The Basel Committee on Banking Supervision last week issued new guidelines for mark-to-market accounting by banks. The new guidelines relax the requirements for using mark-to-market in downturns, failing to address the fundamental problems that helped to get the financial system into the current mess. Mark-to-market accounting, like the credit default swap, is a novel technique that in the recent crash has proven itself a weapon of mass financial destruction. Bank regulation is being carried out in the wrong Swiss city; it needs a draconian Geneva Convention.

The principal objective of financial regulation should be to prevent the banking system from destroying itself. In a free market, with tight monetary conditions and no deposit insurance, banks that became over-inventive would soon find themselves in difficulties, taken over by one of their rivals or forced into bankruptcy. Pretty soon it would be realized that accepting short-term deposits was incompatible with an excessive interest in the more arcane financial innovations. Those would be left to hedge funds and brokers, whose bankruptcies would affect nobody except their partners and any shareholders foolish enough to have entrusted their money to them.

In the world we inhabit, financial destruction is all too easy. On examination of the recent unpleasantness, it becomes clear that, given the environment of easy money and moral hazard in which we live, not every financial technique that can be invented should be. Techniques that may be harmless or even beneficial in the theoretical perfect market prove highly destructive in the world of real finance.

Mark-to-market accounting is one such technique. Theoretically elegant in a perfect market, – but as I have frequently discussed, no real-world market is perfect – in our world it has proved immensely destructive. Under this technique all assets and liabilities of the institution are “marked to market” valued at the price they might fetch in a transaction between willing buyer and willing seller on the balance sheet date.

When the market for subprime mortgages and their securitized detritus collapsed, banks using mark-to-market discovered they were compelled to mark prices down in a draconian manner, even on securities that appeared likely to pay full value at maturity. This naturally caused distress among eminent bankers. The Basel Committee has now recommended that banks should be able to reclassify securities that have become illiquid, ceasing to mark them to their no longer valid market price. This recommendation appears common-sensical, but does not address several of the other major problems of this accounting technique.

One major problem is the effect of mark-to-market accounting on liabilities. Under this system, liabilities as well as assets must be marked to their market price. Theoretically, this takes overall changes in credit conditions out of the system, because liabilities and assets are affected equally. In practice, it produces absurd results, whereby banks record huge MTM profits as their credit deteriorates and their liabilities become worthless, then huge losses as the liabilities recover in value. Under this accounting, the worst thing a bank shareholder can hear is that the Feds or some other sugar-daddy has steeped in and prevented bankruptcy – at that point all the liabilities leap in value causing a huge loss.

Another problem with mark-to-market accounting is that it can make financial statements pretty well incomprehensible. I am a modest investor in some of the energy royalty trusts, which take pools of oil reserves, extract and sell the oil and pay dividends to investors based on the proceeds. The more intelligent of those trusts hedged their oil sales forward when prices hit $140 per barrel – in one case the trust hedged its entire output until 2011 at prices of over $100 per barrel.

Economically, this hedging makes perfect sense, but the accounting doesn’t reflect it. Common-sense accounting would show the fully hedged company having high, stable profits in 2009 through 2011 while un-hedged companies lost money in the last quarter of 2008 and the first quarter of 2009, recovering partially after oil prices rose back to $70. Instead the fully hedged company recorded a huge profit in the fourth quarter of 2008, because the value of its hedges had increased, even though the value of its reserves had more than correspondingly declined. Then the fully hedged company recorded losses from its hedge positions in the second quarter of 2009, even as the value of its reserves increased and it became possible to hedge 2012 production at a price that left a profit. The actual operating profitability of the energy royalty trusts was very difficult to discern from published information, even for me and I regard myself as a fair financial analyst.

An accounting system that takes a company that has reduced risk intelligently and makes its profits subject to wild uncontrollable swings with no economic basis in reality is not doing its job. It’s as simple as that.

The other more serious problem of mark-to-market accounting arises in bull markets. When I studied accounting, almost the first principle I learned was that assets are carried in the books at the lower of cost or realizable value. That principle is abandoned in MTM accounting. Traders are able to buy illiquid assets, establish a “market price” for them higher than the price they paid then, under MTM accounting, mark them up to the new “market” price and record the profit, no doubt receiving some juicy percentage of that profit as bonus. Naturally, this is an incentive for those traders to acquire or create more such assets, whose “markets” are controlled by a small circle of dealers, which can be used to provide an endless stream of mark-to-market profits. Little surprise therefore that the balance sheets of Wall Street’s major investment banking operations, when times got tough in 2008, turned out to be full of illiquid and hugely overvalued rubbish.

Mark-to-market accounting has been blamed by many commentators for wiping out the capital of the major banks and investment banks, causing a huge financial crisis. What those commentators don’t realize was that MTM’s most serious role in the crash was in allowing traders and managers to mark UP positions during the boom, paying themselves bonuses for doing so. You can’t blame Wall Street “greed.” Traders like other people respond to the incentives put in front of them. It’s up to accounting regulators to avoid incentivizing asset-watering and balance sheet fraud.

The history of financial markets in recent decades is littered with inventions like mark-to-market accounting, generally based on some aspect of modern financial theory, that have in practice turned out to have hugely damaging side-effects. Rather than the Basel Committee, which has repeatedly proved itself a creature of the banking industry, we need a sterner regulator, which will prevent the use of such dangerous techniques. To rely on industry self-regulation is futile. It’s as if the attempt to control weapons proliferation and limit war crimes had been left to a committee representing the armaments industry.

Banking thus needs a Geneva Convention, an agreement between the world’s financial centers. This should not attempt to control the financial services business overall — that is much better done on a national level, as lightly as possible. Instead it would focus on and outlaw the techniques most likely to inflict huge collateral damage on third parties. In such few cases, the financial services sector should be treated as defendant rather than as participant, and its wails of anguish over the loss of rent-seeking scams ignored.

Mark-to-market accounting, first, should by all means have the bear market exit route proposed by the Basel Committee – that seems necessary to avoid bank insolvencies in downturns. More important however, the practice of marking prices up without actual sales should be prohibited. Only when illiquid assets such as subprime mortgages, hedge positions or private equity are sold should any profit be recorded. Naturally, banks holding appreciated assets would be free to disclose information on them in footnotes, but their appreciation should only be taken into income (and the bonus pool) when the assets are sold.

As a side-benefit, investors may then again be able to understand the accounts of energy royalty trusts. Again, fancy valuations of those trusts’ hedging techniques can be given in footnotes. The operating statements should record the prices achieved in that quarter (whether by direct sales or through hedges) and the associated costs.

Financial techniques that need Geneva Convention treatment include securitization, which should not be allowed to remove assets artificially from balance sheets, thereby hugely increasing hidden leverage. Likewise high frequency trading, by which the securities industry extracts “insider trading” rents from the economy should be subjected to a “Tobin tax” reducing the rent-seeking capability of electronic trading desks.

Finally, of course, there are credit default swaps. With their unique capability to cause explosive losses and allow irresponsible game-playing by creditors in bankruptcy, these are in a class of their own, the germ warfare of modern finance. They should be banned outright, with their inventors and designers subject to appropriate moral obloquy.

It is appropriate that global banking regulation should be carried out in prosperous, neutral Switzerland. However the 2008 crash demonstrated that allowing it to be overseen by the Bank for International Settlements in Basel – “the bankers’ bank” — allows financial services malefactors altogether too much control over their own regulation. A Geneva Convention, outlawing the most expensive and obnoxious practices, should be imposed on the financial services sector by an outraged world.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)