Friday, October 14, 2011

Thank you Vikram Pandit: he makes the case for disclosure of current asset and liability-level data

Is Citigroup about to become the first global financial institution to disclose its current asset and liability-level data in an effort to restore investor trust in the firm?

It certainly seems that way given how its senior management has confirmed all of your humble blogger's arguments in support of providing market participants with current asset and liability-level data.

As reported in an American Banker article (no link as subscription required),
Pandit ... argued in a speech in Washington last month that Basel III won't work because it is too opaque .... he said the [systemically important financial institution capital] surcharge should be better tied to the risk posed by a company, whether that's a bank or any other type of financial firm. 
And the market, Pandit said, should help the government make these determinations. 
"The missing element in Basel, I believe, is transparency. Under the current rules, it's hard to tell whether two banks with a declared 10% Tier 1 ratio are equally risky," Pandit said. "You don't know how they calibrate risk because you don't know enough about what those underlying assets actually are or how that risk is measured."...
Actually, while it is interesting, how each bank calibrates and measures its risk is of secondary importance.

What is of primary importance is that with disclosure of the underlying assets and liabilities each bank can calibrate and measure the risk of the other bank for itself.  Based on this assessment, each bank can adjust its exposure and the pricing of this exposure to the other bank.

What is even more important is that with this disclosure, all the other market participants can assess the risk of each bank themselves and adjust the amount and pricing of their exposure based on this assessment.
"Right now, loan-loss reserves, value-at-risk, stress-test results and risk-weighted assets are run only against an institution's actual portfolio, whose composition is known only to insiders and select regulators. ... 
As a result, market participants are dependent on the regulators' assessment of risk.  This can get the financial markets into trouble, as the current financial crisis shows, if the assessment of risk is not accurate or properly communicated to the market.

Brian Leach, Citigroup's chief risk officer, makes the case for the impact of current asset and liability-level disclosure and how this impact will take the form of market discipline.
 [Current asset and liability-level disclosure] would give the market a much better idea of a company's risk appetite, and that in turn would influence a company's funding and capital costs. 
"If you know that I am riskier than the guy next to me, you are going to charge me more for my debt or require that my return on equity is higher," Leach said. "You will take capital away from me and shrink me until you are happy about the returns." 
Citigroup supports Basel III as the minimum standard; it wants Pandit's proposal to set the SIFI surcharge. 
"The capital markets will look at the overall riskiness of an institution and essentially charge that incremental surcharge that the regulators are trying to figure out how [to] do," Leach said. "The marketplace would look and say these people are much riskier than those people and they are going to have to carry a surcharge."...
Ultimately, market discipline requires disclosure of each firm's current asset and liability-level data.  Without this data, market participants cannot assess the true risk of the firm.

There are no substitutes for disclosure of each firm's current asset and liability-level data.  Although Wall Street's Opacity Protection Team (OPT) is likely to suggest that a substitute can be found.

For example, the OPT might propose using a benchmark portfolio of assets in place of disclosure of current asset and liability-level data.

This benchmark portfolio of assets is comparable to the dummy assets the rating agencies used to value structured finance securities.  As the financial crisis showed, rating dummy assets and not the actual assets underlying a structured finance security results in improperly assessing the risk of the actual assets.

Using a benchmark portfolio of assets to assess the risk of a bank rather than the bank's crurent asset and liability-level data runs the same risk as using dummy assets instead of actual assets for improperly assessing the risk of the bank.
There is a growing faction of experts, including some regulators, who have concluded a way must be found to effectively harness the market to help police financial firms. 
Regular readers and senior management of Citigroup know the way to effectively harness the market to help police financial firms has been found:  disclosure of each firm's current asset and liability-level data.

The question is will Citigroup, in the tradition of John Reed and the recognition of the write-downs on Less Developed Country debt, lead when it comes to disclosure of its current asset and liability-level data?

When John Reed brought transparency to Citigroup's Less Developed Country loan portfolio, the market responded by aggressively bidding up its stock.

Will Vikram Pandit show the same type of leadership with regards to Citigroup's current asset and liability-level data?

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