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Who watches the watchdogs, who audits the auditors and who catches the thieves?

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On September 3, 2018, the Wirecard stock reached the all-time high of 195.5 euros on the Frankfurt Stock Exchange. On June 17, 2020, the price WDI was 104.5 euros, and at the end of last week the closing price was 3.3 euros, after reaching a low of 1.4 euros on June 26, 2020.

The shares of the payment processor, the largest in Germany's fintech sector, were included in DAX 30 in September 2018, replacing Commerzbank shares, and will remain there for another two months, until the new annual review of the index structure.

Given that the Wirecard structure also included a bank, the entire regulatory and supervisory action was carried out by German BaFin (Federal Authority for Financial Supervision).

It was precisely the BaFin that refused to proceed with a thorough audit of the company following revelations in the Financial Times, which were first published about a year and a half ago.

The history of the FT Wirecard case shows that irregularities were reported before 2017, including allegations of money laundering, but a full audit by EY in 2017 "revived investor enthusiasm" and WDI shares doubled in price.

In January 2019, the Financial Times published an article about the launch of an investigation into the company in Singapore, and Wirecard was quick to label the revelation as "fake news." At the same time, BaFin launched an investigation of the newspaper, which was accused of manipulating the market.

In February 2019, BaFin announced a ban on the short sale of WDI shares for two months, after the price fell below 100 euros. The motivation for the decision included "the importance of the company for the economy" and "the serious threat to market confidence," according to the Financial Times.

The uncertainty surrounding the company dissipated in the second half of June 2020, amid massive delays in publishing the audited financial results for 2019.

On June 16, 2020, two Philippine banks, BPI and BDO, notified auditor EY that 1.9 billion euros were non-existent, and two days later the lack of those funds was announced by Wirecard. The company later acknowledged that the previous financial statements were unreliable and CEO Markus Braun was arrested.

According to anonymous sources quoted by Reuters, the company also has debts of about 3.5 billion, which cannot be paid and must be written off by creditor banks, given that "a source close to creditors said that two thirds of the revenues of recent years were false ".

How was that possible, especially when the giant EY has been the company's auditor since 2008? Moreover, what confidence can investors have in the audited financial results of large international banks that are also signed by EY?

Who audits all the four major auditors, beneficiaries of a privileged position in the market, given that they receive almost exclusive authorization from central banks to verify financial statements in national banking systems?

According to FT, for more than three years EY did not request information about Wirecard accounts from a Singapore bank, in what is described as "a routine procedure". Did the auditors simply forget or was it something else?

"EY relied on documents and screenshots provided by third parties or even Wirecard," the Financial Times added, and a senior auditor at a competing firm said that "obtaining independent bank account confirmations was the equivalent of a training day at audit school".

Now EY has to justify in court why it failed to uncover the Wirecard fraud, considered the largest in post-war Germany, as Wirecard shareholders launched a lawsuit to recoup the losses.

"We have been monitoring Wirecard since 2008 and we have gathered a lot of material. It was obvious from the beginning that something was wrong," a lawyer for the investors told FT.

So far, nothing has been said about the possibility of also suing the German financial markets institution, and nowhere in the Wirecard history presented by the Financial Times is there any information about BaFin's possible apology for the unfounded accusations it launched against the newspaper.

Instead, the German supervisory authority launched an extraordinary campain to desincriminate, which went beyond the threshold of ridicule, as the European authorities are considering the option of investigating BaFin.

Valdis Dombrovskis, vice-president of the European Commission, called for an inquiry into whether BaFin had "breached EU law", as the case could have extremely negative and long-term implications for investor confidence in the EU, according to a FT article. No one believes that such an investigation will yield any result.

The initial reaction of the BaFin leadership seemed right out of the "Casablanca" movie, where captain Renault was saying he was shocked by the existence of illegal gambling in Rick's cafe, while receiving his winnings.

Felix Hufeld, president of BaFin, recently said that "this was a classic case of criminal behavior," according to The Telegraph. Discussing the article, one reader was quick to point out that there was at least one "positive" aspect to the whole story: "Now you know which audit firm to hire if you are planning a major financial fraud."

Following the "failure" of German supervisors, numerous proposals for reforming supervisory activities emerged, and the most absurd came from Lorenzo Bini Smaghi, president of Societe Generale and a former member of the ECB's executive board.

Bini Smaghi argues that a single financial market supervisor is needed at European level, without taking into account the extreme level which the feeling of false security of financial service users and investors can reach.

And then, how can the principle of "revolving doors" between supervisors and supervisors be "forgotten", perfectly illustrated by the recent case of the former executive director of the European Banking Authority (EBA), who "got his transfer" to the position of executive director of the main banking lobby group, the Association for Financial Markets in Europe (AFME)?

Former banker Martin Hutchinson recently wrote on his website that "even German watchdogs are useless." In his view, "if anyone can make a regulatory and supervisory framework work, then the Germans are it", and the scandal surrounding the Wirecard shows that the problem could be, in fact, another one: "regulations cannot detect fraud."

Hutchinson's conclusion is that "regulation of financial markets is unnecessary" because "it does not provide significant protection for consumers or counterparties."

The former banker also points out that this does not mean a return to the "law of the jungle", as long as a number of radical reforms are implemented, the most important of which being the interest rate policy.

With central banks imposing a downward trend in interest rates in recent decades, financial asset prices have risen sharply, Hutchinson points out, and this has made "financial engineering" more profitable than productive investment and innovation.

A hike of the interest rates would have the effect of reducing the attractiveness of the financial sector, according to the former banker, and among the effects would be a significant reduction in the number of fraud cases.

Aside from the curative effect of interest rates closer to normal, the sanitization of financial services, especially among those of systemic is not possible without a harsh application of the "skin in the game" principle, corresponding to a strong material and criminal liability, both for regulators as well as for auditors.

Any other attempt at "reform", which does not include the full liberalization of the financial audit market and the principle of extended liability, will be useless and particularly costly, given that it can offer nothing but a sense of false security and the illusion of control.

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