Transparency in bank portfolios is the key to investor confidence; I’ve insisted all along that the chances of repeat of the 2008 Lehman disaster are slim to zero, because most of the dodgy stuff has long been out of US bank portfolios (not so in Europe, whose bank securities should be avoided like the plague bacillus). Citigroup’s Vikram Pandit attracted some attention for suggesting that model bank portfolio with transparent risk models could improve confidence:

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.

Institutions would be required to produce, on a quarterly basis for that benchmark portfolio, a hypothetical loan/loss reserve level, value at risk, stress-test results and risk-weighted assets. Right now these measures are run only against an institution’s actual portfolio and only a limited number of the results are disclosed. Worse, those results have no common frame of reference. The benchmark portfolio would supply that needed frame of reference.

How a given company’s risk measurements perform against the benchmark portfolio tells the world how its management thinks about risk, and so just how conservative or risky its own portfolio probably is. An institution that cheerfully reports minimal expected losses from the benchmark portfolio in the event of a one-in-a-thousand market decline is probably understating the risk in its own portfolio. By contrast, one that predicts significant losses from the benchmark portfolio even from a routine decline is a firm that is very conservative about risk.

In a recent Asia Times column, I suggested that the banks should make their risk models and data bases public, so that independent estimates could validate the banks’ judgment, or not, as the case might be, and investors could compare banks’ models. Most investors never will have the sophistication to understand bank risk models, but if institutions they trust get a close look under the hood, confidence will improve.

There is a way to do it, in a way that investors will come to trust within a reasonable time frame. Make risk modeling a transparent business with universal access to data and models. The regulators should require large financial institutions to provide their internal data on defaults and delinquencies to the public.

Many of the large banks have enormous amounts of data describing the characteristics of defaulting borrowers and the circumstances under which they defaulted. The Federal Reserve should collate this data into a single set, and make it available for download on its website.

The large banks also should be required to publish their internal risk models. To require a private company to divulge proprietary information is a burden, but in light of the 2008 catastrophe, the public has a right to know how the banks are measuring their own risk.

Once the data and models are available, independent analysts (including the rating agencies) will have an independent capacity to measure the riskiness of bank portfolios. Public scrutiny and third-party analysis will compel bank senior management to improve risk measurement in order not to appear less transparent than the competition.

None of this is particularly difficult. It is a matter of sorting data and crunching numbers and comparing results. It will take the investing public a bit of time to learn what actually occurs in bank portfolios. But this approach could produce robust measures of risk, and allow banks to take on the kind of risk that promotes economic growth, while giving the market the means to punish banks that take on excessive risk.

I’ve been arguing since September in my “Macrostrategy” reports that the worst is behind us for US banks, and that as lending recovers, so will bank profitability and bank stocks.

This entry was posted on Wednesday, January 11th, 2012 at 2:35 pm and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.