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UK Banks Settlement and Litigation costs

The capital framework facing the banking model

Post 2008 the global banking model has come under pressure from regulators, government authorities, clients and shareholders. In the immediate aftermath of 2008, governments focused on strengthening balance sheets and lifting capital levels using every means possible including a) shareholder rights/placing issues b) rapid disposals of assets c) bond buybacks and in extreme cases d) nationalisation and e) bankruptcy. Lifting capital levels was seen as absolutely vital to prevent further government rescues and reduce the risk of “too big to fail”.

Capital enhancement has resulted in the reduction in capital intensive trading divisions, as a result of the US Dodd-Frank legislation, and the generalised reduction of personnel/ branch networks as more banking is managed online. In the future there will be fewer branches, fewer staff and lower requirements to hold physical cash. Frequent stress testing by central banks of all banks has been introduced to ensure banks capital levels maintain an orderly trajectory and provide the vital discipline of peer group comparison.

Recently the emphasis has shifted to the creation of large in house non-core portfolios that will be sold over a period of time, reducing assets and hence capital requirements ahead of Basel III (the global standard on bank capital adequacy). Some banks have large non-core assets that effectively drag on profitability. Banks are trying to find buyers for non-core assets but this remains a multi-year job that is likely to result in capital losses when these assets are sold for under carrying value.

Basel III will take effect on 31st March 2019. This global regulatory standard on bank capital adequacy provides a leverage ratio test. The test usefully converts off balance sheet items into credit exposure equivalents using credit conversion factors. The run up to Basel III has generally worked to increase the level of banks’ Tier 1&2 capital (tier 1 capital is the equity value that can be used to absorb losses), (Tier 2 capital can be used to absorb losses only in administration).

Capital may be stronger but what about operational/ legacy risks

In the face of multiple governmental probes, allegations of wrongdoing and market manipulation and endless settlements, the impression has been created that the banking sector is in a relatively punch drunk state reeling from these pressures.

The legal issues stem from the operation of vicarious liability, hence if staff at a bank does something wrong, the liability of that wrongdoing rests with the bank. Of course the wrongdoing is very diverse, it can range from market manipulation, lack of risk disclosure, failure of procedures that govern operational risks such as anti-money laundering, lack of market disclosure, “rogue trading” “mis-selling” such as payment protection insurance (PPI). In recent years more muscular regulation, increased regulatory oversight and compliance and active encouragement of “whistle blowers” has led to more reporting of wrongdoing. In theory there should be a way to limit legal liability, but in practice this is hard.

Every time a bank “settles” with the US Department of Justice or the FCA or the SEC it encourages private litigation, a series of law suits from parties who claim to have suffered loss from the wrong doing. It also creates a “settlement” which involves a payment in respect the proscribed wrongdoing, but does not prevent the re-opening of the settlement later on if wrongdoing can be proved to have re-occurred. It will be interesting to see if HSBC’s claim that the wrongdoing of HSBC Suisse in 2005-7 is covered by the 2012 $1.9bn settlement with the US Dept of Justice. By its very nature these collateral legal actions are very hard to predict in terms of cost and liability.

Fines and charges have “arrived” since the crisis. Since January 2011 around £21.6bn was paid for compensation resulting from mis-sold payment protection insurance (PPI). The Libor fines and civil litigation resulted in five banks paying $5.8bn in penalties – however FX manipulation could result in $20-$30bn of fines and litigation expenses.

The forthcoming UK bank reporting season will see its fair share of legal charges and once more the argument will do the rounds between the bank and its accountants as to whether these are one off costs or the normal cost of operations. What counts is whether investors identify these costs as one-offs or not. Hence the identification of “adjusted” profits that strip out these items and statutory profits which do not. The table below detail fines expressed in the relevant company’s reporting currency.

 

UK Bank Results Date 2014 Settlement/ Lit expense (estimate/actual)* Pre-tax profit 2014 (expected/ actual*) COMMENT
Barclays 3 March £500m FX £6bn More costs due
HSBC 23 February $3bn FX*/PPI $18.6bn* Very high costs in 2014
Lloyds Banking 27 February £2bn £7.24bn Ongoing high costs expected
RBS 26 February £780m £5.22bn Citizens impact in 2014
StanChart 5 March $300m $5.72bn Q4 likely weak
TSB 25 February N/A £215m Post IPO co has blank sheet

In the context, settlement/ litigation charges are high but affordable in the range of 10%-20% of pre-tax profit. In some cases these estimated charges may be below the actual agreed costs – Barclays for example has provisioned only £500m for regulators FX investigations but both RBS and HSBC have already been fined about $4bn.

Lloyds Banking Group is expected to detail on 27th its updated PPI estimate and also its plans in relation to bonds issued in 2009 which it claims it is entitled to redeem at par subject to regulatory consents. This could result in significant litigation if Lloyds proceeds to redeem these bonds, which are widely held by the public.

CONCLUSION

Should the forthcoming earnings season show settlement and litigation expenses starting to decline – that would be a positive catalyst. However the short term expectation is 2014 and 2015 will prove a continuation of very high litigation expenses. Whilst on their own these will not derail the banks, it remains a significant drag on EPS momentum and the ability of banks to lift shareholder payouts.

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