Monday, January 16, 2012 Corporate Finance & Investment Banking Blog
Banking apples and oranges by Antonio Mello

Vikram Pandit, the CEO of Citigroup, used an opinion piece in last week’s Financial Times to make an interesting proposal on risk disclosures: banks and other financial institutions should be required to report how their internal modeling assesses the risk in a “benchmark” portfolio. Regulators would define the contents of this hypothetical portfolio, and banks would report “a hypothetical loan/loss reserve level, value at risk, stress-test results and risk-weighted assets.”

It’s a useful proposal that could give investors and other market participants additional useful information. But it also has its limitations, and does not resolve some inherent problems with risk-based capital requirements, and does not eliminate the need to control bank size and risk by other means.

What is the value of having banks report on a hypothetical portfolio? The hypothetical portfolio wouldn’t match any bank’s actual portfolio, so bank reports on a hypothetical portfolio wouldn’t say anything directly about the bank’s actual risk.

But they would tell us something about how each bank’s risk model works and how they compare one to another. That’s useful information when we are comparing reported financials on the actual portfolios, because those reports are compiled by the different banks using their different models. The risk numbers from two banks may differ both because the assets in their portfolios differ and because they measure risk differently. Forcing the banks to report risk for a common “benchmark” portfolio tell us nothing about each bank’s assets, but it does tell us something about their models. If one knows more about the models, one can better understand the meaning of the numbers banks produce on their actual portfolios.

Risk models can be very complicated. There are many, many elements to the model. Outsiders often don’t appreciate how much discretion there is in calibrating the models. The Great Financial Crisis was a useful wake-up call. But a regular exercise that displays the different results obtained on a common “benchmark” portfolio can be very helpful in identifying key differences. This can alert investors to critical issues, and focus management time and economic research on them.

This post was originally published on January 16, 2012, in Betting the Business - a blog by co-authors Antonio Mello of the Wisconsin School of Business and John Parsons of MIT.


CATEGORIES: Finance