Assessing a bank: a game of shadow boxing

In his Wall Street Journal Heard on the Street column, David Reilly makes the point that until investors understand what the value of a bank's assets are, they will not award banks high valuations.

Big banks aren't just black boxes. They are black boxes within black boxes. 

That has always been the challenge for investors—exactly what their assets are worth isn't always clear, and just how they make their money is sometimes hard to discern. 

Investing is all about first, independently assessing the risk of and valuing an investment and second, making a buy, hold, or sell decision based on the difference between the independent valuation and the price being shown by Wall Street.

If an investor cannot independently assess the risk of and value an investment because it is a black box, they cannot "invest".

Rather, buying stock or debt in a black box is simply blindly gambling on the value of the contents of the black box.

Going into 2013, that potentially becomes an even bigger issue. Investors still can't say for sure how a plethora of regulatory actions, ranging from expected final interpretations of Basel capital requirements to the Volcker rule prohibition on proprietary trading, will affect revenue and profit.

The Bank of England's Financial Policy Committee is trying to help investors by urging banks to disclose all the information that investors need.

What is clear is that the regulatory changes, along with more subdued markets, are putting margins under pressure. And that has big banks rethinking their businesses.....

The trouble is, investors trying to assess what would make sense to shed or keep often have little visibility on the underlying returns of various activities. One reason: Trading revenue is an important driver of revenue and profit, yet it is also one of the most opaque areas of banking.

Fitch Ratings, for one, recently decried this state of affairs, saying more detailed reporting by big banks of "trading and market-making revenues in public disclosures is essential." 

That is especially the case when it comes to what is called the "FICC" business, or fixed income, currencies and commodities. This involves trading in products tied to interest rates, corporate credit, mortgages, currencies and commodities and is hugely important for the five big U.S. banks: J.P. Morgan Chase, JPM +0.07% Bank of America, BAC +0.38% Citigroup, C +0.83% Goldman Sachs Group GS +0.73%and Morgan Stanley MS +1.40% .

Capital-markets revenue accounts for anywhere from a quarter to a half of total revenue at these banks. Within this business, FICC is the main driver. It averaged about 60% of the banks' capital-markets revenue in the first nine months of 2012.

Despite this, the banks tend to give scant detail about the trading operations when discussing quarterly or annual results. There isn't even uniform disclosure around how much capital is used by the firms to underpin the businesses....

Regular readers know that the simple way to end opacity is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants could assess bank trading businesses.