European View

MPS, Deutsche Bank and the ECB’s lopsided banking supervision

by Claudio Gatti

24 Exclusive content for IT24

“Banks in the whole of the euro area are now supervised based on the same high standards […] as objectively as possible, not through national lenses, and following the principle of ‘same business, same risk, same supervision.’”

This is how Sabine Lautenschläger, vice-president of the European Central Bank’s regulatory body, the Single Supervisory Mechanism (SSM), described her mandate at a conference on November 7th, 2016 in Munich.

“We scrutinise each and every one of these banks and determine their risk profile,” she continued. “We are extremely thorough and comprehensive: we look not only at the amount and quality of capital and liquidity, but also at the corresponding risk management, as well as the business model and governance.”

This declaration of impartial rigor by Ms. Lautenschläger, supported by her commitment to apply the “same methodology” to all banks, clashes with the results of an investigation by Il Sole 24 Ore-ItalyEurope24 focused on Monte de’ Paschi di Siena (MPS) and Deutsche Bank (DB), the European banks most affected by the two major problems plaguing the EU banking system: Non-Performing Loans (NPL) and “Level 3 assets ,” or derivatives.

An in-depth look of the regulatory activity carried out by SSM on MPS and DB highlighted an inconsistent approach. The SSM has been strict with MPS and indulgent with DB: with the Siena-based Italian bank, the SSM not only imposed specific capital requirements and NPL coverage, but forced strict deadlines. With the Frankfurt-based Deutsche Bank, on the other hand, it allowed a dispensation from rules applied to everyone else and granted a much more gradual timetable.

But the strongest evidence of this lopsided treatment arises from the two inspections that the SSM recently conducted in Siena at MPS and in Frankfurt at Deutsche Bank.
The SSM sent to Siena Jan Hemmers as chief inspector, a French-German supervisor known for his strictness, who spent much more than the usual six months in an inspection geared toward reaching deep into the specifics of the NPL portfolio.

Nobody can argue with that goal. Especially considering MPS’s past compliance failures that led the Bank of Italy to sanction the entire top echelon of MPS for a total of almost €3.5 million; the weak capital requirements the Siena lender displayed in the recent stress tests and the high number of non-performing loans in its credit portfolio.

“In my view the SSM has been far too lenient with MPS. Therefore, it is good that it recently intervened with much more determination,” said Nicolas Véron, a French economist from the Bruegel economic think tank considered close to the central bank.

But according to his own colleagues, Hemmers went well beyond “determination.”

A credit inspection is usually made up of different phases: credits are clustered in homogenous groups, and a limited number of loans are selected as samples from the most significant of these groups. These loans are then priced taking into consideration all discounting factors. Finally, a statistical projection is made from those samples.

“Officially an inspection is always neutral. But in reality, context and perception play a significant role. Inspectors clearly know if their mandate is to come down hard, or not do too much damage,” said a former inspector who works in a private bank (not MPS). “It is clear that Hemmers went to Siena with a mandate not to pull any punches.”

Even the choice to pick him may not have been random. At the SSM, Hemmers is well-known for being inflexible. In fact, in a previous inspection in Greece, his tendency to go to the extreme lead him to conclusions that were first contested by the Greeks, and then significantly revised in the course of the revision process in Frankfurt.

The same thing happened in Siena, but in a much more tense manner. As reported by Il Sole in January, members of the Italian contingent of the inspecting team felt the need to write a dissenting opinion even before the concluding report was presented to the SSM.

This “minority report,” circulated both within the Bank of Italy and the SSM, brought to light an internal disagreement on the conclusions that the team leader was reaching, a clear indication of the fact his findings were not above criticism.

More importantly, the approach followed by Hemmers clashed with that of the inspection just completed at Deutsche Bank, carried out by Emanuele Gatti, a supervisor from Bank of Italy.

His team was asked to focus on organizational processes and work on assessing the DB’s risk management. Gatti was not even asked to try to independently value the bank’s Level 3 assets.

This despite the series of violations that cost Deutsche Bank more than $19 billion in fines or settlements with US, UK and Swiss authorities; despite the fact that, according to information found by Il Sole 24 Ore-ItalyEurope24, the 2014 asset quality review (AQR) omitted to value DB's significant portfolio of Level 3 assets; despite the fact that the bank barely made the capital requirements in the July 2016 stress tests, in part thanks to a favourable treatment by the SSM which allowed the bank to account for the sale of a Chinese subsidiary not yet formally closed; and despite the fact that a significant number of DB’s current top executives were active when the bank was either violating rules or concealing its violations.

According to Deutsche Bank, “the Supervisory Board has brought about a new beginning in the composition of the Management Board. And that’s not all: at the level directly below, three quarters of our managers are either new to their positions or even, in many cases, new to the bank.”

But the reality is that five of the 11 members of the Management Board and seven of the 20 members of the Supervisory Board held senior positions before as well.

Starting from the planning phase of the 2014 AQR, both the SSM and its advisors from the consulting firm Oliver Wyman decided not to value Level 3 assets. Sources close to the matter told Il Sole 24 Ore-ItalyEurope24 that the head of the Oliver Wyman team, Ian Shipley, admitted that it would not have been possible to assess highly structured derivatives because the central banks and the consulting firms that would have supported them in the AQR lacked the necessary expertise. We wanted to ask Mr. Shipley for confirmation of this, but he declined our request for an interview.

According to our sources, Shipley pointed out that while the methodology for examining NPLs is accessible to any inspector, for derivatives the only experts capable of “running the models” and challenging the values reported in the banks' balance sheets were those working for the very same US investments banks that sold those products. Resorting to any of them would have led to a potential conflict of interest.

Aside from expertise, the ECB would have also lacked access to data and, above all, time.

While NPLs are relatively simple to examine, derivatives are complex legal contracts priced on the basis of complicated variables, and each one of them requires its own individual model. A single NPL requires between half a day to three days of work, and therefore the evaluation of a €10 billion portfolio with a sample of 1,000 positions calls for 500-3000 days. Assessing the same amount of derivatives would require an amount of time that no inspection could afford.

This is why in the 2014 AQR Oliver Wyman and the ECB's Sabine Lautenschläger opted for taking quite a superficial approach on the Level 3 assets.

“If you don’t value any individual derivative and don’t make any projection, how can you claim that you are doing a real check?” said a source close to the matter.

“The 2007/2008 financial crisis taught us that the evaluation of Level 3 assets, whose value is based on an internal model and not determined by the market, shouldn't be seen as something written in stone. For the supervisor, not evaluating those assets accurately implies not having learned that lesson,” added Emilio Barucci, an expert in quantitative finance at the Polytechnic University of Milan.

According to an ECB spokesperson, “the SSM staff does have the expertise and experience needed to supervise market risk, including the so-called ‘Level 3 assets,’ according to the accounting and valuation definition.”

Barucci does not agree: “It seems that not even in the second round of the stress tests, the ones carried out in July 2016, the SSM decided to make those evaluations. This leads me to believe that they haven't yet developed the necessary internal expertise,” he said.

Though in more cautious terms, even an economist close to the ECB such as Nicolas Véron agrees with that assessment: “If the question is: has the SSM reached a level of comprehension of Level 3 assets capable of sustaining a complete supervision approach? The answer is: probably not yet.”

This could be the reason why the mandate the SSM gave to Gatti’s inspection team did not include the task of pricing the DB's derivatives.

“Doing an inspection at Deutsche Bank and not assessing the Level 3 assets, is exactly like doing an inspection at MPS without evaluating the NPLs,” said one source familiar with the matter.

Il Sole 24 Ore-ItalyEurope24’s investigations show that even in areas where inspectors had a mandate to carry out in-depth investigations, Deutsche Bank did not come out well. Although the final report is still being edited internally, the final findings will show deficiencies in various areas.

“The inspection highlighted that processes are not adequately monitored and that the risk management systems are not sufficiently integrated or strong enough to challenge the front office, that is the division which generates profits for the bank,” said a source. “Risk management in a bank is usually considered as solid as its ability to challenge the front office, especially when we are talking about derivatives with no real market value. But in order to do that, you need to have a very solid infrastructure, which the inspection showed that Deutsche Bank does not have.”

Nine years have passed since 2008, when the German bank found itself technically in default, but its risk management does not have yet the required solidity. The identity of the manager in charge shows how little has changed in that area. The Chief Risk Officer, or CRO, of Deutsche Bank is Stuart Lewis, a manager who has worked in the bank since 1996 and who was deputy-CRO between 2010 and 2012, a period in which the risk management of the bank ignored a problem with 100 billion dollars of derivatives called Leveraged Super Seniors, that lead the American regulatory authority SEC to force a $55 million settlement.

Doubts about Lewis’ choice for that role were expressed even by Bill Broeksmit, the risk management expert and DB executive who committed suicide on January 26, 2014, most probably as a result of the psychological pressures due to the many investigations targeting his bank. In an email he sent to a friend before his death, Broeksmit wrote “Stuart’s background is in credit risk. He won’t be especially fluent in model risk.” Yet since 2012 Deutsche Bank has given Lewis the task of monitoring its most serious risk it has, the model risk.

When we asked about the different treatment reserved for non-performing credit and Level 3 assets, the ECB responded by minimizing. “Level 3 assets are not NPEs. (Non-Performing Exposures) They comprise diverse types of market instruments, and consequently the supervisory actions related to such assets depend on their risk characteristics.”

This was their statement to the outside. But Il Sole 24 Ore-ItalyEurope24 learned that, internally, the problems brought to light by the recent inspection at Deutsche Bank forced the SSM to finally worry about its lack of visibility on Level 3 assets.

“In their assessment of the risk management processes, the inspection team identified a number of weak points regarding all kinds of derivatives: from those built around life insurance to those around the climate. And last but not least some highly complicated financial bets with Qatar,” said a source. “The weaknesses of risk management raised suspicions about the pricing processes.”

As a result, Il Sole 24 Ore-ItalyEurope24 learned that the SSM quickly set up a special working group with the mandate to find ways to get better visibility on the valuation of all derivatives.

While NPLs’ risks for Italian lenders remain as serious as ever, it must be said that, by now, Level 3 assets do not constitute a system risk for the European banking system. But this is due to the fact that banks such as Deutsche Bank that in 2008 were at risk of default were given the time to gradually reduce their exposure. This is how DB was able to go from €87.663 billion of Level 3 assets in December 2008 to €25.8 billion recorded in September of 2016.

Except that, still today, nobody outside Deutsche Bank has any idea if that amount is in fact correct or not.