How to duck regulation, MF Global edition

By Felix Salmon
June 5, 2012

Is 12,500 words on the demise of MF Global, courtesy of Fortune, not enough for you? How about 275 pages on the subject from James Giddens, the official trustee? They’re both tl;dnr as far as I’m concerned, so many thanks to Dealbook for picking up on one particularly salient theme of the trustee report: an MF Global subsidiary called MF Global Finance USA Inc, or FinCo.

The main thing you need to know about FinCo is that it was completely unregulated — it was basically an off-balance-sheet vehicle where Jon Corzine could park risk outside the purview of regulators. So when regulators started asking him to raise more capital against his risky European bond positions, he just moved a chunk of those positions out of MF Global proper and into FinCo:

While MF Global did move some cash around to protect against losses, the firm also transferred its roughly $3 billion in holdings of Italian bonds from the brokerage arm of the company to the “FinCo,” according to the report. By doing so, the firm met its requirements without having to raise money… The Italian bonds represented about half the firm’s risky European position.

Now I have to admit that I’ve been scouring the report this morning, searching on terms like FinCo and “net capital” and “Italian”, and I can’t work out what bit of the report Dealbook is talking about here: it would be great if they could use their DocumentCloud technology to show us rather than just tell us exactly what Giddens is saying. But assuming that the report says what Dealbook says it says, this seems incredibly damaging to Corzine.

The start of the financial crisis, remember, was in large part brought on when big banks like Citigroup started seeing enormous losses in their off-balance-sheet vehicles, and then were forced to recognize those losses by bringing them on balance sheet. Corzine, here, seems to have taken the decision that moving risk off his balance sheet was a great idea — even after having seen how dangerous it could be.

Meanwhile, that other rockstar banking CEO, Jamie Dimon, is testifying to Congress next week, and Andrew Ross Sorkin has a list of very good questions that he should be asked. To that list I would add one more: why was most of the Chief Investment Office’s activity based in London? The CIO’s investments were very much on JP Morgan’s balance sheet, of course, not off it. But they were pretty much out-of-sight, out-of-mind as far as regulators were concerned: the US regulators didn’t see them, and the UK regulators didn’t care about them.

The fact is that the CIO did most of its risk-taking in London for much the same reason that AIG Financial Products was based in London: regulatory arbitrage. Which is a problem regulators are always going to face, when dealing with big international banks. What MF Global did was far, far worse than what JP Morgan did. But the motivations were similar. And right now, regulators are simply not equipped to deal with such shenanigans.


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Can i surmise that the twin problem of banking is the following:

1. Regulators are one step behind and are trying to define how banks should adhere to guidelines when they have very little idea about the complex financial instruments that banks are creating

2. As you pointed out, most mega-banks accept customer deposit and don’t turn it around for commercial and personal lending and use it to earn money based on high-risk investment banking activities.

In my view, the government should stop catching up with the industry because they never can. I think they should define a playing field that is aligned to the main economy. In summary, why not define commercial banking as trade ops, third party treasury, loans and working capital mgmt and personal banking as personal loans, mortgages and credit cards. If loans/deposit ratio is less than 95%, the banks pay a 5% tax on the differential as calculated on a daily basis and paid quarterly.

Any money that banks receive and invest in other areas outside this will be permitted if and only if they pay a 1% financial tax. Propreitary trading – Great. Pay 1% tax on the transaction. complex financial products like swaps, CDS etc – go ahead, but pay 1% of the overall exposure – either for managing the bank’s risk or earning or for customers.

In my view, what this will do is to unwind and make the financial world lot smaller than the 10x current global GDP and at the same time allow a market for derivates and other products that can be money generators without the bank investor unknowinggly taking a lot of risk.

Posted by InfiniteThought | Report as abusive

Both MF Global and JP Morgan were audited by PWC, who did not flag JP Morgan’s VAR issues, its’ governance and compliance issues and certainly did not flag any of the issues regarding risk and compliance or repo to maturity issues at MF Global.

Posted by Sechel | Report as abusive

I’m in favour of a financial transactions tax, but surely 1% is a bit steep? As for the ‘glory boys’ of MFGlobal and others – including JPMorgan – this clearly shows that just because something is legal doesn’t mean it was right, and that morals really should be more closely followed in the world of banking.

Posted by FifthDecade | Report as abusive

Sechal: You validated my point. I don’t expect the auditors to understand the risk and report them appropriately. if they had the expertise, they would turn themselves into a hedge fund.

FifthDecade: I know that 1% sounds steep but my intention is to disincetivize speculation. My point is that financial industry today has no entry barrier in taking risky positions. You probably need more regulatory compliance to open an office cafeteria than become a player in the market. And invariably it is the investors and the country at large that pays the price when many a bets go awry.

Imagine, if JPM lost $20 bn instead of $2 bn. Wouldn’t it take us closer to recession when there is no underlying macroeconomic situation (talking about this in isoloation rather than in conjunction with Europe situation)

Posted by InfiniteThought | Report as abusive

I imagined disincentives were at the nub of your point. The problem with regulation is that it concentrates on completing the paperwork, it seldom questions the quality of any actions or advice the paperwork refers to. So in that sense, a higher transactions tax would be a consideration for players. However, if you kill transactions completely, it doesn’t just hit speculators, it also hits everyone else.

IMO there should be some kind of long term, ongoing financial responsibility for the dealmakers. At the moment the deals are measured as successful or not at the point of transaction, not when they fall apart down the line. If the person who made the money from creating and selling them had to pick up the tab when they went wrong, that would be a fair result.

The trouble today is the ‘blame everyone else’ culture. This applies to finance, politics, and even everyday life. Once upon a time we looked upon honourable behaviour as being meritorious – these days it’s Mammon and Greed that drive behaviour – with a dose of religious indignation as a cover of course.

Posted by FifthDecade | Report as abusive