Deutsche Bank's Monte Dei Paschi derivative shows why banks must disclose current exposure details

As Bloomberg reports, Deutsche Bank designed and sold a derivative to Monte dei Paschi so the large Italian bank could hide losses that it had already incurred.

The very fact that a bank could engage in a trade to hide its losses confirms the need for banks to provide ultra transparency.

By requiring banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, it eliminates the ability of banks to hide their losses.

Deutsche Bank AG (DBK) designed a derivative for Banca Monte dei Paschi di Siena SpA at the height of the financial crisis that obscured losses at the world’s oldest lender before it sought a taxpayer bailout. 

Germany’s largest bank loaned Monte Paschi (BMPS) about 1.5 billion euros ($2 billion) in December 2008 through the transaction, dubbed Project Santorini, according to more than 70 pages of documents outlining the deal and obtained by Bloomberg News. 

The trade helped Monte Paschi mitigate a 367 million-euro loss from an older derivative contract with Deutsche Bank. As part of the arrangement, the Italian lender made a losing bet on the value of the country’s government bonds, said six derivatives specialists who reviewed the files. 

“I can’t understand why any financial institution would engage in a trade like this for legitimate objectives,” said Frank Partnoy, a professor of law and finance at the University of San Diego who structured derivatives at Morgan Stanley and has read the files. “They shouldn’t ever be doing that.”...

Which is why banks should not operate behind a veil of opacity, but rather should have their entire business exposed to the best disinfectant of bad behavior: sunlight.

The Santorini transaction shows how investment banks devised opaque products that years later are leaving companies and taxpayers with losses. 

From the Greek government to the Italian town of Cassino, borrowers have lost money on bets that were skewed in banks’ favor. In December, an Italian judge convicted bankers at four firms, including Deutsche Bank, of fraud in arranging an interest-rate swap for the city of Milan....

Under the FDR Framework, government regulators are given responsibility for ensuring transparency.

Had banks been required to disclose the details of these opaque products, they probably wouldn't have sold them and the buyers probably wouldn't have purchased them.

“You have two banks gambling on regulatory action in late 2008, at a time of supposed crisis, and they are using overly complex and opaque derivatives to do it,” said Partnoy, the University of San Diego professor. “Deutsche Bank made a fortune for facilitating the trade. You can’t tell any of this from looking at their financial statements.”...

As your humble blogger has been saying since the beginning of the financial crisis, so long as banks are opaque "black boxes", bankers will engage in gambling.

Current disclosure rules for banks are not up to the task of preventing or exposing this gambling.  A point Professor Partnoy makes.

The only way to expose what is happening so that market participants have the information they need to assess each bank is to require ultra transparency and disclosure of each bank's exposure details.

Santorini “exemplifies the complex structuring, questionable internal decisions and lax external supervision rampant in the lead-up to the crisis and beyond,” Dempster said....

The only way to prevent this from recurring in the future is by restoring transparency to all the opaque corners of the financial system.  This includes bank balance sheets.

Monte Paschi shareholders haven’t been in a position to know about the bank’s derivative bets because its filings didn’t provide sufficient information on Santorini and its liquidation, according to two accountants in Italy who reviewed the documents....

Please re-read the previous paragraph because if shareholders aren't in a position to know about derivative bets, they aren't in a position to exert market discipline to prevent these bets in the first place.

“This transaction shows the complexity of banks’ balance sheets,” said Mark Williams, a former bank examiner for the Federal Reserve and now a lecturer at Boston University’s School of Management, who also reviewed the documents. “It leaves one wondering what other skeletons are in the closet.”

The only way to know what skeletons are in each bank's closet is to have them provide ultra transparency and disclose their current global exposure details.