A scandal at home lays bare Draghi's struggle

A derivatives scandal at Italy's third-largest bank shows the challenges the ECB will face in supervising thousands of Europe's smaller institutions, and the reputational risk it must guard against while doing so.

FT.com

The mud bubbling up from the banking scandal at Monte dei Paschi di Siena has served as handy campaign material for Italian politicians to lob at rivals ahead of this month’s election. Now even an Italian 1,000km away is wary of being splattered.

Ordinarily, questions would be prompted by the simple fact that Mario Draghi, president of the European Central Bank, was governor of the Bank of Italy from 2006 to 2011, when some of the risky derivatives positions on MPS’s books first came to light.

But take into account that the Frankfurt-based ECB will soon gain powers to supervise banks across the whole eurozone and the timing could hardly be worse.

It highlights exactly the sort of reputational risk the ECB has itself expressed the need to guard against when taking over supervision. The institutional change required is great – the bank will have to take on up to 2,000 extra staff – and involves adopting a very different approach to its primary interest rate-setting task.

While independent monetary policy can be just that – highly independent, if not downright monastic – the same is not true of bank supervision. Supervisors need to get into banks, go through the books and, when things go wrong, take decisions on the fate of a lender that will have political consequences.

And while missteps in monetary policy can be economically devastating, they can in theory be reversed and do not come with an explicit price tag for a bailout that politicians can then tell taxpayers is the fault of supervisors asleep at the wheel.

Much remains unclear about what happened at the Siena bank, which counts itself as the world’s oldest. But the bank’s pending €3.9 billion government bailout follows the acquisition of Antonveneta in 2007, when ABN Amro was carved up, and hundreds of millions of euros in losses on the secret derivatives contracts discovered in a document that lay hidden in a safe inside the Tuscan fortress that serves as MPS headquarters.

Draghi has not publicly addressed the MPS problems but will get the opportunity to do so on Thursday at his monthly press conference.

No doubt keenly aware of the danger for the ECB linked to the mudslinging, he diverted to Milan last week after attending the World Economic Forum in Davos in order to brief Vittorio Grilli, Italy’s finance minister, ahead of a parliamentary hearing on MPS.

The Bank of Italy followed that by releasing a five-page defence of its regulation of MPS ever since the Antonveneta acquisition. It pointed out that it had allowed the acquisition to go ahead provided that the Tuscan bank raise funds to rebuild its capital base afterwards and that MPS came under closer scrutiny by its supervisors (led by Draghi) in 2010. It also highlighted the limits of its powers to change management at MPS.

What then could be the lessons for Draghi and the ECB as they prepare to take on responsibility for the next set of dodgy derivatives hidden in safes or other banking malpractice in any one of 17 countries?

The most obvious might be make sure you have some of the best people in their fields once the ECB takes on supervision of up to 200 of the biggest lenders from early next year.

There have already been suggestions that the eurozone’s national supervisors, many of which are also the national central banks, have been steeling themselves for a brain drain to Frankfurt.

But day-to-day supervision of the bloc’s thousands of smaller banks will remain the principal concern of those national central banks, so that brain drain may itself cause problems. Keeping supervision with national central banks was a compromise born of fierce lobbying by Germany’s savings banks. But, technically, the ECB will have the power to intervene in any bank and issue orders to national authorities, although initially it will have no formal power of compulsion.

So don’t expect supervisory questions about Monte dei Paschi to be the last domestic mudfight that the ECB will have to wade into.

Copyright The Financial Times Limited 2013.