Monte dei Paschi scandal is all about lack of transparency

In summarizing the Monte dei Paschi derivatives scandal, Reuters highlights how the lack of transparency at the bank led directly to a lack of oversight either by the bank's senior management, its board or its financial regulators.

The lack of transparency contributed to this scandal at many levels.

The secret document at the heart of the Monte dei Paschi banking scandal lay for months in a concealed safe in a 14th century Tuscan palace....

Lack of transparency resulted in a secret derivative contract.  By definition, the counter-party to the contract knew of the document.

As I discussed in an earlier post, when all banks are required to provide ultra transparency and report on an ongoing basis their current global asset, liability and off-balance sheet exposure details, a simple cross-check of exposures would have identified the existence of this contract.

Nomura and Deutsche Bank would have wanted to do this cross-check because they would have wanted to receive the benefit of the derivative contract.  If the other side doesn't acknowledge a deal, how do you enforce it?

The document found at the 540-year-old bank's head offices - which are appropriately in a restored ancient fortress - was a contract mandating Japanese bank Nomura to carry out deals on behalf of Monte dei Paschi.

How could Nomura carry out deals on the bank's behalf without anyone at the bank being aware of it?

It revealed that, unbeknown to the new management under Viola, two derivatives transactions known as "Alexandria" which had looked separate were in fact linked. This meant they should have received different accounting treatment, leading to heavy losses. 

This discovery prompted an internal inquiry that has, so far, revealed losses of up to 720 million euros ($977 million)....

What do these derivative contracts say and how much more could Monte dei Paschi lose?

The Bank of Italy is also under fire, with critics accusing it of lax oversight and lack of transparency about suspected financial irregularities at the Tuscan lender....

How is it that the Bank of Italy didn't notify the board and senior management of Monte dei Paschi and tell them to suspend all trading until the financial irregularities were fixed?

Whether the contract was deliberately hidden or simply forgotten, Monte dei Paschi's former top management seems to have had little idea of what traders in the finance department that negotiated such risky deals were doing - despite repeated complaints from internal auditors, according to senior sources with knowledge of the situation and documents seen by Reuters. 

Three years before the document was uncovered, Monte dei Paschi's own risk control unit and its audit committee had already expressed serious concerns to Vigni about the way the bank's finance department handled risky trades. 

Internal documents obtained by Reuters show an audit of the department in August and September 2009 had uncovered a "systematic overshooting of risk limits" in the management of the group's 24-billion euro proprietary portfolio. 

Proprietary trading involves a bank taking trading positions in securities such as stocks or bonds to make profits for itself, rather than trading on behalf of a customer. 

Close examination of the documents, which included letters addressed to Vigni outlining the internal auditors' misgivings, suggest that the finance department operated like a bank within a bank, entering into derivative trades and hedging bets that went wrong with little scrutiny from Vigni or then Chairman Giuseppe Mussari....

ex-finance department chief Gian Luca Baldassarri and his team were viewed as the real bosses inside the bank, with a weak understanding of markets among the top management allowing them to engage freely in opaque financial deals....

As we know, by definition derivatives are opaque.  

"The risk management unit constantly raised alarm bells," said a senior source with direct knowledge of the situation. "However, these were very powerful people."...

And what did the financial regulators do when the risk management unit raised alarm bells?

Baldassarri - who worked at the bank between 2001 and 2012 - and another Monte dei Paschi manager in London are referred to as "the five percent gang", according to a judicial document seen by Reuters. 

This document contains minutes of a 2008 interrogation conducted by a Milan magistrate of a former Dresdner Bank employee, Antonio Rizzo, as part of a separate Milan inquiry. 

The "five percent" label refers to a fixed fee that, according to Rizzo, the duo would ask for themselves for every financial transaction they managed to push through....

The former mid-level manager said Monte dei Paschi's top brass didn't grasp what the finance department was doing from its offices overlooking the Renaissance buildings of Siena. "They could do what they wanted because no one really understood what they were doing, neither Mussari nor Vigni," the official said....

Please recall that had the bank been required to provide ultra transparency, the lack of understanding by senior management would not have been so problematic.  Market participants would have pointed out the problem and exerted discipline to fix the situation.

Prosecutors are now also investigating "Alexandria", the complex 2009 structured transaction with Nomura, and two other deals - the 2008 "Santorini" trade with Deutsche Bank and the 2006 "Nota Italia" trade with JP Morgan. 

Deutsche has said its deal had been approved by Monte dei Paschi. JP Morgan declined comment. 

The documents obtained by Reuters do not refer specifically to the three derivative trades, which are alleged to have been used to conceal losses at Monte dei Paschi....

When banks are required to provide ultra transparency, they cannot conceal losses.

In addition to the internal audit committee and the risk management department, some board members also criticised the type and size of investments carried out by the finance department and the lack of accountability, sources said. 

In 2011, two board members - Francesco Gaetano Caltagirone and Axa representative Frederic Marie de Courtois d'Arcollieres - raised questions about what they said was an excessive exposure to Italian government bonds, according to a source close to the matter.... 

Monte dei Paschi's 25-billion euro Italian government bond portfolio made a net return of just 65 million euros in the first nine months of 2012 because of a fall in benchmark European interest rates. 

It would have made around 1 billion euros a year had the bank not carried out interest rate swaps in 2009 that moved almost the entire portfolio to floating rates, which fluctuate in line with the market, from fixed rates....

And who was the counter-party who receives the benefit of the fixed rate payments?  Is this deal part of the effort to conceal the losses?

"As in all banks there was a structure that could take risks and another one that was supposed to monitor that. As far as I know the Bank of Italy was aware of this model, and asked for changes. Probably this model was inadequate."

And who monitors that the bank is properly monitoring its risk?  With ultra transparency, it is the market.

A November 9, 2010 Bank of Italy report, also seen by Reuters, showed how inspectors from the central bank had raised concerns about risky derivatives trades after they visited the bank from May to August 2010. 

The inspectors specifically raised the deals with Nomura and Deutsche, which are now at the heart of the scandal.

The Bank of Italy - led until 2011 by Mario Draghi who is now the European Central Bank Chief - has said it realised the "true nature" of the contracts late last year, after Monte dei Paschi's new management discovered the document in the safe.

This highlights how the regulators' information monopoly makes the financial system unstable.  Clearly, the regulators did not realize the 'true nature' of the contracts.  The result is a bank scandal.

Had the bank been required to provide ultra transparency, market participants, including derivative experts, would have seen these deals and understood their 'true nature'.