Pandit Risk Transparency Proposal Falls Short

At least give Vikram Pandit credit for acknowledging that banks’ opaque financials are a problem.

In an an op-ed published this week in the Financial Times, Citigroup’s chief executive proposed a novel solution: have regulators create a “benchmark” portfolio – an imaginary collection of real assets that would mirror, as best as possible, the kinds of assets systemically important financial institutions hold. Banks would be required to disclose, on a quarterly basis, how their risk models would assess this hypothetical portfolio.

For example, they’d have to say how much they would set aside in loss reserves for the make-believe book, what kind of risk-weightings they would apply, value at risk and stress-test results. Since each bank would be evaluating the same (theoretical) portfolio, investors would be able to compare their approaches on an apples-to-apples basis.

If banks won’t reveal what they’re holding, Pandit is saying, make them tell investors how they’re thinking about what they’re holding. 

Pandit’s been beating this drum for a while. In a speech to the Bretton Woods Gathering in Washington in September, Pandit said transparency is what’s missing from the discussion of the new Basel III capital requirements. Unfortunately, “for reasons ranging from complexity to competitiveness, financial institutions are not prepared to disclose their entire balance sheets to the world.”

Pandit’s idea to make banks show the rigor of their analysis through what-if exercises is all well and good, but far from the whole solution.

“Applying current risk approaches to a standard portfolio is taking a snapshot of a moving target, which does provide relevant information about the way each viewer's risk camera works,” says Emanuel Derman, a Columbia University professor and author of “Models Behaving Badly.” “But the universe of potential investments is ever changing and has more complex risks than can be captured in one snapshot. It will take structural changes as well as better risk reporting to restore faith in the financial industry. ”

Pandit’s proposal gives us no way to judge a bank’s risk appetite. This is the sum total of all risk management approaches, business decisions, reporting, and day-to-day discussions guided by feedback from real-time risk metrics. When risk appetite is clearly articulated and consistently communicated – with the tone set at the top – you see the boundaries that shape strategy, target-setting, and decision-making.

In my opinion, it’s not that helpful to see the aftereffects of risk management policies by looking at metrics. It’s more important to understand the philosophy that guided model assumptions, set acceptable value ranges, and tempered excessive exception-making under multiple scenarios. 

Fernando de la Mora, the leader of PricewaterhouseCoopers' banking and capital markets risk practice, gives a qualified endorsement for the model portfolio idea. PwC “supports Mr. Pandit's proposal and we believe this is an idea worth pursuing further. Results, however, will have to be presented in way where differences can be attributed to credit quality, model, risk type and jurisdictions.” 

I think there’s a better, more direct way, to judge a bank’s risk appetite and to compare key indicators of risk taking such as loan/loss reserve levels, value at risk, stress-test results, and asset valuation and concentration across systemically important banks. It’s already been floated by the Public Company Accounting Oversight Board.

The audit industry regulator issued a proposal last June for changes and additions to the standard auditor’s report. Auditors are knowledgeable, technical experts who have unfettered access to confidential and proprietary bank investment and loan portfolios, asset valuations, significant estimates, and the models used to develop financial statement amounts.

The proposed changes to the auditor’s report are focused on enhancing communication to investors. During the board’s outreach to public company executives, auditors, institutional investors, and audit committee members, many asked why auditors, who are in a unique position to provide relevant and useful information because of their extensive knowledge of the company and across the industry, are not telling investors more about the risks that companies are taking.

The auditor, unlike the management team or the audit committee, is an independent third party. That independence and objectivity should provide an advantage to shareholders and other stakeholders seeking information about risk-taking. Institutional investors told the regulator that “expanded auditor reporting in advance of the financial crisis might have been helpful in assessing the quality of the financial statements, and providing early warning signals regarding potential issues [such as] a discussion of off-balance sheet contingencies or the sensitivity of loan loss estimates.”

One of the PCAOB’s proposals is a supplemental narrative report, an Auditor's Discussion and Analysis. Auditors can discuss their views regarding significant matters such as management's judgments and estimates, accounting policies and practices, and difficult or contentious issues, including “close judgment calls.” An AD&A might also highlight areas where the auditor believes management could have made different or fuller disclosures. Some investors would also like to understand the quantitative and qualitative factors considered in establishing materiality levels.

Financial statements include many estimates that are based on management's judgments and assumptions. These judgments and assumptions can also affect selection of accounting treatments for transactions. For example, bank financial statements use fair value or “mark-to-market” accounting extensively. Estimates for asset values may be wide ranging and ultimately subjectively determined, especially when assets are thinly traded or illiquid. 

Human judgments and estimates are inherently biased. Users of financial statements should be interested in additional information about the reasonableness and consistency of, changes in, and ranges of possible outcomes and management's selection of values within those ranges. This could include the reasonableness and consistency of, and changes in, assumptions, inputs, methodologies and accounting policies that are built into models.  

Another alternative proposed by the PCAOB is the addition of “emphasis paragraphs” to the auditor’s report. This additional information could be required in areas such as significant management judgments and estimates, areas with significant measurement uncertainty, and other areas that the auditor determines are important to discuss for a better understanding of the financial statement presentation.

The PCAOB held a public roundtable on the audit report proposals Sept. 15. By the Sept.30 deadline it had received 152 comment letters. Unfortunately, none of the systemically important banks registered a public opinion on the proposals.

Two firms audit the four largest US banks - PwC audits JP Morgan Chase and Bank of America and KPMG audits Wells Fargo and Citigroup. It would be good to know if those two auditors and those four banks, at least, were willing to consistently disclose risk appetites and audit key risk appetite metrics like loan loss reserves, asset valuations, and legal contingencies. 

The US Chamber of Commerce doesn’t like any of the PCAOB’s proposals and takes exception, in general, to the “PCAOB’s go-it-alone approach to audit standard setting.”

Bank of New York Mellon had a unique view amongst the public companies represented. Although opposed to an AD&A and any “emphasis paragraphs,” the bank welcomes the addition of the auditor’s assurance on Management’s Discussion and Analysis similar to comfort letters under the 1933 Act. 

State Street Bank doesn’t like the PCAOB’s AD&A proposal or the “emphasis paragraphs” suggestion and, although not opposed to an auditor’s assurance on MD&A, sees very little benefit compared to the potential cost associated with this additional auditor activity.

Large investment companies, pension funds, and investment advisors such as the AFSCME, CalPERS, and the AFL-CIO are in favor of additional information from the auditor about significant management judgments, estimates, and areas of measurement uncertainty in the financial statements and significant changes in or events impacting the financial statements.

Public company financial executives and directors, including audit committee members, and their auditors generally oppose an AD&A or expanded “emphasis paragraphs.” It’s interesting to note that companies and their auditors both feel that executives should be the primary source of information to investors. They worry about expanding the auditor’s role and the risk of “dueling information” between preparer and auditor.

Audit firms are concerned, according to the comment letters, about the potential liability of preparing additional information for investors that may go over and above, or contradict, management’s representations. Companies fear the costs of any additional work by auditors to prepare more disclosures for investors. Both groups are nervous that enhancing the auditor’s report with an AD&A and “emphasis paragraphs” will somehow impair the three-way communication between auditor, audit committee, and executives.

Auditors, company executives and audit committee members are ignoring shareholders who are strongly asking for more disclosure. They obviously didn’t hear PCAOB Chairman Jim Doty tell the Canadian Public Accountability Board’s Audit Quality Symposium: "The auditor is decidedly not supposed to be a trusted advisor to the company."

Francine McKenna writes the blog re: The Auditors, about the Big Four accounting firms. She worked in consulting, professional services, accounting and financial management for more than 25 years.