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Fintech Accounting: Continental Grift

October 21, 2020

Fintech Accounting: Continental Grift

October 21, 2020
in Global Finance

CES Resident Faculty Hans-Helmut Kotz comments on the German Wirecard scandal in this article of Global Finance.

by Charles Wallace

Wirecard was one of the great success stories of Europe’s fintech sector and a German national champion, holding a coveted place in the DAX 30, the country’s main stock index. But since it was suddenly declared insolvent on June 25 following the disclosure of a €1.9 billion hole in its accounts ($2.1 billion at that date), the e-payments company—like Enron two decades earlier—has become a glaring symbol of mismanagement, prompting demands that the EU take control of financial supervision away from local authorities.

Wirecard represented a spectacular fraud. Its CEO, Markus Braun, was arrested; and its chief operating officer, Jan Marsalek, fled the country. But critics are wondering how the company could have escaped detection by its auditors and regulators for so long.

One explanation is that Germany classified Wirecard as a technology company, not a financial institution. The Federal Financial Supervisory Authority (BaFin) said it therefore had no authority to supervise the company, even though it processed billions of dollars in transactions for credit card companies in the UK, the US and as far afield as Indonesia and Malaysia.

“I think part of the problem was the authorities were proud they had a Silicon Valley-type startup here in Germany,” says Wolfgang Schirp, a Berlin lawyer who has filed a class action lawsuit on behalf of investors against Wirecard’s auditors, Ernst & Young (EY). “Nobody really understood the business they were in.”

BaFin’s president, Felix Hufeld, who came under withering criticism in Germany following Wirecard’s collapse, called the scandal a “complete disaster.” He acknowledged at a public conference in June that there is “a whole range of private and public entities, including my own, who have not been effective enough to prevent something like that happening.”

Another complicating factor is that oversight of company audits in Germany is in the hands of a self-regulating industry agency, the Financial Reporting Enforcement Panel (FREP). After the Wirecard scandal broke, FREP said its role was only to ensure that accounting standards are adhered to, not to uncover fraud. But the German government found that defense wanting and announced June 29 that it was canceling FREP’s contract, to terminate at the end of 2021.

German regulators weren’t the only ones who failed to detect fraud at Wirecard. Singaporean authorities in August arrested a director of a local accounting firm that had provided letters falsely attesting it held millions of dollars of Wirecard’s funds in escrow. Similar charges are being investigated against two banks in the Philippines.

“There are clear indications that this is a large-scale fraud in which several parties around the world and in various institutions were involved, with deliberate intent to deceive,” the Stuttgart branch of EY auditors said in a statement.

Fractured Enforcement

But the supervision problem is especially acute in Europe, says Nicolas Véron, senior fellow at the Peterson Institute for International Economics; because, while the EU makes the rules, they are then implemented and enforced by national authorities that are often understaffed and underfinanced—especially in smaller countries—and often want to protect their local champions.

“It’s a systemic problem in Europe, where you have a single market across borders,” says Véron. “You have a very strange mix of incentives for national supervisors that you don’t have in normal countries that have their own borders for financial purposes.” The Wirecard case illustrates the failure of supervisory enforcement of corporate reporting requirements and payment services, he says, suggesting that an EU-wide supervisor would be a better approach than the current system of delegating supervision.

After the 2001 Enron scandal in the US, Véron notes, Congress passed the Sarbanes-Oxley Act and established the Public Company Accounting Oversight Board to supervise auditors and punish firms that conduct improper audits. Europe lacks such a central authority.

A bigger problem may be the rules themselves and how they are applied by supervisors, says Hans-Helmut Kotz, economist at the Minda de Gunzburg Center for European Studies at Harvard University. Accounting rules currently have “so much leeway that it is fiendishly difficult” to track the activities of the same company across borders. The US and Europe haven’t even been able to resolve the differences between the Generally Accepted Accounting Principles of the US and the International Financial Reporting Standards used in the EU and many other jurisdictions.

“How can we guarantee rules are implemented in a completely disinterested way and the authorities are shielded from industry influence?” Kotz says. “I would be in favor of supervision being Europeanized.”

There’s precedent for such a shift. In 2014, the European Central Bank (ECB) took over direct supervision of the EU’s 120 largest banks following the collapse of a number of institutions as a result of the 2008 financial crisis, which had required huge taxpayer bailouts. European states adopted the Single Supervisory Mechanism in 2013, giving the ECB prudential oversight of about 80% of eurozone banking assets; by all accounts, ECB oversight has been a success.