He observes that bank capital ratios are not very informative as there are a number of assumptions that go into calculating the risk-weightings of the assets. To provide additional information, he suggests using a benchmark portfolio and then drawing inferences to Citigroup and other financial institutions.
The last time the financial markets relied on a benchmark portfolio was for rating structured finance securities. The rating agencies used a benchmark portfolio of mortgages. We know how their reliance on this benchmark mortgage portfolio turned out.
The lesson from that debacle is the importance of assessing the actual exposures and not some artificial benchmark.
To do this requires the Citigroup and other financial institutions provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details so market participants could calculate for themselves a much more informative capital ratio.
It is hardly surprising that the financial crisis and ongoing economic turmoil have caused some to question the value of capitalism. But in fact the crisis was not an indictment of capitalism. It should be seen, rather, as a call to improve how we practise it.
Many remedies have been proposed to shore up the safety of the financial system, including the Dodd-Frank law and the higher capital requirements of the Basel process. I support both. But I also believe a market-driven mechanism would further strengthen the system.I too believe that we need to improve how we practice capitalism. My improvement is requiring every opaque area of the financial system (for example 'black box' banks and opaque structured finance securities) to provide ultra transparency.
When market participants have access to all the useful, relevant information in an appropriate, timely manner, they are in a position where they can assess the risk of any exposure and adjust the amount and price of this exposure to reflect the risk.
Currently, banks are required to hold specified levels of capital relative to their outstanding loans. Regulators set those requirements based on their judgment of market risks and worst-case scenarios.
There are limits to this approach. As practised ... it presumes a level of clairvoyance that no regulator can possess....
[C]apital requirements are not as transparent as many presume. It is not enough to require financial institutions to disclose capital ratios. Without knowing what that institution’s underlying assets are (only insiders and select regulators know that), outsiders, including most investors, cannot properly assess how that institution calibrates risk.Where Mr. Pandit and I differ is that investors are not primarily interested in how a financial institution calibrates risk. Investors are primarily interested in the risk being taken by the financial institution.
Please re-read the previous paragraph as it highlights the difference between a red herring argument to protect opacity and implementation of transparency.
Let's look at how Mr. Pandit's observation would read if the focus was where it belongs on investors understanding the risks a financial institution is taking:
Capital requirements are not as transparent as many presume. It is not enough to require financial institutions to disclose capital ratios. Without knowing what that institution’s underlying assets are (only insiders and select regulators know that), outsiders, including most investors, cannot properly assess how much risk that institution is taking.
This is the way the paragraph needs to be written if the goal is to strengthen the financial system. The obvious conclusion is that if investors don't have the information they need to properly assess how much risk is being taken, they do not have the information for properly pricing their exposure to the financial institution.
What is needed is a way to compare apples with apples. Regulators should create a “benchmark” portfolio and require all financial institutions, not just banks, to measure risk against that. The benchmark portfolio would not actually exist on the balance sheet of any one institution. Rather, it would be a collection of real investments that stand in for the kinds of assets that most financial institutions actually hold at the time. What is more, its contents would be 100 per cent public....As investors in structured finance securities discovered to their dismay, they had bought securities that bore no resemblance to the benchmark portfolio.
Having learned this lesson once, investors understand that they need to have ultra transparency into all of a bank's exposures. Investors can use this data to create their own apple to apple comparisons!
Shining a light on the reality behind reported capital ratios would encourage financial institutions to take a more conservative approach to risk. Investors would reward institutions whose approach to risk and capital holdings seem to be sound and punish those who appear to get it wrong. In this case, as in so many others, the crowd can be wiser than individual experts. But the crowd can only be as wise as the information it uses to make its evaluation. Right now, there isn’t enough.And that is why ultra transparency is needed. It is the ultimate in shining a light on what is happening in each financial institution.
I well remember what it was like to recapitalise Citigroup at the height of the crisis. I understand the stresses on institutions, and the system, amid financial turmoil. The best solution is not to mitigate panics but to aim to avoid them. One way is to give the market the tools to discipline firms that leverage up too far and take too much risk.
The financial industry certainly lost trust with the public in the crisis. But that loss of trust arose not from a failure of capitalism but from specific failures by certain participants in the financial system. We could go a long way to regaining that trust by making the system more transparent, by clearing some of the obscurity that causes people to believe the system is a game rigged against their interests.I couldn't agree with Mr. Pandit's conclusions more about the need for transparency. I am looking forward to his call asking for my assistance in creating the mother of all financial databases so that Citigroup can lead the financial sector in providing ultra transparency!