Robert P. Bartlett’s Credit Risk Models

Recently, Robert P.  Bartlett’s article Making Banks Transparent, 65 Vand. L. Rev. 293-386 (2012), was included in this year’s list of the Ten Best Corporate and Securities Articles.  The article is a self-proclaimed “thought experiment” that uses two case studies to suggest that more specific, limited credit risk models can be used to increase bank transparency.  According to Bartlett, increased bank transparency will help financial institutions avoid crises like the subprime mortgage crisis, by allowing market participants to “more effectively monitor and price the risks embedded in particular institutions.”*

Bartlett begins by acknowledging two potential issues with increased transparency.  First, there is the problem of confidentiality.  Banks want to protect both their relationships with customers and their own investment strategies.  Federal banking policies have responded to this concern by exempting “such position-level data from mandatory public reporting.”  Second, there is the problem of complexity.  A tremendous amount of information exists that could be reported, so the cost of such an obligation is high.

Bartlett addresses these potential problems, suggesting that “using the knowledge of credit risk modeling to inform banks’ disclosure obligations can significantly enhance bank transparency while largely averting each of these two issues.”  The way to solve confidentiality and complexity problems is by “analyzing credit risk in a bank’s investment portfolio in terms of a limited, standard set of quantifiable metrics.”

The body of the article uses two case studies to create these metrics.  The 1984 collapse of the Continental Illinois National Bank and Trust Company, and the 2008 near-collapse of Citigroup, provide data and information that Bartlett uses to “estimate the core set of parameters needed for a basic credit risk model” of each bank’s credit portfolio.  Bartlett then illustrates “how standard approaches to credit portfolio modeling might have used disclosure of these parameter estimates to detect each bank’s insolvency risk well in advance of its distress.”

While “making financial institutions more transparent to the marketplace has become a central reform objective for both commentators and regulators alike,” this goal has been difficult to achieve.  Both Dodd-Frank and the international Basel Accords “provide surprisingly little guidance.”  Bartlett’s credit risk models offer a text-book solution that may or may not be workable in practice.  With “sufficient caution and a due regard for questioning a model’s assumptions, the analysis that follows suggests that even with their faults, credit risk models can help facilitate the long-desired, but persistently evasive, goal of providing a metric with which to probe a bank’s portfolio risk.”

Click here to read the complete article.

*All quotations cite Robert P. Bartlett, Making Banks Transparent, 65 Vand. L. Rev. 293-386 (2012).