Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Vikram Pandit's Dangerous Idea

Vikram Pandit
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Vikram Pandit has a proposal aimed at shining a light into the black boxes that are the balance sheets of our biggest financial institutions.

Writing in Wednesday’s Financial Times, Vikram Pandit says that banks should be required to explain how they would measure risk in a standard portfolio created by regulators. The idea is to allow investors to “compare apples with apples”.

Here’s a link to the FT story. But since it is behind a firewall, you’ll only be able to read it if you are subscriber.

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.

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.

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.

So far the proposal has been well received. Felix Salmon at Reuters thinks it is clever. The gang at FT Alphaville say they would “welcome such disclosure.” Mark Carney, chairman of the Financial Stability Board said that the plan “couldn’t hurt.”

I’m not sure the other Carney fellow is correct. The Pandit plan could hurt.

Banks assessing the benchmark portfolio would very likely feel a lot of pressure to avoid being outliers. Each bank would attempt to tailor their assessment so that it appeared neither too conservative nor too daring. And because the assessments are meant to reflect their internal models, this means that they would be incentivized to conform their internal risk models to what they expect is in every one else’s risk models.

You see where this is going right? One of the terrible things we learned during the financial crisis was that there was too much homogeneity in our financial institutions. Too many of them were taking the exact same view of housing and mortgages. We want to encourage variety in banking—not herding.

There are already powerful forces pressing banks to adopt thesame strategies. We don’t want to add another.

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