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Why Bank Disclosure Is So Awful and How to Fix It

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Bank executives are endlessly annoyed that shares in their companies trade at substantial discounts to book value. It's obvious to them that their stock is not properly valued by the market.

The enormous, 9,500-word cover story in the January/February issue of The Atlantic by Jesse Eisinger and Frank Partnoy goes a long way in explaining why investors are so skeptical about bank stocks. The pair go through the annual report of Wells Fargo to try to see if even a very careful and close read can produce anything intelligible about the risks the bank is taking, how it is valuing its assets, and even what its assets and liabilities really are.

What they discover, of course, is that this cannot be done. Banks are black boxes. The public disclosures are nearly useless, collections of overlawyered jargon that obscure more than they reveal. Even when Eisinger and Partnoy attempt to make very detailed inquiries into questions raised by the annual report, they run into a blank wall.

It's hard not to laugh a bit at some of this. Eisinger and Partnoy come off as so earnest—and therefore earnestly frustrated at the unwillingness of Wells Fargo to provide any clarity whatsoever.

We asked Wells Fargo officials if we could talk to someone at the bank about its disclosures, including those concerning its trading and derivatives. They declined. Instead, they suggested we submit questions in writing, which we did.

In response, Wells Fargo public-relations representatives wrote, "We believe our disclosures on the topics you raised are comprehensive and stand on their own." In answering our written questions about the annual report, the representatives simply pointed us back to the annual report. For example, when we inquired about the bank's trading activities, Wells Fargo responded: "We would ask you to refer to our discussion of 'Market Risk-Trading Activities' on pages 80–81 in the Management Discussion and Analysis section of the Wells Fargo 2011 Annual Report."

Yet it was precisely those pages that generated our questions about the bank's various categories of trading.

If you have a good deal of free time or a long commute, I highly suggest you read the whole thing. This is hardly a new story but rarely has it been told in such glorious detail. If you have even more free time, go ahead and read Dealbreaker's Matt Levine's kinda-sorta defense of opacity in bank financial disclosure. Basically, Levine says that banks need to be dark and secretive if they are going to engage in trading and market making. But ultimately, he agrees with critics that this pretty much makes them uninvestible. You can't know enough about them to understand what their stock might be worth.

Eisinger and Partnoy think that a regulatory regime that threatened bank executives with jail time if it turned out that their financial statements weren't accurate and adequate would go a long way to clear away the black-boxiness. They want this standard of accuracy and adequacy to be intentionally left vague, figuring that prudent chief executive types would err on the side of better disclosure.

Legislators could adopt similarly broad disclosure rules, as Congress originally did in the Securities Exchange Act of 1934. The idea would be to require banks to disclose all material facts, without specifying how. Bankers would know that whatever they chose to put in their annual reports might be assessed at some future date by a judge who would ask one simple question: Was the report complete, clear, and accurate?

The standard of proof for securities-fraud prosecutions, meanwhile, could and should be reduced from intent, which requires that prosecutors try to get inside the heads of bankers, to recklessness, which is less onerous to prove than intention, but more so than negligence. The goal of this change would be to prevent bankers from being able to hide behind legalese. In other words, even if they did not purposefully violate the law, because they had some technical justification for their conduct, they still might be liable for doing something a reasonable person in their position would not have done.

Senior bank executives should face the threat of prosecution the same way businesspeople do in other areas of the economy. When a CEO or CFO sits holding a pen, about to sign a certification that his or her bank's financial statements and controls are accurate and adequate, he or she should pause and reflect that the consequences could include jail time. If bank directors and executives had to think through their institution's risks, disclose them, and then face serious punishment if the disclosures proved inadequate, we might begin to construct a culture of accountability.

I'm not sure that's really the way things would go. The threat of jail might result in even less disclosure because it is obviously easier to prove negligence—the standard Eisinger and Partnoy would employ—for actual errors than for omissions. The best way to avoid saying things that aren't true is not to say anything at all. This is part of the reason we're in the mess to begin with.

It's no coincidence that the era of bank financial opacity has coincided with the era of securities litigation. Serious litigation reform that made it far more difficult for the securities bar to bring cases against companies for what is said in public filings would probably improve the filings. Repealing Regulation FD, for starts, would allow a company like Wells Fargo to actually answer questions put to it by people like Eisinger and Partnoy, rather than just kicking them back to the annual statement filed with the SEC.

If investors really would value more disclosure from banks—and I have no doubt that they would—banks would compete for better disclosure, absent some kind of market friction. So if banks aren't competing for investor dollars with better disclosure, something must be standing in the way. It's not collusion. Believe me, Bank of America would love to crush JP Morgan Chase with far better disclosure practices. If Eisinger and Partnoy realize that " these changes would be for the banks' own good," you can be the executives at these banks realize it also. So it's likely the very regulations already in place that are standing in the way.

We know financial companies can provide better disclosure when they need to. Look at the extraordinary steps undertaken by Jefferies & Co. when it was facing a life-or-death market moment in the winter of 2011. When it is worth it, banks will make the disclosures necessary.

Unfortunately, there is very little understanding that much of what is wrong with our financial system is not the result of the absence of regulation. Our most serious challenges are the unintended products of regulation. Disclosure is just one more area in which the market solution—banks competing for investor confidence with better disclosure—is blocked by a regulatory scheme that encourages banks to avoid detailed financial statements.

Follow me on Twitter @Carney

  • Jeff Cox is finance editor for CNBC.com.

  • Lawrence Develingne

    Lawrence Delevingne is the ‘Big Money’ enterprise reporter for CNBC.com and NetNet.

  • Stephanie Landsman is one of the producers of "Fast Money."

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