Monte Paschi scandal provides more evidence bank supervision by regulators inadequate

On two separate fronts, the Monte Paschi scandal provided evidence that supervision by bank regulators is inadequate as a substitute for the combination of transparency and market discipline.

First, Mario Draghi said that the Bank of Italy did what it was suppose to do and could only have done more it granted additional powers.  Second, the Bank of Italy made a previously undisclosed loan to Monte Paschi in late 2011.

As reported by Reuters,

European Central Bank President Mario Draghi denied suggestions on Thursday that he had been lax in his oversight of the scandal-hit Monte dei Paschi when he was governor of the Bank of Italy....

In his first public comments on the crisis, Draghi told the ECB's monthly news conference in Frankfurt that the Bank of Italy had "done everything it should and appropriately and on time." 

As governor of the Bank of Italy at the time, Draghi was ultimately responsible for bank oversight prior to his departure for Frankfurt to head the ECB in November 2011....

Let's assume that Mr. Draghi is correct in his statement about the performance of the Bank of Italy.

This simply confirms that supervision by bank regulators doesn't work as a substitute for transparency and market discipline.

If banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, the derivatives could not have been hidden as the counter-parties would have wanted them acknowledged so they could get the benefit of each deal.

While there are no legal restrictions that prevent banks from disclosing on a borrower privacy protected basis all of their current exposures, banks prefer not to do this.

Rather, banks prefer that the bank regulators, like the Bank of Italy, who have supervisory responsibility and the legal right to see all the useful, relevant information that is needed to assess the solvency and risk of the banks have a monopoly.

Why?

Because then the banks are not subjected to market discipline.  In fact, to the extent that the banking supervisors don't follow up aggressively on any problem, the banks are not subject to any discipline.

He said he had signed two reports into Monte Paschi by Bank of Italy inspectors, the first of which, from mid-2010, has been leaked to the press and raised several irregularities in Monte Paschi's operations and accounts....

Draghi said that as it does not have policing powers, the Bank of Italy was limited in its ability to counter fraud, one of the charges which prosecutors have leveled at Monte Paschi's former management.

Keep in mind that it was always an option for the Bank of Italy to disclose to the market that it had found these irregularities involving derivatives.

By not disclosing its findings to the market, the Bank of Italy allowed Monte Paschi to present a false picture of its financial condition.

Facing several different questions on the historic lender, Draghi suggested that the Bank of Italy could have benefitted by having more powers to supervise effectively....

More supervisory powers wasn't going to change the failure of the Bank of Italy to disclose information that the market needed to properly assess the risk and solvency of Monte Paschi.

In fact, it can be argued that due to safety and soundness concerns, the Bank of Italy had an incentive to not disclose the derivative irregularities.

As reported by the Wall Street Journal, the Bank of Italy extended a secret loan of almost 2 billion euros to Monte Paschi in late 2011 as it was experiencing liquidity problems due to the derivatives that the Bank of Italy had not disclosed to the market.

Again, had Monte Paschi been required to provide ultra transparency everyone would have known about the loan.

Instead, it looks like the Bank of Italy intended that the loan should be hidden and Monte Paschi make false representation about its financial condition to the market.

Monte dei Paschi di Siena SpA, the 541-year-old Italian bank at the center of a burgeoning financial scandal, was so strapped for cash in late 2011 that it negotiated a covert loan of nearly €2 billion ($2.7 billion) from the Bank of Italy even as executives were publicly describing the lender's funding position as comfortable, according to the Bank of Italy and people familiar with the deal.

The bottom line and the reason there is a scandal is that Bank of Italy failed to disclose material information about Monte Paschi that market participants needed to have if they were to accurately assess the risk and solvency of the bank.

The lesson from the scandal is that bank regulators need to be stripped of their information monopoly by requiring all banks to provide ultra transparency.

At a minimum, this subjects the banks to market discipline and eliminates the possibility that bank regulators will fail to disclose material information.