Pandit's departure ends dumb idea of using benchmark portfolio to measure risk at banks

With Vikram Pandit's departure from Citigroup, the idea he promoted of using a benchmark portfolio to measure risk analysis at individual banks can be consigned to the junk heap where it belongs.

In an earlier post, I addressed why the idea of a benchmark portfolio protects the ongoing opacity of banks while providing potentially misleading information.  The information is potentially misleading because of 'basis risk'.

The simple fact is that the assets on and off each bank's balance sheet could be dramatically different than the assets in the benchmark portfolio.  As a result, the risk of the bank could be far greater than the risk it shows by how it values the benchmark portfolio.

Basis risk is the difference between the actual risk of the bank's exposures and the benchmark portfolio.

The only way to know what the actual risk of the bank's exposures is if the bank provides ultra transparency and discloses on an ongoing basis its current global asset, liability and off-balance sheet exposure details.  With this information, market participants can independently assess the risk of the bank for themselves.

An excerpt from the earlier post.

[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.