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Friday, March 29, 2013

Laiki Bank is only a symptom. The problem is elsewhere!

This interesting article describes how the Greek tycoon Andreas Vgenopoulos built his Marfin Investment Group (MIG) to which the now defunct Laiki Bank had belonged. Please note that the article was published in June of 2012!

The story in nutshell: Greek wants to build Empire and become tycoon. For that he needs money. He realizes that it is easier to get money in the name of a bank than in the name of a company (or in his own name). He also realizes that it is easier for a bank to get money when it is domiciled in Cyprus instead of Greece. He gets hold of a bank in Cyprus and uses it as one giant sucking mechanism for money. He spends that money, in the name of the bank, to finance the expansion of his group based in Greece. He also spends money to finance himself and befriended partners to buy shares in his group so that the stock market value of his group explodes. Add to that a little corruption and the story is complete.

On the surface, there is nothing obviously illegal about the above practices except, of course, for the despicable corruptive part of it. But it could also been done without corruption. There is nothing illegal about a bank's financing the expansion of a group. There is nothing illegal about a bank's financing the acquisition of shares in a third-party company using those shares as collateral (provided, of course, that sufficent security margins are maintained).

You and I can, without any money on our own, open a bank and furnish it with an equity of, say, 100 MEUR. All we would have to do is to state in the bank's statutes that the equity will be paid up within 3 months. During these 3 months, we make a 100 MEUR loan to ourselves and put that money into the bank as equity. No cash moved. The bank now has total assets of 100 MEUR (its loan to us) and equity of 100 MEUR. No debt; no leverage. On the surface, triple-A quality. Then we start raising funds in the name of the bank and lend these funds to whoever we want (including ourselves and/or our other corporate enterprises).

There are only 3 reasons why this would normally not work: banking laws, banking regulations and the observance/control of the latter.

If a bank makes a loan to its owners, the bank is reducing its equity. If the bank makes a loan to a series of seemingly third-party companies which are secretely under the control of its owners, the fact that it is reducing its equity is covered up. But, at the end of the day, it is still lending to its owners and, thereby, reducing its equity.

Please note that, on the surface, everything would appear quite proper: the bank's books balance; the bank's loans seem well-structured; the bank's management tells credible stories about the marvels of their growth strategy. The bank may even pass EU stress tests with flying colors.

The whole system stands or falls with supervisors/controllers of banks doing more than just making sure that the i's are dotted and the t's crossed. Put differently, if supervisors/controllers only make sure that the i's are dotted and the t's crossed, literally unlimited malpractice can take place behind the facade of balanced books.

I have written ad nauseum that, in the case of Greece as a country, no one (neither in Greece nor at the EU level) seems to have been concerned about the application of the enormous funds which entered the country. In Cyprus, it seems that no one at the EU level spent any amount of time to understand how the Cypriot banking sector applied all those billions and billions of funds which it attracted.

In Greece, the EU had almost 10 years to look at the country's Balance of Payments and to monitor the staggering increases in foreign debt of both the public and private sector (banks). In Cyprus, they had over a year to shed light on what the Cypriot banking sector was really doing. Still, the Eurogroup took decisions in the last couple of weeks which would suggest that they had absolutely no idea as to what the Cypriot banking sector was doing. Apparently, they had done nothing for at least a year and then they gave the new President a couple of weeks to come up with a solution.

It is simply mindboggling to observe how little competence the Eurogroup and EU politicians have in the area of setting incentives for growth in the real economy. It is even more mindboggling to observe how little competence the Eurogroup, EU politicians and - above all - the monetary experts at the ECB have in the area of seeing through the operations of a banking sector. All they seem interested in is that the books balance.

If the Eurozone were a multinational corporation, its top management would have been fired a long time ago. Some of them might even have been brought to court for illegal practices. And none of them would have found a new job due to their lack of economic, financial or commercial competence.

7 comments:

  1. Even so, is there anything like "peer-control" in EU-banking planet?

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  2. Just one question? Before banking union, do you know how much control rights and duties were at EZB and how much control rights and duty were at Central Bank of Cyprus?

    If I have read and unterstood it correctly, the german banks are supervised and controlled by Deutsche Bundesbank and the EZB has to trust (or mistrust) the control quality of the national central bank - at least before implementation of banking union.

    If that is true, and for cyprus as well, I think the cyprus central bank (and its controllers) is to blame, not the EZB.

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    1. The banking supervision is entirely a national affair. A national Central Bank typically has primary responsibility but others (e. g. Ministry of Finance) also get involved. The primary responsibility of banking supervision is to check compliance with the banking law and regulations. What I have suggested in my article is that a bank can be in full compliance and yet be exposed to enormous risks. To understand that requires more than compliance checking.

      Why do I still see responsibility on the part of the ECB? The ECB is a lender to all banks and any lender has the responsibility to analyze and judge the creditworthiness of one's borrower.

      The ECB and national Central Banks act in concert. Both have huge and highly competent staffs who make all sorts of monetary and financial analyses. That staff could be put to use for a better understanding what the banks really do.

      The ECB and national Central Banks may not have complete insight into a bank's lending activities but they have complete insight into a bank's cash flows, i. e. where the funds are coming from and where they go. With a banking sector like that of Cyprus, there ought to be plenty of reasons for the ECB and the national Central Bank to say something like "let's take a close look at what Laiki is really doing so we can understand their risk". That would go beyond compliance checking. That would be more like due diligence.

      When one bank buys another one, there is a lengthy due diligence process. Essentially, the buying bank takes the takeover target apart to assess what it is really worth. At the end of this exercise, the buyer generally has a pretty good idea of what he is buying. I am suggesting that banking supervisory authorities would not have much of an idea of what they are buying if they were to buy one of the banks which they supervise.

      That's not only an issue for Cyprus. It's more or less the same everywhere. The German supervisory authority (BAFIN) was allegedly caught by surprise when the gigantic failure of HypoRealEstate occurred.

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    2. Thanks Klaus, I intuited a few weeks ago that there was something not quite right about Marfin.

      This Bruegel paper What Kind Of European Banking Union? discusses the deficiencies in the current setup - and how to fix them.

      The Cyprus Securities and Exchange Commission (CySec) appears the prime regulatory agency for financial services in Cyprus, similar to BAFIN in Germany. Here is its most recent press release

      ANNOUNCEMENT

      The Cyprus Securities and Exchange Commission would like to inform the investing public that, since the onset of the events which led to the decision at the Eurogroup meeting of 25th March, it continuously monitors the developments and makes recommendations to the authorities responsible for taking decisions, whenever it deems appropriate. The recommendations made are in line with the mandate of the Cyprus Securities and Exchange Commission regarding the protection of investors and the proper functioning of the market.

      The Cyprus Securities and Exchange Commission fully shares the public concern and recommends remaining calm and not acting hastily.

      Nicosia, 28 March 2013


      At the EU level the prime agencies for regulating Financial Services are at least the European Banking Authority and/or the European Financial Stability Board.

      Maybe the spotlight should be turned on these institutions rather than the ECB and CBoC.

      On the May 24 there's a public hearing in Brussels on Financial Supervision in the EU.

      CK

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    3. Addenda to previous comment - here is the ESRB About page - it appears to have all the resources of the ECB available to it and then some - Draghi is Chairman, the Central Bank chiefs are voting members, FinServ agency chiefs are non voting members.

      Clearly this is the agency that should have said "let's take a close look at what Laiki is really doing so we can understand their risk" - what's more that's its job - its even implied in its name!

      CK

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    4. Thanks for putting facts around my gut feeling that there are plenty of resources at ECB and national Central Banks. I am now awed by how many resources there are and how much they failed with the specific responsiblity they were charged with.

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  3. Yes, good column Klaus, and good comments from Canutely King.

    My impression is that there are institutions in Banking Supervision in Europe, currently, that are more just there for purposes of camouflage. They've deliberately been created without the required competencies. So, for example, the EBA http://www.eba.europa.eu/Aboutus.aspx

    "The EBA has some quite broad competences, including preventing regulatory arbitrage, guaranteeing a level playing field, strengthening international supervisory coordination, promoting supervisory convergence and providing advice to the EU institutions"

    And *how* is it supposed to prevent regulatory arbitrage, just for example? It couldn't even insist on getting quality data for its (by now widely derided) stress tests.

    By contrast, when the spanish "bottom up" stress test was carried out by Oliver Wyman last september, they had access to the raw data. Because the spanish central bank insisted on it.

    And jurisdictional arbitrage really has proven a big problem. National Bank Supervision, in a common currency area! Now that was one big flaw.

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