indirectly harm the ability to operate these pools, even though they are largely exempt from SEC regulation.

That is because the Governmental Accounting Standards Board may require governments to account for their investments in these pools as if they had a floating NAV.  In turn, the new accounting could lead the pools to be in violation of state statutes regarding ‘prudent investment policies,’ under current law, given for example how laws are written to avoid a possible ‘loss of principal.’

So, should governments all put their money in big, even too-big-to-fail, banks?  Is bank money riskless?  Not by a long shot, unless we are always going to be bailing out these creatures.

Pretending that risky things aren’t risky can actually be the best recipe for disaster.  A longer story for another day, one that dates to the development of accounting principles in the early 1900s – on the heels of the Panic of 1907, the worst banking panic up to that time in US history.