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Regulation: Supervisors still can’t get it right

The demise of MF Global shows that, more than three years after Lehman, financial watchdogs remain miles off the pace. But there is a solution.

The demise of MF Global leaves a lot more questions than answers. And most of them involve the regulation and supervision of financial markets.

First, everyone in the market talks about the broker’s sudden demise. But was it? Certainly the MF Global situation played out over a number of weeks. That’s an awfully long time in the current financial markets.

Rumours of problems at MF Global started at least a couple of weeks before it filed for bankruptcy. As concerns about the broker’s exposure to European sovereign debt grew, even the perennial latecomers at the ratings agencies saw the need for downgrades. (see Repo: MF Global exposes short-term risks Euromoney December 2011)

Where were the regulators at the Commodity Futures Trading Commission and the SEC while all this was happening? We still don’t know.

Even after MF Global filed for bankruptcy at the end of October, the full extent of its positions and malpractice only became apparent when lawyers, accountants and advisers representing a potential buyer, Interactive Brokers Group, went through due diligence on the books.

It was these professionals that discovered that the broker’s books might not be properly funded, and that there was evidence of commingling of client funds.

Surely the regulators themselves should have been all over MF Global by this stage? Especially as many in the market can’t help but compare Jon Corzine’s defunct business to another broker, Refco, which went bust as long ago as 2005.

But here’s the problem: for all of the talk that the layoffs at big banks would lead to an influx of highly qualified professionals with experience of current financial markets practice at the world’s regulators, it hasn’t happened.

It was never going to.

People still involved at the cutting edge of the markets laugh at the qualifications of those who are supposed to supervise them. In most cases, these supervisors’ experience is years if not decades out of date.

No wonder, then, that it was only once the proper professionals got in to look at MF Global that a $1.2 billion commingling scandal was uncovered.

There’s no simple answer to this, but there could be a solution, albeit one that it is not palatable to anyone in the banking industry. But the fact is, if you want the regulators to be able to quickly get to the bottom of a problem at a financial institution, then the only people who can do this are those working in financial markets.

Part of the price that banks should have to pay for being regulated could be to provide lists of specialists that could be called upon at short notice by regulators who need help. Banks, of course, do this all the time themselves internally. So they may complain, but they could cope.

Of course the biggest complaints would come from banks that were subject to raids from regulatory Swat teams staffed by rivals. Two quick answers to this: you’re prepared to do it when it suits you (ie, at a time of takeover or merger talks); and don’t get into such trouble that the regulator needs this sort of access in the first place.

There’s another regulatory issue that most people seem to have missed through the demise of MF Global.

Just a few weeks before his firm went bust, Corzine was outlining to the Financial Times his ambitious plans for the business. He wanted to displace his old shop Goldman Sachs as the top investment bank in the world within a decade. One of the ways that Corzine would do this, he openly admitted, was through prop trading – which such firms as Goldman could no longer do.

So we got to a point where a firm with just $500 million of capital could take a $11 billion-plus position in the distressed European sovereign debt market – or, put another way, one where a fall of less than 5% in the value of its holdings would wipe out its entire capital.

Plenty of smaller firms want to muscle in on the terrain of the regulation-encumbered big investment banks. Regulators must be wary. If a ‘small’ investment bank takes big punts and gets them right, it can grow very quickly.

Just imagine how great the fallout could have been had Corzine & Co got even a quarter of the way to its Goldman-usurping position, and (legally) bet a similar proportion of a firm that size on a losing cause.

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