Italian bank derivative scandal ongoing reminder why banks should provide ultra transparency

As more information comes out about Monte Paschi's derivative scandal, the more the scandal confirms that banks must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Why?

Because bank regulators cannot be relied on to a) properly assess the risk of each bank, b) accurately communicate this risk to market participants and now c) effectively follow-up when banks engage in accounting irregularities.

As a result, market participants need the banks to provide ultra transparency so a) market participants can independently assess the risk of each bank and b) exert market discipline on the banks so that their accounting statements reflect the true financial condition of the bank.

From a Bloomberg article, we learn that even though it regulated Monte Paschi, the Bank of Italy did not think that it was responsible for 'policing' the bank even after it uncovered a previously unreported derivative transaction.

To say this is troubling is an understatement.

The Bank of Italy under former Governor Mario Draghi spotted accounting irregularities that allowed Banca Monte dei Paschi di Siena SpA to mask losses more than two years before the lender was forced to say it will have to restate profit. 

In 2010, “a problem came to light” on Monte Paschi’s booking of a structured deal called Santorini, Italy’s Rome- based central bank said in a report dated Jan. 28. 

The Bank of Italy alerted “other authorities” a year later and talks with those regulators, which it didn’t identify, haven’t concluded. It didn’t explain the delay in forcing the bank to disclose the information. 

The Bank of Italy’s account of Monte Paschi’s use of derivatives, released yesterday, calls into question its oversight of the world’s oldest bank, which is seeking the second taxpayer bailout in four years....  

“I would have expected the Bank of Italy to have requested transparency from Monte Paschi back in 2010 after reviewing the transactions,” said Carlo Alberto Carnevale-Maffe, professor of business strategy at Milan’s Bocconi University. “Hidden documents found recently wouldn’t have changed the substance of the original findings.”

Had all banks been required to provide ultra transparency, Monte Paschi wouldn't have "hidden documents" in the first place.

But assuming that Monte Paschi did not want to disclose the derivative deals, market participants, including regulators, could still have found out about these deals by looking at the disclosures made under ultra transparency by Monte Paschi's counter-parties.

With ultra transparency, the ability to look at the counter-parties' exposure details is a simple check and balance on each bank's disclosure of its exposure details.  This simple check and balance improves the reliability of each bank's financial statements.

The Bank of Italy said that as early as 2010 it sought daily liquidity reports from the lender as margin calls on Santorini drained funds. 

The regulator said a week ago Monte Paschi hid documents, impeding its analysis of the “true nature” of the company’s dealings. 

Regulatory oversight of Monte Paschi was “continuous and thorough” and the bank remains solid even with a capital shortfall and possible losses linked to structured deals, Finance Minister Vittorio Grilli said in parliament yesterday....

The highlighted text is a simple restatement of why market participants cannot rely on regulators to a) properly assess the risk of a bank and b) accurately communicate this risk.

Santorini helped Monte Paschi obscure a 367 million-euro loss from an older derivative contract with Deutsche Bank, according to more than 70 pages of documents outlining the deal and obtained by Bloomberg News. As part of the arrangement, the Italian lender made a losing bet on the value of the country’s government bonds. 

The bank’s new management is still trying to determine the extent to which Santorini and two other derivative deals were used to distort earnings. Monte Paschi never disclosed the effect of the 2008 deal in its annual reports. 

The bond bet was among transactions that drew the Bank of Italy’s scrutiny as early as 2009 as repo operations were “resulting in the absorption of high liquidity margins,” the regulator said in its Jan. 28 report....

The highlighted text shows why, in the absence of ultra transparency, bank financial statements cannot be relied on as they contain a) distortions in valuations that are done with regulatory approval such as suspension of mark-to-market accounting and creation of 'zombie loans' under regulatory forbearance and b) distortions in valuations by the banks themselves including not reporting the impact of derivative exposures or as shown by JP Morgan's Whale trade, understating losses.

Monte Paschi told the Bank of Italy in 2011 the structured deals were part of its “carry trade” strategies and weren’t submitted to its administrative body.... 

Italy’s third-largest bank and prosecutors are now reviewing three money-losing derivative deals, Santorini, Alexandria and Nota Italia. 

The lender said it discovered in October that former managers signed a “mandate agreement” with Nomura Holdings Inc. (8604) to cover losses on a mortgage-backed derivative called Alexandria with new, riskier derivatives. 

The hidden document, proving the link between the unprofitable Alexandria derivative with the new one, should have led the bank to book a loss of more than 200 million euros on the original transaction, instead of spreading it over the 30- year maturity of the new deal....

The Bank of Italy’s role isn’t to “police” Monte Paschi, the current governor, Ignazio Visco, 63, said Jan. 25 in an interview with Bloomberg Television in Davos, Switzerland. 

The Bank of Italy “summoned the senior management of Monte Paschi” and of the foundation that is its biggest shareholder in November 2011 “to make them face up to their responsibilities and ask Paschi to quickly and definitively turn around the way it conducts its business,” the report said.

The role of policing the banks actually belongs to the market.  However, market participants cannot police the banks so long as the financial regulators have a monopoly on all the useful, relevant information in an appropriate, timely manner.

By ending the regulators' information monopoly and requiring the banks to provide ultra transparency, market participants have access to the information they need to actually police the banks.

Monte Paschi risks further losses of as much as 500 million euros on a 2010 securitization of about 1.5 billion euros of real estate loans, dubbed “Chianti Classico,” weekly Panorama said today, citing documents that include minutes of board meetings from November and December of last year. ... 

“New derivative accounting policies are needed in Europe to avoid similar situations in the future,” said Giuseppe Di Taranto, professor of financial history at Rome’s Luiss University. “There’s too much room for interpretation under current rules.”

The new derivative accounting policy is that banks must disclose all of their derivative exposures.