Sunday, October 2, 2011

Thank you Vikram Pandit: Disclosure needed for market discipline, proper pricing of risk and eliminating surprises in financial system

A Heard on the Street column by David Reilly ("Ghosts could be lurking in banking machines") neatly makes the case for requiring banks to make current asset and liability-level disclosure.
When it comes to banks, what you don't know can definitely hurt. 
That's a hard-learned crisis lesson and helps explain, in part, why big U.S. banks have taken such a pounding of late. As Europe wobbles, investors in firms like J.P. Morgan ChaseCitigroup, Goldman Sachs, Bank of America and Morgan Stanley, are again trying desperately to figure out their euro-zone risks. Morgan Stanley, in particular, suffered for this reason Friday. 
A big problem for investors is varied, sparse or confusing disclosure about derivatives exposures—even after the financial crisis showed that the inter-connectedness of firms is often as big a threat as their size.... 
Granted, executives offered some detail on European exposures when reporting second-quarter results, saying they were manageable. But investors were often given net, not gross, exposures, and can't tell how exposed the banks' massive derivatives portfolios may be to big European banks through counterparty risk. 
The only way that market participants will ever be able to understand the exposures is if they are given each bank's current asset and liability-level data.

This is true for both the investors and, more importantly, the banks.  Without this data, how can a bank properly assess the risk of another bank that it might be doing business with?
Even bankers acknowledge shortcomings. 
In a recent speech, Citigroup CEO Vikram Pandit noted derivatives "remain too opaque." He added, "Lack of transparency inhibits market discipline, obscures risk and leaves nasty surprises buried in the system." 
Please re-read Mr. Pandit's comment.

His comment makes the case for adopting the FDR Framework and fully implementing its disclosure requirement!
If only Citi walked Mr. Pandit's talk. 
During the bank's second-quarter call, analyst Mike Mayo of Credit Agricole asked about the bank's exposure to troubled European countries. "What is the gross number and what's the difference between the gross and the net?" Citi CFO John Gerspach replied: "I don't think that the gross number is relevant." 
But it is. 
As Morgan Stanley found Friday, confusion over gross and net exposures can spook investors. The difference is usually due to cash and collateral held against loans as well as derivatives used as hedges. Yet investors often don't know how big the hedges are—an important point since hedges often aren't perfect— or who the counterparty is. 
Divining counterparty risk and concentrations of it is tough and disclosures vary. Morgan Stanley gives a country breakdown of derivatives exposures. J.P. Morgan doesn't do that, but does give a derivatives breakdown based on region. In its second-quarter filing J.P. Morgan said it had net derivatives assets with exposure to Europe, the Middle East and Africa of $35 billion. 
But there is no similar geographic breakdown for the firm's gross derivatives assets of nearly $1.4 trillion. 
If a counterparty fails, gross figures may prove more important for investors. "The asset can disappear and you're left with the liability," explains Credit Suisse accounting analyst David Zion. 
Plus, during periods of extreme market turmoil a problem with a counterparty's counterparty—something almost impossible to measure—can come to haunt even banks that have chosen their trading partners well.
Actually, the combination of 21st century information technology with asset and liability-level data would make it very easy to determine the risk posed by a counterparty's counterparties.
Given the difficulty in gauging which banks hold what risks, investors are often choosing to simply sell bank stocks.
A wise decision when investors cannot answer the question of who is solvent and who is insolvent and therefore assess the risk of any exposure to the banks.
That leaves banks with a choice as third-quarter reporting season approaches: provide more and better information about derivatives and European exposures, or continue to get tarred with the euro-fear brush.
If we are ever to restore confidence in the global financial system, banks must not be left with the choice between transparency and opacity.

Under the FDR Framework, banks would not have this choice.  Governments would require them to disclose their current asset and liability-level data.

Given that we have effectively reached the limits of fiscal and monetary policy, it is time for policy makers and regulators to adopt a new approach to ending the solvency crisis.  This approach is adopting and implementing the FDR Framework and its disclosure requirements.

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