The Bear’s Lair: Even German regulators are useless

Following the discovery of fraud at the German payments processor Wirecard, the media are asking how German regulators can be so clueless. That is the wrong question. If anybody can make regulation work Germans, precise, efficient, un-corrupt and indomitable can do so. So, the problem must be, not that German regulators are inept, but that regulation as a whole cannot catch fraud. As 2008 proved, it cannot catch sophisticated cutting-edge scams, either. So wouldn’t we be better off without it?

Wirecard is a large German payments processor, founded around 2002 by Markus Braun, which went public in 2004 by reverse merger with a relic of the dot-com bubble. In the late 2000s it expanded into the Asia-Pacific region, developing a prepaid virtual credit card and later receiving investment from Softbank. With its combination of whizzy software and globalized payment, it appeared a typical product of the new millennium.

Then in June 2020 it was discovered that around $2 billion of cash stated on Wirecard’s balance sheet did not in fact exist. Banking relationships with Philippine banks that had been used to satisfy the auditors also did not exist, and documentation relating thereto appeared to have been forged. Braun has been arrested, and commentators are blaming German regulators for not spotting there was a problem. The blame game is made worse by the fact that German regulators had during 2019 investigated a short-seller of Wirecard shares and banned the practice – a common occurrence in that speculation-hostile jurisdiction.

On the whole, this is unfair. Regulation is largely a matter of ticking boxes, and German regulators are thus very good at it. If I were a consumer worried about the behavior of local companies (but not so much about the cost of their products and services), German regulators are the ones I would want to keep those companies in line. So, if even German regulators failed, the problem is likely to lie in the activities being regulated, not in the quality of the regulators.

This is not surprising. Auditors are happy to point out that they can rarely catch outright fraud and given that regulators rely on auditors for much of their information, it is unrealistic to expect regulators to catch it either. As the Wirecard case showed, fraudsters can design real-looking pieces of paper that justify claims of assets that do not in fact exist, and neither auditors nor regulators have the capability to detect forgeries in cases where no wrong-doing is initially alleged.

The same is also true of “financial engineering” scams, which were all too prevalent in 2006-07, and came to light in 2008-09. Regulators by and large are not the best and brightest in the financial arena – they are not paid to be. Hence traders and “quants” generally move much faster and can design novel products such as (in the 2000s) credit default swaps (CDS) and collateralized debt obligations (CDOs) the full characteristics of which are not apparent to regulators.

As became painfully obvious during the financial crisis, the full characteristics of many of those new products were not apparent to the people designing them, nor to their bosses who “signed off” on the transactions concerned. Wall Street’s risk management methodologies were completely inadequate to deal with the pathological risk profiles of the new products. The products’ inventors and their superiors were naturally drawn in by the products’ potential profits and incentivized through bonus systems not to worry too much about the risks. Thereby stemmed disaster, which regulators were unable to prevent – how could they have prevented it, when even internal bank executives were not aware of the perilous risk chasms involved?

In principle, I am thus prepared to claim that regulation of financial markets is futile, and should be removed, since no significant protection of consumers or business counterparties is achieved by it. That does not however mean that I rejoice in a return to the law of the jungle. Far from it. There are however policy and cultural changes that can be made that will civilize the market, reducing the level of fraud and malfeasance far more effectively than mere regulation.

The first and most obvious is a drastic reform in interest rate policy. Decades of ultra-low interest rates have inflated asset prices beyond belief. This has made asset manipulation and “financial engineering” far more profitable than productive investment and innovation. Far too many of the world’s best brains are in financial services, attracted by the fancy salaries and bonuses received in the sector. Raising interest rates and thereby reducing the attraction of financial services to the world’s shyster intelligentsia will itself reduce the level of malfeasance, though it will not eliminate it altogether.

The next most important reform is a return to having financial services carried out in long-standing organizations. It is absurd to believe that it is so difficult for a large bank to design a payments system that an independent “payments processor” must take over the payments for several countries’ retail transactions. Banks have been designing payments systems for centuries; they can perfectly well hire a few programmers and design a new one internally, even if it must be made compatible with the Internet. At worst, they can hire an outside consultant to do this; it will then be extremely expensive and won’t work very well, but since it will operate within the bank’s overall operation, any bugs will be the bank’s responsibility.

With such a structure, widespread fraud becomes very unlikely; the bank has too many other businesses that would be irretrievably damaged by such a fraud. Large institutions are not great at innovation, but an Internet-enabled payments system is not a true innovation, except in the minds of tech “entrepreneurs” trying to pitch their software to a venture capitalist. Simple and marginal improvements in the engine-room of a business should be carried out within the business, not sub-contracted to outsiders.

The final change that would improve the integrity of financial services, although not especially in the payments area, is a return to oligarchic capitalism. If you are doing large and complicated transactions on which the future of your business rests, you have two alternatives. One is to hire a fleet of lawyers, draft several thousand pages of documentation and pray that there are no hidden mistakes or deliberate errors in the documentation that would allow the deal to be destroyed. The second is to mutter “verbum meum pactum” and have a really good lunch with a merchant banker with whom you were at school and have known all your life, sealing the deal afterwards with a handshake and a few notes on the back of a table napkin. The latter approach is far cheaper, far more efficient, far quicker and ultimately much more reliable.

The Securities Act of 1933, which broke up the traditional U.S. “full service” banks and the British Financial Services Act of 1986, which destroyed the merchant banks, have a lot to answer for. Oligarchy is a very efficient way to conduct any high-value service, where integrity is essential and the details matter as much as the big picture. With a British merchant bank, in particular, you could have a personal relationship with the Director responsible, who was unlikely to leave the bank for a better offer, because the merchant banks had an unwritten rule that they did not hire from each other. The merchant banks also benefited from an implicit Bank of England guarantee through their membership of the Accepting Houses Committee. Hence you could trust a merchant bank in even the largest transaction, even though its balance sheet and staffing were quite small.

The 1986 Act was supposed to bring the benefits of regulation to the City of London. In fact, it brought a massive legal bureaucracy, shifted all the business to foreign financial juggernauts full of greedy overpaid careerists, and by doing so both vastly increased the costs of doing business and destroyed the integrity of the market. The previous oligarchic market, with institutions that had been in existence for 100 or in some cases 200 years, was both cheaper and far superior. The lunches were better, too.

The poor Germans. They thought that if they could break up the British merchant banks, then as the strongest economy in Europe they would gain most of its financial services business. Deutsche Bank in particular sat there in its new Frankfurt tower like a gleaming dazzlingly-polished Mercedes, ready to take over a position its leaders had envied since before 1914. Alas, today Deutsche Bank totters close to bankruptcy and the Germans cannot even preserve the integrity of their market from random shysters through regulation, their preferred solution in all areas.

What a pity!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)