(Bloomberg) -- Deutsche Bank AG employees may have manipulated internal indexes as part of an allegedly fraudulent scheme to help Banca Monte dei Paschi di Siena SpA conceal losses, according to an audit commissioned by German regulators.
The study, requested by watchdog Bafin and seen by Bloomberg, says an internal Deutsche Bank review described “abnormalities” in the values of proprietary indexes used to set the price for the Monte Paschi deal in December 2008. While investigators at the Frankfurt-based bank couldn’t “unequivocally” link that to manipulation or the deal’s outcome, Deutsche Bank didn’t have any guidelines for monitoring the indexes for potential rigging, according to the audit.
The internal Deutsche Bank report has never been made public. Its findings are also cited in Italian court documents seen by Bloomberg.
The audit shows banker abuse of benchmarks may have gone beyond the rigging of industry measures such as the London interbank offered rate, or Libor, that has already triggered probes and fines for global lenders. Deutsche Bank last year paid $2.5 billion to settle claims of interest-rate manipulation -- more than any other lender -- amid accusations of a widespread effort to rig rates for financial gain.
“The Paschi deal is dependent on indexes, and then the indexes may have been manipulated to be more in favor of Deutsche Bank,” said Michael Dempster, founder of the University of Cambridge’s Centre for Financial Research, who has consulted for clients suing banks over derivatives deals. “It is a subtle part of the structure that could be used to load it to the bank’s advantage.”
The index trades also show the layers of complexity underpinning a deal Italian prosecutors say was an illicit scheme to mask losses at Monte Paschi, which is fighting for survival eight years after the ill-fated transactions. Deutsche Bank and six current and former managers were indicted in a Milan court Oct. 1 for allegedly helping falsify the Siena-based lender’s accounts through the deal, known as Santorini. The trial is scheduled to begin Dec. 15.
Michele Faissola, who oversaw global rates for Deutsche Bank at the time, and Ivor Dunbar, former co-head of global capital markets, are among those facing trial. Both were top deputies to former co-Chief Executive Officer Anshu Jain, and both have left the company. Faissola declined to comment, and Dunbar didn’t respond to messages. The audit doesn’t link any individuals to the trading that may have influenced the indexes.
Charlie Olivier, a spokesman for Deutsche Bank in London, declined to comment beyond an October statement that said the lender intended to “put forward our defense in court.” Oliver Struck, a spokesman for Bafin in Bonn, said the regulator doesn’t discuss individual firms.
Deutsche Bank in February said Bafin completed inquiries into multiple cases including Monte Paschi, crediting the firm for implementing changes and planning to take further measures. An overhaul of the management board and the departure of some senior executives contributed to the regulator’s assessment that the remedial actions taken by the company were sufficient, a person with knowledge of the matter said at the time.
The Monte Paschi deal came to light in 2013, when Bloomberg revealed how the trades enabled the lender, the world’s oldest, to obscure hundreds of millions of euros of losses on a previous transaction with Deutsche Bank. The German firm reaped about 60 million euros ($64 million) in profit from the Santorini deal in the first two weeks of December 2008, according to documents outlining the transaction.
Deutsche Bank conducted its internal probe from November 2013 to April 2014. Bafin commissioned accounting firm Peters Schoenberger & Partner in January 2014 to conduct the separate audit, which was completed that December. That probe examined Deutsche Bank’s role in the transaction and its subsequent internal inquiry. The outside auditors said they had nothing substantial to add to the bank’s findings regarding the index movements. Italian prosecutors submitted both documents to the judge in the Milan court case in August.
Banks use benchmarks such as Libor to set borrowing costs for transactions. Some derivatives are linked to formulas developed internally known as proprietary indexes. For Deutsche Bank’s deal with Monte Paschi to have worked as planned, indexes tied to interest rates needed to hit certain levels at the transaction’s inception, according to the audit.
They did. Deutsche Bank employees “appear to have traded in the futures contracts that determined the development of the indices,” the audit found, citing the bank’s own probe. The traders may have “deliberately” influenced the indexes and the outcome of the interest-rate bets, according to the internal probe. Milan prosecutors also mentioned the audit’s findings in an Aug. 30 filing, a copy of which was seen by Bloomberg.
The Monte Paschi deal involved two Deutsche Bank proprietary indexes, the DB FRB EUR (2) Index and the DB Trends EUR Index. Both were tied to the value of derivative products wagering on the Euro interbank offered rate, or Euribor.
The two-pronged Santorini trade had to be carefully calibrated so that at the outset one leg would be a winner and the other a loser, according to the audit. Monte Paschi used the winning leg to offset the old loss, and then retained the new, losing arm without immediately disclosing that it was carrying a growing loss of hundreds of millions of dollars.
The audit also raises the possibility that Deutsche Bank employees may have created a smokescreen for manipulation. Bank executives involved in the deal told auditors that one index chosen for the transaction was going to have heavy trading on the Santorini pricing day because it was the index’s roll date, when trading books are rebalanced.
“A targeted impact on the indices due to an increased level of trading activity could be ‘concealed,’’’ the audit found, without concluding whether that was the case.
The trading that aroused suspicions had enough volume to move market prices and took place in a short period of time, according to the separate Italian court documents that summarized Deutsche Bank’s internal probe into the deal.
The transactions led to an estimated jump of 7 basis points, or 0.07 percentage point, in the price of the securities that determined the indexes, the documents show. That move on Dec. 5, 2008, helped ensure that the interest-rate bets hit the desired target.
Global banks use proprietary indexes for some complex financial products they sell to clients including hedge funds, corporations and retail customers. Deutsche Bank runs about 3,500 of them through a group called DB Index Quant, or DBIQ, according to its website. The indexes are linked to everything from corporate debt to the price of wheat.
While regulators have fined the biggest banks about $9 billion since 2012 for their abuse of public indexes, watchdogs have just begun to pay attention to ones that banks develop in private. In Europe, lawmakers included proprietary indexes in a regulation approved this year monitoring the use of “benchmarks in financial instruments.”
The U.S. Securities and Exchange Commission last year warned of the complexity and lack of transparency of some financial products sold by banks that use internal indexes. Bank of America Corp. paid $10 million in June to settle SEC claims it masked costs and misled retail investors when selling $150 million of securities tied to a proprietary index in 2010 and 2011, according to an agency statement. The Financial Industry Regulatory Authority fined Barclays Plc $1 million last year for using “materially inaccurate” information when publishing an in-house index.
UBS Group AG, the world’s biggest wealth manager, paid the SEC almost $20 million last year to settle claims the firm misled investors who bought $190 million of securities linked to a proprietary currency index in 2009 and 2010. UBS employees, some using “colorful and sometimes obscene language,” added unjustified costs to the deal while making their own trades in advance of transactions related to the index, according to an SEC statement. The Zurich-based lender lacked “meaningful controls” over such trading, the agency said.
UBS, Bank of America and Barclays didn’t admit to wrongdoing as part of the settlements.
“Those investors can’t understand the investments themselves, let alone the indexes,” said Craig McCann, an economist at Securities Litigation & Consulting Group who published a paper on proprietary indexes in October. “Fundamentally, such a product is great for investment bankers. Not investors.”