FeaturedIssue 02 - 2020MAGAZINE
Analysis_Germany-reforms-Wirecard

Germany’s banking system will see new reforms

The Wirecard scandal has raised concerns about the existing regulations and urged authorities to introduce new reforms

Mired in an international financial scandal involving wide allegations of accounting malpractices, Wirecard has been pushed to the brink of bankruptcy. In June, Wirecard filed for insolvency after the Financial Times published a series of investigation reports along with internal documents revealing that €1.9 billion was missing from the company. This was followed by the shocking arrest of its chief executive officer Markus Braun.

In 2015, the Financial Times took notice of the irregularities surrounding Wirecard and began publishing its “House of Wirecard” series on FT Alphaville raising significant questions regarding the company’s financials. During the time of collapse, the company was processing payments for many known fintechs such as Payoneer. As a result of bankruptcy, many of its clients saw their funds frozen as investigations were being carried out. Wirecard, which offered electronic payment transactions and risk management services, was valued at $28 billion.

The investigations by authorities and the whole insolvency proceedings had left Wirecard’s creditors facing lengthy negotiations with administrators over recovery of their money invested in the company. Banks that loaned out money to Wirecard had been demanding more clarity from the company in return for the extension of almost $4 billion in debt. Markus Braun started Wirecard as a small Bavarian startup and eventually became a global fintech giant. The company became so successful that it knocked Germany’s Commerzbank out of the DAX stock market index in 2018.

Wirecard files for insolvency
On June 25, 2020, Wirecard said that due to impending insolvency and over-indebtedness, the company was forced to file for bankruptcy. Since the news of its bankruptcy broke out, its shares plunged by more than 90 percent over the following week after EY, its auditor, refused to sign off on its annual report. That prompted Markus Braun, Wirecard’s chief executive officer, to step down from his post. Soon he was arrested by German authorities on the basis of the allegations, according to whistleblower reports and the Financial Times releasing internal documents. After his arrest, Mr. Braun was released on a bail worth €5 million. Authorities also raided Wirecard’s headquarters in Munich and four other properties belonging to Wirecard in Germany and Austria as a part of their investigation process. On July 22, German prosecutors arrested three former top executives of Wirecard. According to prosecutors, the three top senior executives were suspected in the criminal racket faking the company’s accounts and bilk creditors of billions of euros.

Questions were raised on Wirecard’s finances and business conduct for years, however, things started to crumble for the company only when its auditor revealed that around €1.9 billion went missing from its accounts. The German prosecutors accused the chief executive, who is also the founder of Wirecard, of misrepresenting the company’s earnings by inflating its sales with falsified income using so-called third-party acquirers. Soon, Markus Brawn was replaced as chief executive officer of Wirecard by James Freis, a former compliance officer who previously worked at the Germany stock exchange. Interestingly, James Fries was hired to serve on Wirecard’s management board only the day before his appointment as the chief executive. During the trial, many clarified that Wirecard was not included in the proceedings carried out by German authorities. German regulator BaFin is responsible for deciding whether a bank should file for insolvency, although there are other measures that can be taken when a lender runs into trouble.

Wirecard scandal calls for a banking reform in Germany
Since its inception, a number of concerns were raised regarding the ill practices of Wirecard, however, the matter was not escalated. Many perceive the collapse of Wirecard as a gross failure on the part of Germany’s supervisory authorities. The ability of the country’s governing bodies came under the scanner and were highly scrutinised when the news of the Wirecard scandal reached international media. It is no doubt that the German banking sector is driven by a political and business culture peculiar to Germany. Being well aware of the flaws and loopholes in its system, many in Germany turned a blind eye to the functioning and malpractices of Wirecard as it was rapidly evolving into a technological giant, which would in turn would flourish the fintech sector in Germany.

It is no doubt that the German banking sector needs huge reform, even though fintechs are booming in cities such as Berlin and Frankfurt. Deutsche Bank, a German banking giant, once a global force, is now a shadow of its former self. The emergence of Wirecard saw Commerzbank being knocked out of the DAX stock market index in 2018. The emergence of many neobanks means traditional banks in Germany have to deal with savings accounts with zero interest rates. Even the co-operative banks in Germany are not in a healthy position. Public sector banks dominate the banking sector in Germany as they are under less profit pressure than private banks. This often leads to lower margin interest returns and higher risk costs.

Also, many distributors and independent financial brokers as part of the German banking system take in a lucrative margin. Such structures are not uncommon in Europe and only exist in the German banking sector. Unlike some European countries, Germany has extremely strict consumer protection laws, which make high interest rates for subprime customers in the credit card business impossible.

So what are the changes that Germany can bring to its overbanked banking sector? Firstly, what Germany needs to do is vouch for the idea of transparency. It is an important factor since it involves finances and it also encourages the adoption of ideas and new methods which can bring in an revolutionary change to the banking sector. Embracing transparency also might prevent a repeat of a scandal of this sort. Secondly, the country must accept the fact that its economy, which is the fourth-largest in the world, would be strengthened not by protecting powerful personalities, but by keeping all parties involved under check.

Finally, when it comes to the regulation, the government bodies involved in the process need a massive cultural change. After the Wirecard scandal, many argue that regulators in Germany should rather focus on market regulations instead of focusing on the elite. It is highly important for German regulators to understand their priority and initiate the right course of action for the nation to attain a sustainable economic strength. Many top executives in the financial sector have called for more powerful auditing and accounting processes. It is no doubt that the audit process and tasks, powers and liability of auditors should be reconsidered by authorities to implement important decisions.

SoftBank’s $1 billion investments in Wirecard under scrutiny
In recent times, Softbank has caught the world’s attention with the launch of its Vision investment funds that invests in potential companies across emerging markets. However, Softbank has also been heavily criticised for its investment strategy from time to time. The company has invested in companies such as Uber, WeWork and Oyo. Last year, the company invested around $1 billion in Wirecard, as part of a broader tie-up between the two on digital payments. However, the timing of the deal has raised questions as Wirecard filed for bankruptcy within months.

The scandal has rocked the Munich-based payment company and its shares have fallen more than 80 percent. Analysts argue that the Softbank deal with Wirecard was structured in such a way that there was no financial risk to SoftBank. Also, Softbank made the investments knowing the allegations that were already being made against the company about its accounting practices. However, SoftBank did not notice any irregularities and they believed Wirecard’s books were sound, healthy and correct.

The transaction was completed by SoftBank Investment Advisors, the SoftBank subsidiary in charge of its huge $100 billion Vision Fund. Also, Switzerland-based investment bank Credit Suisse was hired as an advisor. The deal received shareholder’s approval in June, while Wirecard secured an investment-grade credit rating from Moody’s in August. The Zurich-headquartered investment bank also helped SoftBank further sell its debt to a group of institutional investors to book early profits and protect its investment. According to reports, the $1 billion financing came out of SoftBank executives’ pockets and not from its balance sheet, which further raised several questions on the matter.

Finance ministry announces reforms after Wirecard scandal
According to the Financial Times, Germany’s Federal Ministry of Finance has announced a plan for significant reforms. The ministry has taken significant actions and updated its rules and regulations in the wake of the Wirecard scandal. After the Wirecard news spread like wildfire, the regulators in the country came under immense pressure and scrutiny as a scandal of such magnitude happened under their nose. As a consequence, the Federal Financial Supervisory Authority (BaFin), Germany’s financial watchdog, will be granted sovereign powers that will allow the agency to intervene immediately in publicly-traded companies, according to one of the new rules introduced by the finance ministry.

In a statement, the ministry said, “BaFin should have the right to carry out special audits of all capital market-oriented companies, including the right to access information from third parties, the ability to carry out forensic investigations and the right to inform the public about its auditing of balance sheets earlier than is currently the case.”

The finance ministry also plans to strengthen APAS, the German agency whose mission is to oversee auditing firms. The ministry plans to empower the agency by providing it with the power to impose tougher sanctions. As per the new plan, companies would be required by law to change their auditor every 10 years. In addition, the Ministry said it would lobby to turn the European Securities and Markets Authority (ESMA), into a European Securities and Exchange Commission that would function like the US Securities and Exchange Commission, which has more power to demand information from listed companies.

The scandal raises serious concerns in B2B payments
Wirecard somehow managed to falsely implicate that it had €1.9 billion in its Philippine banks, even if it did not and its auditors at EY missed it. So did the German regulators for a brief period of time. After the news of the Wirecard scandal broke out, many even feared that there could be another Wirecard fraud to identify in the country’s financial landscape. Wirecard was involved in business to business (B2B) payments which are more complicated than business to customer (B2C) payments. B2C transactions are carried out face-to-face. For example, customers buy groceries from a supermarket and pay immediately as a result completing their transactions. However, B2B payments involve invoices, adjustments and other obstacles that makes the matter complex.

When we take into account all the B2B transactions happening everyday, we notice a huge amount of money moving from one account to another on a regular basis. The numbers go up to millions. However, it is very difficult to keep a track of such transactions as and when they happen. To keep a track on all these transactions, the sector would need a huge number of auditors which it does not have. So its very easy for a scandal like Wirecard to go unnoticed and that too for a long period of time. Wirecard shed light about poor oversight from auditors and regulators over an industry that is poorly regulated. The Wirecard scandal has brought out several implications when it comes to B2B payments.
Many analysts are questioning how regulations will be managed if a holding company has various subsidiaries running different operations. In the case of Wirecard, its subsidiaries include Wirecard Card Solutions (UK), Wirecard Bank (Germany) and Al Alaam (UAE). Many experts are also wondering how can a sector stop a scandal like Wirecard from happening if no reforms take place? Another interesting fact is that Wirecard’s auditors EY missed the scandalous transactions in its books for quite some time. It also raises serious questions on whether the audit process can always be trusted.

Wirecard to be removed from DAX index
More recently, it was reported that insolvent payments company Wirecard will finally be ejected from Germany’s benchmark DAX index after exchange operator Deutsche Boerse announced a change in one of its rules. In August, Deutsche Boerse announced a rule change that will be implemented to remove Wirecard from the DAX index with two trading days’ notice. Wirecard, which was valued at $28 billion, became a constituent of the DAX index in 2018, replacing German lender Commerzbank.

Wirecard’s stocks soared by as much as 37.5 percent in Frankfurt as more than 130 investors lined up to buy what is left of the company. Its worth noting that it was a significant gain for Wirecard since its shares plunged more than 80 percent after filing for bankruptcy. Michael Jaffe, the company’s insolvency administrator revealed that the company had enough liquidity to keep operating for the time being. Bloomberg reported that a bidding process will be held in August to help sell the remaining of Wirecard to the potential 130 investors. When the company filed for insolvency last year, it reported debt of nearly $4 billion. Last month, it was reported that Wirecard North America, a separate entity with more than 20 years in the payments industry is up for sale. The company has hired an investment bank, whose name was not disclosed, to manage the sale of the company.

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