In a forthcoming article in the Vanderbilt Law Review, Robert P Bartlett III, Assistant Professor of Law at the University of California, Berkeley, proposes a disclosure regime designed to enhance accurate pricing of a bank's exposure to credit risk while at the same time safeguarding the confidentiality of a bank’s proprietary investment strategies and customer information. The article, Making Banks Transparent, begins from the premise that bank disclosures are notoriously lacking in granular, position-level information concerning their credit investments. Consequently, in times of market stress, investors must speculate as to which and to what extent banks maybe exposed, causing disruptions in credit markets and amplifying systemic risk. Bartlett proposes a mandatory disclosure regime based on credit modeling employing the very analytical tools banks themselves have developed and use to understand their own credit exposures.
[C]redit modeling by market participants has the potential to meaningfully increase market discipline while minimizing the disclosure of sensitive bank data.
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By analyzing credit risk in a bank's investment portfolio in terms of a limited, standard set of quantifiable metrics, credit risk models provide an architecture for analyzing a bank's overall exposure to credit risk that is both well understood within the financial sector and parsimonious in the information required to be processed. For the same reasons, disclosure of these standard metrics provides a potentially simple but powerful method for a financial institution to communicate useful information concerning its exposure to credit risk without the need to disclose proprietary position information.
Using a pair of case studies, the collapse of the Continental Illinois National Bank and Trust Company in 1984 and the near collapse of Citigroup in 2008, and employing a simple Monte Carlo-based credit risk model to each bank's unhedged, gross exposures, the paper examines how a "model sensitive" disclosure regime might better enable market participants to detect a bank's insolvency risk and assess its overall capital adequacy.
Basically, Bartlett argues that central the same state-of-the-art credit analysis that informs banks' own risk management processes should also inform the structure of mandatory bank disclosures to investors.
Indeed, sensitivity to developments in credit risk analysis is already a well-established practice when it comes to setting capital requirements in both the United States and abroad. It was, after all, an appreciation of the evolution of credit risk analysis that initially prompted regulators to permit banks to set their regulatory capital using their own internal models in Pillar I of the Basel II Capital Accords. As this Article has demonstrated, however, there is no reason why the lessons of credit risk management should be so limited. Notwithstanding the simplicity of the CINB and Citigroup models, each serves as intriguing illustrations of how reconciling bank disclosure policy with even basic credit risk modeling might provide significant new information to the marketplace while avoiding the constraints that have traditionally hamstrung bank disclosures. As such, credit risk modeling would thus seem especially pertinent to designing not only bank's "Pillar I" capital requirements but also their "Pillar III" disclosure obligations.
The paper also argues that Bartlett's model sensitive disclosure regime would be an easy transition by banks and pose minimal risk of exposing banks'; proprietary trading information.
Because such an approach leverages the same aggregate metrics banks themselves use to monitor their risk exposure, the disclosure regime proposed in this Article would impose a minimal disclosure burden on banks while avoiding the need to reveal sensitive position-level data. In the process, the Article demonstrates how using credit risk models to inform bank disclosure policy represents a potentially tractable solution to the challenge of enhancing bank transparency while protecting banks' proprietary information.
Though the article does not make the claim that either the financial crisis or the current European sovereign debt crisis may have been averted by model sensitive disclosure, Bartlett's case studies provide thought experiments that may prove quite useful to bank regulators as they consider ways to improve transparency of the traditional and shadow banking activities of systematically important financial institutions.