Saturday, January 2, 2010

German Case Shows Need for Financial Crisis Inquiry

As the response to the financial crisis moves from rescue to accountability, truth about how we got into this mess is beginning to emerge. The Irish Times reports about a German case that could shine some light on Irish regulatory failures. The relevant bits from the article are in blue:
GERMAN LAWYERS investigating the near-collapse of the Hypo Real Estate (HRE) group are considering legal action against former board members of its Dublin-based subsidiary, Depfa plc.

Many of the risky activities carried out by the Dublin-based bank that brought HRE and Germany’s financial system to the brink of ruin last year took place when several prominent Irish businesspeople sat on the Depfa board.
Over two weekends at the end of September 2008, the federal government and leading German bankers agreed an emergency rescue package for the HRE group, spun off from HypoVereinsbank (HVB) as part of a takeover by Italy’s Unicredit. The final rescue package cost €102 billion in loans and guarantees and was followed last year by full nationalisation.
In October 2008 the HRE board fired Funke [former CEO], saying he had covered up the true extent of the banking group’s problems – right to the last-minute rescue negotiations.
A year on, Funke is suing his former employer for what he believes are outstanding financial entitlements, worth a reported €3.5 million. The company is countersuing.

The first claim is that, by taking-over Depfa in 2007, HRE bought a pig in a poke. Lawyers for HRE claim that Depfa was experiencing serious liquidity problems even before the €5.7 billion deal.

Documents shown to a recent parliamentary inquiry in Berlin confirm that Depfa’s liquidity problems were known before the HRE takeover and were not exclusively caused by the Lehman collapse.
Bauer is doubtful that the necessary due diligence was carried out before the deal went through.

“The takeover of such a large bank – bigger than HRE itself – took just two weeks,” he said. “After two weeks they made their decision, but anyone who knows their banking knows how complex things can be.”

I'm not sure that this claim, standing alone, will succeed. Courts, rightly, accord a great deal of latitude to directors in their business decisions. Courts usually refuse to substitute their judgements about the soundness of business decisions for those taken by the board. The logic is simple: businessmen are in a better position than judges to decide how their company must be run, and second-guessing business decisions based on the wisdom of hindsight chills profitable economic activity.
In this case, however, the lawyers seem to be making a bigger claim (harder to prove, but would allow the court to act, if proven):
As well as “gross negligence” in preparation for the Depfa purchase, HRE lawyers accuse Funke of presiding over faulty risk management procedures and “numerous breaches of Irish banking regulatory law” by Depfa.

The Irish Financial Regulator imposed a fine of €250,000 on Depfa ACS Bank, a subsidiary of Depfa plc, on December 16th last.
The picture that has emerged of Depfa in Germany in the last months is of a badly run institution that pursued risky business practices by exploiting weak supervision in Ireland and, in Germany, fragmented supervision and perfectly legal loopholes.

This is precisely why an independent commission must inquire into the crisis in Ireland. Regulatory reform cannot be accomplished without identifying legal gaps and regulatory failures. The German inquiry seems to suggest that Irish laws or their enforcement were to blame, and we must get to the bottom of this.

A parliamentary inquiry in Berlin threw some light on the frantic rescue of September 2008.
Perhaps the most enlightening description of Depfa came from Jochen Sanio, head of German regulator BaFin. He described it as a “pigsty” and HRE as “the root of all evil”.
Even without the benefit of hindsight, he said that Depfa’s juggling of short- and long-term liquidity and pocketing the difference in interest rates was less a business model than a “liquidity trap”.

The article also quotes the German Finance Ministry:
“No one claims that everything was fine with HRE’s business model until that rescue weekend. However, the parliamentary inquiry’s job wasn’t to examine HRE’s business model but to look at whether the financial regulator did its job within the legislative possibilities available, and it did,” said a finance ministry spokesperson. “Of course there were gaps in the laws where the regulator didn’t have the ability to gain information.”

Just how glaring these gaps in Germany’s banking regulations were became clear with the evidence to the inquiry of German regulatory head, Sanio.
He said that HRE’s structure as a holding company rather than a mere bank enabled the institution to operate just outside the German regulator’s gaze. Those loopholes have since been closed.

As the court case unfolds, we can expect to hear more about Irish legal loopholes and lax enforcement. The only question is whether we are willing to do the hard work ourselves, or will be satisfied with others pointing them out in foreign courts.