Italian bank derivative scandal offers more evidence that financial regulators need help

Reuter's is out with another article on Monte Paschi, the Italian bank involved in the derivative scandal, that offers still more evidence of why financial regulators are not up to the task of policing the financial system.

They need help.

The way to provide the regulators with help is to strip them of their monopoly on all the useful, relevant information about each bank and require each bank to provide ultra transparency and disclose its current global asset, liability and off-balance sheet exposure details.

With this information, the market, with its ability to both analyze the financial institutions and discipline the institutions, can help the financial regulators.

Mario Draghi was informed of doubts raised by Bank of Italy inspectors about the Monte dei Paschi bank but had little control over what has been widely criticized as ineffective oversight of the scandal-hit lender, a senior BoI source told Reuters. 

The roots of the corruption and derivatives scandal at Monte dei Paschi all stem back to when Draghi, now president of the European Central Bank, was chief of Italy's central bank from 2006 to 2011. 

The Bank of Italy (BoI) says it did everything in its powers to oversee Monte Paschi, including forcing it to raise new capital and applying behind the scenes pressure to force out its executives, who left last year....

But the BoI, under Draghi's leadership, is under fire for not acting faster to sanction those managers and make its doubts public even though its inspectors had spotted the derivatives contracts at the centre of the scandal back in mid-2010....

As I have previously said, one of the problems with regulators having an information monopoly is that their disclosure to the markets seldom matches the reality of what is actually going on with a bank.

However, the senior BoI source stressed that the decision on launching a sanctions procedure, involving publicly blaming and fining bank officials, does not depend on the BoI governor and its five member executive board, but on the bank's inspectors and then a series of lower committees. 

"The inspectors are the only people responsible for initiating a sanctions procedure so if they don't find anything in the course of their inspection then it's not possible for the top management to start the process," said the source, who asked not to be named. 

"We instruct the staff to be absolutely free from any influence from us, to present exactly the case, so if a sanction is decided then they present a proposal to the board and the board decides on the actual implementation of the sanctions."

The highlighted text summarizes one of the reasons that the disclosure from financial regulators seldom matches reality.  By their very nature, financial regulators talk with one voice.

The text describes the bureaucratic process that the inspectors must go through to change what the financial regulator is saying knowing 100% of the time that the bank that is threatened with sanctions will lobby the board not to impose sanctions.  Please recall, Monte Paschi is one of Italy's most politically connected banks.

In the summer of 2010 BoI inspectors uncovered two opaque derivatives contracts that could cost Monte Paschi 720 million euros and are now at the center of fraud investigations, yet did not propose that sanctions be launched. 

That decision "had nothing to do with the board," the official said, though he added that Draghi was shown the inspectors report....

So Draghi shot down the inspectors' trial balloon.

That 2010 inspectors' report was leaked to the press and sparked much of the current criticism of the BoI because the sharp criticisms of Monte Paschi's accounts and operations made by the inspectors were not followed by pressing action....

A trial balloon that was a call for action.

"We may perhaps appear to be slow, but I think we are deliberate," the official said. He also stressed that although Monte Paschi failed to comply with the BoI's requests, the wrongdoing was already done at the time of the 2010 inspection. 

"What took place afterwards was to try to disguise the losses but it wasn't a recurrent or growing pattern of misbehaving," he said.

If banks were required to provide ultra transparency, the BoI could have taken all the time it wanted as the losses would not have been disguised to the financial markets.

For their part, market participants would have exerted discipline while the BoI was being deliberate.

The center-left has generally been more cautious, calling for more powers for the central bank rather than openly blaming it for laxity. 

The idea that the BoI lacks sufficient powers for effective oversight has become a common theme in the Italian press, with attention focusing on the fact that while it can replace the board of an offending bank, it cannot fire individual managers.

The BoI source made clear that giving the bank this power would be a welcome step, though he was careful not to acknowledge any blame for the Monte Paschi scandal. 

"If we get that power it will certainly be an additional tool but I don't subscribe to the idea that we don't have sufficient powers and that the exercise of our powers wasn't effective," he said.

Excuse me, the BoI exhibited an incredible degree of laxity by not disclosing what it knew to the market.  This failure to disclose meant that market participants did not have information they needed to properly assess the risk and solvency of Monte Paschi.  By definition, investors mis-priced any capital they invested in the bank since 2010.

In case anyone thinks that I am singling out the BoI for its failure to share with market participants information that these participants needed to properly assess the risk and solvency of each Italian bank, I have written numerous posts about financial regulators in other countries engaging in exactly the same behavior (the list includes, but is not limited to, Ireland, the UK and US).

The only way to prevent financial regulators from engaging in this behavior in the future is to strip them of their information monopoly and require the banks to provide ultra transparency.