his article references the recommendations of the Enhanced Disclosure Task Force, which was co-chaired by PIMCO’s Christian Stracke. The full EDTF report is available on the Financial Stability Board (FSB) website, click here.
The persistently high borrowing costs and low equity prices of global banks is one of this year’s great financial puzzles. Why, in an era when central banks are doing nearly everything they can to ensure liquidity in funding markets, do banks still have to pay so much more than industrial companies to borrow in the bond markets? Why, when banks have done so much to improve their balance sheets, dramatically increase capital ratios and tighten lending standards do many banks still pay anywhere from 50% to 100% more in credit spreads relative to similarly rated industrials? Granted, real credit risks remain in banks, especially related to lingering concerns about the European sovereign crisis and the economic outlooks in the U.S. and China, but those macro drivers should raise similarly grave credit risks for industrial companies with the same credit ratings.
What is going on?
While there are likely a number of reasons behind the disparity in credit spreads at banks versus similarly rated industrials, we believe that one key driver is simply that investors have a very difficult time understanding the risks they take in lending to a bank. Many banks have gone to considerable lengths in recent years to disclose more information about their risks, but the fact remains that investors tend to see banks as opaque black boxes where risks are still poorly disclosed or – worse – actively obscured by management. Industrial companies may be complicated, but their risks in general can be readily understood. In the case of a bank, however, both bond and equity investors often have great difficulty knowing precisely what they are investing in. Among their many questions: What are the loans and securities on a bank’s balance sheet, what is their quality, where do they come from, what is their collateral and what were the lending standards when the loans were made? Even more: What exactly are the liabilities of a bank and what are their times left to repayment? And are those liabilities secured or unsecured, and if secured, then secured by what assets? What are the various other market and operational risks that a bank faces?
For many banks these questions remain difficult to answer with any real precision, even for highly trained professional bank analysts. This is not because there is something inherently incomprehensible about these issues – rather analysts simply do not have enough information disclosed to them to enable more detailed analysis. In the past, before the bank defaults of 2008, this lack of information was not so much of an issue, as "too-big-to-fail" institutions could rely on investors' expectations of sovereign support to keep their borrowing costs low. Now investors must assume that banks will have to stand on their own without recourse to emergency bailouts, so investors need to do their homework to understand the risks they take in buying the bonds and equities of the banks they analyze. And to do this work investors need granular disclosures from banks, something that is still far too rare from most major global financial institutions.
Recognizing this gap between what investors need disclosed and what banks commonly make available, the Financial Stability Board, the multi-national organization that monitors the global financial system, mandated the creation of the Enhanced Disclosure Task Force (EDTF) in May of this year. The EDTF, which PIMCO has had the privilege of co-chairing, has been a unique private sector collaboration of global banks, buy-side investors, accounting firms and ratings agencies tasked with producing recommendations for improved bank financial disclosures. The EDTF's recommendations are expected to be adopted voluntarily and to represent guidelines for how banks can improve their disclosures without releasing competitively sensitive information. Many of our recommendations will take some time to be implemented, but we expect that banks – especially those banks who have been members of the EDTF – will begin to adopt some of the recommendations in their 2012 annual reports, with additional implementation to come over the course of 2013 and beyond. For now, our recommendations are intended to be adopted by large global banks most urgently, but we also expect that smaller regional banks will see the importance of adopting these recommendations where relevant.
The EDTF's recommendations range from the large to the small, and the EDTF's full report can be found at the FSB's website (click here). Key recommendations include:
- More granular disclosure on the composition and characteristics of assets on balance sheet. Many banks have improved their asset disclosure significantly since 2008, but we still see important areas where disclosure can be improved further. Information on the credit quality, collateral backing, vintage year, regional distribution, industry sector and other key loan and securities characteristics is still sorely lacking from many banks around the world, in our opinion. How, investors routinely ask themselves, can anyone lend to a bank without knowing what a bank is doing with those funds?
- More granular disclosure on liquidity, especially full details on the contractual maturity schedule of liabilities, the secured/unsecured nature of liabilities, the availability of cash assets to satisfy liabilities and the availability of unencumbered assets against which secured funds could be raised.
- Much more disclosure on risk-weighted assets (RWA) and how a bank's reported RWA reconcile to its balance-sheet assets. With risk weighting of assets such an important part of the bank regulatory environment, investors need to understand how a bank arrives at its RWA numbers, what models it uses in risk weighting and how those models change from one reporting period to the next. We expect banks to report a flow table of risk-weighted assets in their financial disclosures, explaining the drivers of changes in RWAs and the extent to which changes in unpaid principal, risk characteristics, or RWA modeling drove a change in RWAs.
- More disclosures on market risk, including narrative discussions of how banks arrive at their published value at risk (VaR), so-called stress VaR, and other market risk indicators.
We at PIMCO hope, for the sake of our clients and investors everywhere, that banks will recognize the importance of the EDTF's recommendations as well as their potential to reduce credit spreads on bank bonds and equity risk premia on bank equities. Greater disclosure can bring more efficient markets and with them the likelihood of more reasonable pricing of the bonds and equities that banks issue. These advances should bring more efficient allocation of capital – a clear benefit for our clients but also ultimately can be a great benefit for the broader economy as banks regain more regular access to the unsecured debt markets. It will take time for banks to adopt these recommendations, but as they do, we expect that the stubbornly high risk premium on bank securities should fade.