Still waiting for the truth from the regulator (Village December ’10)

UniCredit breached liquidity requirements in 2007.  Matthew Elderfield nods.  The interconnectedness of banking dysfunctionality.
Michael Smith

There is a general official view that Ireland’s ethical delinquencies are in the past.  Corrupt planning stopped when the tribunals started; and bad bank-regulation stopped with the demise of Pat Neary and the production of two limited and innocuous reports by Patrick Honohan and Klaus Regling. Inconveniently for a country that has started to see regulation in black (then) and white (now) terms, the general view does not reflect the reality. Hold tight for a mind-boggling trip through the complexity of banking dysfunctionality.

Liquidity is the short-term financing vital to ensure the banks still do their core job of funding the economy.  Somehow Ireland went from having liquid banks to having banks so illiquid that a bank guarantee was offered by the government in September 2008.  But there are staff in every bank legally charged with ensuring banks do not become illiquid.  There is an intricate and comprehensive system in place to ensure they cannot become illiquid, bearing in mind their customer base.  It involves arrangements they must have in place if for some reason they become illiquid e.g. they can ask another named financial institution to lend them money short-term.  Every morning the banks have to produce a report showing how they kept their liquidity up to the target the previous day.  The measure used for the target is the ‘liquidity ratio’.

In mid 2007 the financial regulator, Pat Neary  – following a six-month ‘dry-run’ –  introduced a new rule for the liquidity ratio implementing the latest Basel banking accord.  It required that cash inflows equalled at least 90 per cent of cash outflows forecast over the relevant period. This prudential system was, and is, central to how banking is possible.  The system was intended to be stringently monitored by the financial regulator.

In fact Village has evidence that a failure of liquidity, that if it  – as may well have been the case – was typical to both Irish banks and foreign-owned subsidiaries,  shows dysfunctionality on a scale that should have prompted the financial regulator to advise the government to go out into the markets and get funds for the banks immediately, was ignored by the regulator. Nor did auditors pick up on it.  Indeed it is highly likely that liquidity problems were dysfunctionally glossed over by auditors all over Dublin’s financial world around this time. If such dysfunctionality had not occurred and been ignored for so long after the collapse of Northern Rock, Ireland could have dealt with general bank liquidity in a structured and gradual way – and not purportedly needed the bank guarantee that has finished up bankrupting the country and immiserating much of the population.

The people behind this dysfunctionality should be made to account for it.  The new regulator, Matthew Elderfield,  should explain what went on on his predecessor’s watch so we can see what happened.  Instead it appears the new regulator is being disingenuous.

In late July or early August 2007, an experienced financial risk-manager,  says he discovered his employer bank – the Irish subsidiary of the giant UniCredit Bank of Italy –  had been dramatically breaching the liquidity ratio. The risk-manager maintains he was specifically warned by senior personnel at the Irish subsidiary not to report the matter to the financial regulator in Ireland. On one occasion he reported a ratio of only 70% to the regulator (and obtained a receipt). In fact he says “I was getting 75%, even 65%, not occasionally but day in, day out. Banks are obliged by law to maintain all daily records for at least five years so there must be written evidence of this.  At the time, I thought: ‘Is it my fault?’  Then I asked questions and I was told ‘it’s a system error’ or ‘a trader forgot to book a deal’ or ‘it’s complicated.  Give it a bit more time and you’ll understand.  It will be fine’”. In any event, even if taken at face value, such failures would attract penalties under Sections 3.4 and 10 of the regulator’s Requirements for Management of Liquidity Risk, 2006, which seem to impose fairly strict liability. Ascertaining the liquidity ratio is a complex task and eventually the risk-manager turned to a consulting company in London for help, affording it access to UniCredit’s systems.  That company – a company which continues to provide such services for some of Ireland’s most well-known banks – calculated the liquidity ratio at an extraordinary 50% when a ratio of 89% would in normal circumstances be deemed problematic. The risk-manager resigned, in part fearful  of the draconian penalties that applied for breach of the law.

A simple call to UniCredit’s Milan-based parent could have been expected to generate a transfer of many billions of Euro within a few hours, so resolving the problem.  But that would have undermined the parent bank’s confidence in its Celtic subsidiary, and perhaps jeopardised bonuses against a background where the previous year’s final accounts had anyway required substantial and embarrassing revision to the tune of tens of millions of Euro.

Around  two weeks later the financial regulator came in  on a scheduled inspection. It appears all hell then broke loose with the regulator effectively taking over the firm for two weeks.  During this period the arrangement with the expert London consulting company was terminated, so it may have proved difficult for the regulator to ascertain the prevailing liquidity ratio.  The risk-manager was warned by his former employers that repeating his story “to a third party would constitute grounds for a claim of defamation which we would not hesitate to pursue”. Solicitors McCann Fitzgerald wrote to him on their behalf advising that his allegations were “outrageous”. They have claimed the same to Village.

What is surprising is the reluctance of Irish authorities, and indeed Irish politicians, government and opposition alike, to make the running with this still unresolved issue. The honourable exception is Senator David Norris who outlined the events described above and pushed the issue in the Seanad, though without naming the bank – except privately to the Minister.

The regulator
The new until-now ‘poster-boy’ regulator, Matthew Elderfield, has stated in response to questions from the Sunday Business Post, and the Süddeutsche Zeitung,   a respected German newspaper, that “our records do not match the description of events given by Senator Norris; nor did we receive what might be described as a ‘whistleblower’ letter.  We can, however, confirm that an overnight liquidity breach was reported by an institution around the time in question. The matter was followed up with the institution and rectified to the satisfaction of the Financial Regulator at the time”. For a poster boy this is in fact remarkably disingenuous, though certainly true.  The regulator’s records presumably do not match Senator Norris’s because its agents didn’t look hard enough or take a proper record; and they did not receive a whistleblower letter as the letter came from UniCredit itself which limited its declaration to one overnight breach.  Notably, nothing the regulator said undermines the credibility of the risk-manager.

It is impossible that there could be a flagrant breach without a systemic problem since the whole prudential system is constructed with actuarial precision so it can deal with every contingency.  That is what makes it prudential. In prudential circles a 1% breach is taken very seriously.  20% or 40% is calamitous. Impossible even. It is impossible that there would be an overnight move from compliance (90%) to flagrant breach (70% or even 50%), when the maximum deviation allowed from 90% is 1%. Unless perhaps there was a single extraordinary event, an unpredictable ‘act of god’. Anyone with any knowledge of the dynamics of liquidity ratios, including particularly the regulator,  would know this.  If there had indeed been such an extraordinary event, there would seem to be no reason why some intimation of the nature of the problem would not have been provided by the regulator, when questioned about the breach. In the absence of such an extraordinary explanation, seeing a breach of 20% or even 40% would necessarily alert the regulator to a systemic problem likely to be sustained over a long period. It would appear almost certain that the scale of the breach had evolved incrementally – and continued for some time.  Not just overnight. This would tend to corroborate the risk-manager’s story.

Extraordinarily, the financial regulator did not then, and Matthew Elderfield – who has been in office since January 2010 –  still has failed to, interview the risk-manager about the matter.  This is despite the risk manager’s patently abrupt departure (and that of the London consultants) during this controversial episode – and an accelerating number of enquiries to the regulator about the matter. Nor is it clear whether the regulator informed the Milan-based parent of UniCredit or, crucially, the Italian and EU regulatory authorities.

In June 2009 the regulator issued a revision of regulations for liquidity ratios without making any reference at all to the fact that the regulations had been revised to achieve precisely this ‘new’ effect in 2006.  This served deceptively to imply that the regulations had not been in force at the time of the breaches by UniCredit (and by all the other banks whose liquidity imploded illegally, though without media recognition of the illegality, around the time of the bank guarantee). The text of the 2006 document [section 9.4] which specified that the new requirements had taken effect on 1 July 2007 disappeared from the 2009 document.

The bank itself
The 2007 annual report of UniCredit’s Irish subsidiary is signed as chairman by Professor Brian Hillery, one-time FF TD for Dun Laoghaire, current chairman of Independent Newspapers and  Director of the Central Bank. The auditors were KPMG who appear to have had some difficulties with the accounts but to have swallowed their pride. They – as usual – state  concerning the accounts that “to the fullest extent permitted by law  we do not accept or assume responsibility to anyone other than the company and the company’s members as a body” for the audit. The report states that, ‘‘in the light of pressures in the marketplace, we have maintained strong liquidity ratios since the middle of 2007’’. This must be highly controversial since the new legislation came into effect in the middle of 2007, and the risk-manager claims UniCredit was still not compliant in September, occasioning his resignation. Interestingly,  UniCredit in Milan has emphatically denied, to the Süddeutsche Zeitung and more recently the Sunday Business Post, that it is the bank to which Norris was referring in the Seanad. Perhaps it simply didn’t know.

Department of Finance/Central Bank
Finance Minister, Brian Lenihan, has stated that “the supervision of liquidity requirements for credit institutions  licensed and operating in ireland is primarily a matter for the Central Bank and the Financial Regulator… Breaches of liquidity  requirements may be subject to proceedings  under the Financial Regulator’s administrative sanctions procedure or to prosecution”.  Elsewhere he has emphasised that the Central Bank was subject to strict confidentiality requirements “unless the issue gives rise to some broader financial stability issue which did not arise in this instance”. Nevertheless he acknowledged that the Central Bank had been advised of an “overnight” breach around this time but “the institution rectified the position to the satisfaction of the Central Bank”. “The Central Bank required an external review of the liquidity reports submitted to it but did not identify material issues outside the single date highlighted”. He claimed that “appropriate steps necessary to prevent any recurrence off this issue have now been taken by the institution concerned”.

Opposition politicians
A prominent member of one of the opposition parties recently told the risk-manager, “‘we can’t afford the consequence of revealing this story.  We already have enough to deal with when we come to power”.

Joan Burton of the Labour Party was perhaps a little slow to move but, under a little pressure, diligently raised the matter with Brian Lenihan and met Patrick Honohan. Burton had met Honohan previously about the German bank,  DEPFA, and been told that the regulator’s staff was not trained to monitor IFSC activities and that by-and-large, the IFSC had been treated as some ‘off-shore’ entity that did not warrant strict supervision as most of its entities were subsidiaries of much larger overseas corporations, and therefore ‘someone else’s head-ache’.  The Green Party Senator Mark Dearey and its Chairman, Senator Dan Boyle, wrote to the regulator but did not receive a substantive reply.  Sinn Féin’s Arthur Morgan did not reply to correspondence from a senior academic friend of the risk-manager. Fine Gael’s then-Finance spokesperson, Richard Bruton, who met the risk-manager in his solicitor’s office, has sat on the file and his successor Michael Noonan doesn’t appear to know it exists. Former Fine Gael Taoiseach John Bruton is the head of Dublin’s International Financial Services Centre, which aims to attract financial companies to set up there, and is touting Irish the saleability of Irish banks to Gulf sovereign funds.

An inadequate regulatory culture is alive. Lack of interest in the truth abounds.  Figures just don’t matter.  The blind wearing of the green jersey goes on.

The media
The Irish Times has been reluctant to pursue the story, though Fintan O’Toole did an extensive spread on it.  Others in the newspaper were keen that the risk-manager should go public before the paper would pursue it further.  No other media have covered the matter except the Sunday Business Post, whose Kathleen Barrington has given it considerable space.

The New York Times famously alleged as long ago as 2006 that the IFSC was “the Wild West” of banking. Around that time it was reported that General Re’s Irish subsidiary, Cologne Re, was seen as an ideal location for a major fraud because Dublin “did not report to anyone” and so avoided the “North American problem” of financial regulation”.  The simple truth is that one of Ireland’s few genuine policy successes has been attracting major US-based multinationals like Google and Microsoft on the back of a 12.5% Corporation Tax rate.  Irish banks then assume a disproportionate importance to the world economy because these corporations have an interest in channelling profits through Ireland, so avoiding heavier tax rates elsewhere where the profits may in fact have been earned.  This is one of the reasons Irish banking was a flashpoint, certainly the European flashpoint following the collapse of Lehman’s.  The clout of the multinationals conduced to a lax regulatory régime for banking.  It also partly explains the government’s deference to the banks (over the people) in policy terms including perhaps some of the pressure the government was under to guarantee the banks, lest a run threaten the billions of  Euro in multinational profits resting in Irish accounts. Light regulation helped attract multinationals but it was a gamble that, after a time – and on a grand scale – has stopped paying off for Ireland. It stopped paying off because it led uniquely to liquidity problems across the ranges in a nation’s banks and so to guarantees that have precipitated national insolvency.  But the policy of light regulation also risks major legal actions from those who have been victims of the dodgy, sometimes illegal, laxity. It is surprising in this context that the bailout was not linked to higher standards.  In late November the Financial Times commented, “An element of the bail-out should have been specifically targeted at plugging the liquidity gap, if only to signal an acknowledgement of how crucial a role it has played in undermining the global system – in Ireland, just as it did during the big bank failures in the UK (Northern Rock) and the US (Lehman Brothers and Bear Stearns)”.

The reason the green jersey is in play – apart from the obvious embarrassment of mishandled liquidity issues which were so central to our mishandling of the bank guarantee – is that if it can be shown that the regulator systematically allowed breaches of liquidity ratios, indeed still does not recognise those breaches, it could trigger litigation against Ireland by the likes of HRE (Hypo Real Estate).

HRE, was bailed out for €140bn in loans and guarantees in September 2008 by the German government, after HRE had hastily bought – heedless to its underlying liquidity problems – IFSC-based DEPFA.  DEPFA’s directors then included pillars of Ireland’s economic sector including Francis Ruane, director of the ESRI, and Maurice O’Connell, former governor of the Central Bank.

If HRE had not bought DEPFA, so transferring the relevant headquarters from Ireland to Germany, Ireland would have been responsible for this colossal bailout.  It is perhaps reflective of the lack of seriousness of the debate here for so long that this lucky escape from the consequences of our lackadaisical regulation,  was not more widely recognised as far back as 2008. HRE  is suing its former chief executive Georg Funke for allegedly not briefing them properly on the liquidity problems. HRE was, at the beginning of 2010 reported to be considering suing the entire former board of DEPFA too. Crucially its litigation refers to faulty risk-management procedures and “numerous breaches of Irish banking regulatory law” before, as with UniCredit, the bank went to the regulator who in the case of DEPFA settled with its relevant subsidiary for a €250,000 fine without any public indication of the number of breaches.  It is implicit that the Irish regulatory authorities  may have been delinquent in monitoring breaches in a firm that the German regulator memorably described as a “pigsty”. An extensive German parliamentary investigation  into what was after all a bigger bailout than that accorded to Ireland, found that the German regulator had behaved  competently “within the confines of the legislation” which included that HRE, as a ‘holding company’, entirely avoided the gaze attracted by ‘banks’. An enraged German body politic believes Ireland’s regulatory régime did not help. And Ireland, perhaps myopically, refused requests from Germany for a contribution to the DEPFA bailout.

In a separate but analogous case Sachsen Landesbank had to receive over 17bn in emergency funding from Germany following liquidity difficulties with its Irish subsidiary, Ormond Quay, and ultimately was taken over by Landesbank Baden-Württemberg (LBBW Bank).

Unfortunately for Ireland the same smarting Germany, more than any other country, is responsible for the penal bailout interest-rate that may scuttle Ireland – and will take the determining stance on any renegotiation of the deal.

UniCredit is Italy’s largest bank,  a major international financial institution with strong roots in 22 European countries and an international network represented in approximately 50 markets, with 9578 branches and more than 162,000 employees. In the Centre and East of Europe, UniCredit operates the largest international banking network with around 4,000 branches and outlets. UniCredit’s Irish branch managed €27bn at the relevant time.  UniCredit is said to be Italian-conservative in much of its ethic.  It was in the news when its renowned head Alessandro Profumo resigned in September 2010 arising out of a feud with UniCredit’s main shareholders who have been uncomfortable with the bank’s growing need to raise capital, especially from Libya. The Libyan Investment Authority, a sovereign-wealth fund, recently increased its holding in UniCredit by 0.5% to 2.6%, while the Central Bank of Libya holds an almost 5% stake in the bank.

UniCredit operates on its own and through a labyrinth of subsidiaries.
UniCredit’s 96.35%-owned subsidiary, Bank Austria – Austria’s largest bank –  has a twenty-five percent stake in another Austrian bank, Medici, which is in big trouble. In mid-December a  complaint against Ms Sonja Kohn was part of a fusillade of litigation filed in federal bankruptcy court in Manhattan by Irving H Picard, the trustee trying to recover $40bn in assets for victims who sustained cash losses in the enormous ‘Ponzi’ pyramid fraud perpetrated by the world’s most famous fraudster, Bernie Madoff. The trustee contends Bank Medici was nothing more than a conduit set up for the sole purpose of funnelling money to Mr Madoff.  It is alleged Sonja Kohn knowingly raised billions of dollars in cash to sustain Mr  Madoff’s fraud in exchange for at least $62 million in secret kickbacks. Bank Medici was 25-percent-owned by Bank Austria  and the trustee claims in his complaint that it was effectively a “de facto” branch of that bank. The association with Bank Austria gave Ms Kohn and Bank Medici an imprimatur of legitimacy when recruiting investors, the trustee asserted.

Bank Austria,   UniCredit, and its subsidiary Pioneer, are all named as defendants in the trustee’s Madoff lawsuit — which cites their ties to Ms Kohn. UniCredit said in a statement in mid-December that its policy was not to comment on litigation but that it intended to vigorously defend itself against the accusations made against it and its Bank Austria unit.

As if all this were not intricate enough, according to Roman prosecutors cited in the Austrian weekly newspaper, Profil, in March 2010, banks in Austria – including the Austrian branch of Anglo-Irish banks, Anglo Austria,  but also Bank Austria – the UniCredit subsidiary cited in the Madoff proceedings – were used to launder about two-billion Euro for the Italian mafia between 2005 and 2007.

In 2008 Seán Fitzpatrick sold Anglo Austria to a private Swiss Bank, Valartis, a bank which tells no secrets but has 4000 clients with funds of around €1.25bn.

Extraordinarily, FitzPatrick even funded a loan for Valartis of €24 out of the €141m purchase price with the sale completing the day after FitzPatrick’s resignation from Anglo. It was a surprising move at a time when Anglo had liquidity (i.e. cash) problems.  Anglo Austria was a rich source of scarce deposit cash, up to €600m according to the Sunday Business Post’s Kathleen Barrington – a cheaper alternative to the contrived and fast-evaporating interbank borrowings that Anglo had come to depend on, particularly welcome just around the time Anglo was performing its balance-sheet contortions with Irish Life and Permanent. It is an issue of real concen that some of Ireland’s developers or even bankers may have ploughed dodgy assets into this inscrutable repository away from the gaze of NAMA, trustees in bankruptcy, the office of corporate enforcement and the rest. In another twist the UniCredit subsidiary, Pioneer Investments, which has an office in Dublin, owns a large number of Anglo-Irish bank bonds. Pioneer’s Dublin office seems to be a colourful operation. Village was told of a meeting arranged for employees of Pioneer in Dublin with the papal nuncio to Ireland, at which it appeared that a hierarchy, entirely unrelated to the separate hierarchy in the bank, determined the sequence in which baciamani (kisses) were performed around the ecclesiastical ring.
On a more prosaic level, Italian media reports last year suggested  Roman prosecutors  suspected certain Italian taxpayers of using the Vatican  bank, the Instituto per le Opere die Religione (“Institute for Religious Works”) as a cover for tax fraud and embezzlement. According to the well-respected Italian newspaper, La Repubblica,  investigators discerned years ago that  the Vatican bank administered several accounts at other banks including UniCredit. According to press releases, bank investigations revealed that from 2006 to 2008 illegal transactions were carried out totalling about €180 million. In September 2009, the former President of the Vatican Bank, Angelo  Caloia, resigned after 20 years in office.

The last big scandal concerning the Vatican Bank was in 1982 when   Banco Ambrosiano, in which it was the major shareholder, went bankrupt.  Banco Ambrosiano was implicated in multiple fraud and its head, Roberto Calvi, was found hanging from Blackfriars Bridge in London, fuelling one of the subplots in the movie Godfather III.

One thing is for certain in an age where the banking system is so interdependent and so fragile: the silence of national regulators about dodgy banking practices is unsustainable and dangerous. European regulators and their US counterparts need to know what is going on with UniCredit in Dublin and elsewhere. Germany needed to know how DEPFA was being regulated in Ireland. Irish taxpayers need to know who has funds in the former Anglo Austria, and  we could all do with enlightenment about the recurring dodginess of the papal bank. In a world where money can be transferred instantaneously, banking systems are all interconnected. It is hopeless for national regulators to narrow their horizons to protect ‘their own’ banks. Matthew Elderfield is doing no favours to EU banking regulators, or to the world’s banking and economic system, in being disingenuous about liquidity breaches at the elusive UniCredit.