JPMorgan is hardly likely to remember 2013 fondly. Having stood out from its rivals for coming through the global financial crisis in better shape than almost all of them, the bank was humbled in 2013. It was hit with a $23bn bill for fines and settlements and, largely as a result, made its firstly quarterly loss since 2004.
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Its woes stemmed from a wide variety of allegations. Most related to the sale of mortgage-backed securities (MBS) by it and two collapsing banks it bought amid the turmoil of 2008: Bear Stearns and Washington Mutual. In November 2013, it made two major settlements for misleading MBS investors during the run up to the crisis – one for $13bn with the US justice department and other state entities, and another for $4.5bn with a group of institutional investors.
The bank also reached a $1bn deal with US and UK regulators for failings that led to its $6.2bn so-called 'London Whale' trading loss in 2012, and agreed to pay more than $410m after US energy watchdogs alleged that its traders manipulated electricity markets in California and the midwest.
The scale of the fines exemplifies the sheer assertiveness of regulators around the world in the aftermath of the financial crisis. JPMorgan may have been targeted more than any other bank in 2013, but it was far from being the only one to suffer from litigation.
Banks have been fined fairly regularly over the past decade. But, in recent years the size and frequency of these fines has risen dramatically. Of the estimated $199bn of fines, settlements and legal provisions incurred by the world’s 15 most heavily penalised banks between 2004 and 2013, $138bn-worth – or 69% – came in 2012 and 2013.
Home wrecking
Mortgage settlements make up the biggest single chunk of the costs. As well as JPMorgan, these have stung Bank of America particularly hard. Largely because of payments agreed with regulators to relieve homeowners, it was forced to hand out about $50bn between 2004 and 2013 – more than any other lender.
Other major settlements relate to the rigging of interbank rates, which has cost banks about $6bn in fines so far, and the mis-selling of payment protection insurance (PPI) in the UK, for which local lenders have had to set aside £22bn ($36bn) to compensate customers. Regulators have also clamped down on money laundering. In 2012, US authorities fined HSBC, Standard Chartered and ING a combined $3.2bn for facilitating illicit financial transfers on behalf of countries such as Iran, Cuba and Libya, and, in the case of HSBC, Mexican drug cartels.
Public animosity towards banks in the West increased rapidly during the first phases of the financial crisis, when there were widespread calls for the sector to be punished. Part of the reason it took officials until 2012 before they reacted vigorously with legal action was that they wanted to wait until banks had balance sheets strong enough to withstand large fines. “Initially, the regulators started off slowly as some of the issues hadn’t raised their head above the parapet,” says Christopher Wheeler, a European and US banking analyst at Italian investment bank Mediobanca. “Moreover, they didn’t want to destroy banks that were trying to rebuild their capital in the post-crisis period and catch up with Basel III.”
Yet pressure from taxpayers eventually started to have an effect. Regulators became sensitive to claims that they had been too slow to penalise banks for behaviour many believed had caused the financial crisis and contributed to the subsequent economic downturn in the developed world. “There was intense political upheaval regarding the banks getting off scot free and not having anyone go to jail,” says Keith Davis, an analyst at US portfolio manager Farr, Miller & Washington.
There was a marked change in stance, at least in the US, following HSBC’s $1.9bn money laundering deal. The country’s justice department initially reacted to questions about why it had not brought criminal charges or imposed a higher fine by suggesting that doing so might have damaged the bank’s viability and thus US jobs. Commentators mocked that some banking institutions were 'too big to jail'.
Regulators and legacies
John Coffee, a professor at Columbia Law School, argues that Eric Holder, the attorney general in the HSBC case, regretted the justice department’s response. “It got him so much criticism that I think it made him think about his legacy,” he says. “He wants to establish a legacy where he’s seen not as the soft, accommodating enforcer, but as someone who is tough. Since HSBC, his attitude has changed.”
The new, aggressive attitude surfaced during the investigations into JPMorgan’s mortgage activities. The eventual $13bn settlement only came about after the bank’s chief executive, Jamie Dimon, persuaded officials not to file a lawsuit against it in California. “The government wasn’t kidding” says Mr Coffee. “California was chosen because it was severely hit by the subprime crisis. The jurors there would have been aware that communities had been destroyed and the thought was that they would have had that background sympathy.”
Once an agreement was reached, government officials were particularly keen to emphasise the roles they had played. No less than 13 of them were quoted in the justice department’s press release, which frequently referred to the “record-breaking” nature of the settlement and stressed that it was the largest ever such deal between the US government and a single company.
Mr Holder, for his part, did not favour understatement. “Without a doubt, the conduct uncovered in this investigation helped sow the seeds of the mortgage meltdown,” he said. “JPMorgan was not the only financial institution during this period to knowingly bundle toxic loans and sell them to unsuspecting investors, but that is no excuse for the firm’s behaviour.”
Resilient share prices
Despite the huge fines meted out to banks, their share prices and earnings have generally performed strongly, especially in the US. The shares of JPMorgan, which, despite its $23bn in fines and legal costs and loss in the third quarter, still managed to make a profit in 2013, rose by 18% in the 12 months to mid-February this year, while Bank of America’s were up 40%.
The banks’ capital strength partly explains this. Even after all its setbacks, JPMorgan’s Basel III core Tier 1 ratio stood at a high 9.5% at the end of 2013. Mediobanca’s Mr Wheeler says one reason it absorbed its regulatory losses so smoothly was because it was able to release provisions for bad loans it made at the time of the takeovers of Bear Stearns and Washington Mutual.
“With the acquisitions, it put through some big provisions to cover the possibility of further bad debts coming out,” he says. “At one stage after the crisis, that gave them more than 200% coverage of non-performing loans. Because of their fortress balance sheet, they’ve been merrily matching litigation with released provisions.”
In Europe, the picture is more mixed. Some banks have borne their fines fairly easily. Lloyds’s stock has risen about 50% in the past year, despite the billions of pounds it has set aside to compensate customers wrongly sold PPI (its total bill for the mis-selling scandal is close to £10bn). It even traded at a hefty book value of 1.5 times in the middle of February, far above the ratio of most of its European peers.
Yet the situation has proved trickier for other banks. Some have struggled to increase their capital bases as quickly as they had envisioned before the fines took their toll. Royal Bank of Scotland wants to have a Basel III core Tier 1 ratio of about 11% by the end of 2015, but has said it will report a figure still well below that – of between 8.1% and 8.5% – for the end of 2013 after it made additional provisions of £3.1bn to cover litigation related to PPI and its US mortgage activities.
Deutsche Bank, which made a big fourth quarter loss in 2013, in part because of legal costs, was only able to maintain the same core Tier 1 ratio between the end of September and December as a result of a decrease in its risk-weighted assets. “The pattern last year was of regular quarterly provisions by banks to build litigation reserves,” says Jon Peace, head of European banks research at Nomura. “It’s not necessarily eating into capital ratios that much, but it’s preventing a rapid build up of capital.”
Fight or settle?
On a few occasions, banks have fought their corner and refused to accept penalties from regulators. In December, the European Commission (EC) fined eight banks a total of €1.7bn ($2.3bn) for forming cartels to fix yen Libor and Euribor. Crédit Agricole and HSBC rejected settlements, however, while JPMorgan accepted a fine for its activities in the yen Libor market but not the Euribor one (the EC is still investigating all three firms).
Yet by and large, banks have opted to settle with regulators. In many instances this has lessened their punishments. In the EC cases, UBS and Barclays stood to pay fines of €2.5bn and €690m, respectively, but avoided paying anything after assisting the investigators and revealing the existence of the cartels. Other banks received discounts for their co-operation.
Such examples tempt banks to reach agreements and have convinced some executives that rejecting claims outright could end up costing them more if they are eventually found to be in the wrong. “Regulators tend to incentivise banks by giving discounts to those that whistle-blow or help from the start,” says one banker in London. “You’d expect that the longer a bank fights, the worse the charge will be if it loses.”
For most banks, the fear of having investigations hanging over them has been crucial to their early settlements. They have generally sought to remove uncertainty regarding future litigation costs or fines as quickly as possible, and one of the best ways to do this has been by striking a deal with regulators.
Analysts say JPMorgan wanted to avoid a court case against the government as it could have taken a year or more to finish and would have led to plenty of unwelcome media attention. Moreover, lawyers say it is possible that the bank’s final bill, had it lost, would have been higher than the $13bn it settled for. “Jamie Dimon and his board made a decision that it was better to reach a settlement and put this behind them than go down in the bunkers and fight for two years,” says Columbia’s Mr Coffee.
More to come?
Other banks that face accusations relating to US residential mortgages could find it difficult not to follow JPMorgan’s lead and accept a similar type of deal from regulators. “JPMorgan has set a certain standard,” says Mark Williams, an academic at Boston University and a former bank examiner for the Federal Reserve. “Being the largest bank in the US, it is a market leader. How it behaves and what it does sets the tone.”
Are there more fines to come? Judging by the comments of various banking executives and regulatory authorities, it seems likely that there are. “I don’t see any signal yet that the regulators are quite done,” says Marco Mazzucchelli, who was a member of the Liikanen Group, a panel appointed by the EC in 2011 to recommend changes to Europe’s financial system.
The US’s justice department has said that the “size and scope” of its resolution with JPMorgan was a “clear signal that [its] financial fraud investigations are far from over”. Anshu Jain, Deutsche’s co-head, suggested in January that it would take at least until the end of 2014 for the bank to deal with its litigation costs.
Several analysts believe banks will be hit with further mortgage-related fines in the US, while the final bill for the manipulation of interbank rates is likely to rise, especially given that the EU is now looking into Swiss franc Libor rates.
The next big scandal to emerge could be in the foreign exchange (FX) market. A global investigation is ongoing into the fixing of FX trades and the head of the UK’s Financial Conduct Authority, Martin Wheatley, says that allegations of price rigging are “every bit as bad as they have been with Libor”. Few doubt the probe, with which at least 15 banks are co-operating, will lead to multi-billion-dollar fines. “Foreign exchange is going to be a massive one,” says Mr Wheeler.
Mr Coffee echoes the view of many financial markets experts when he says that it would scarcely be surprising if FX trading was manipulated on a large scale. “Any market that’s existed for decades in an opaque, non-transparent [form] is likely to have some shady practices,” he says. “It was so easy in foreign exchange to rake a little bit off and make a little more than you were entitled to in a basically non-competitive market. I think foreign exchange meets all the preconditions of a market being as easy to rig as Libor.”
Preparation and provisions
While banks’ share prices and earnings would not be helped by any additional fines, they have at least prepared themselves for the possibility of significant payouts by setting aside significant reserves. This should help ensure they would not have to raise much extra capital to cover legal bills, say analysts. “Big banks have accumulated pretty large reserves to settle the mortgage [cases],” says Mr Davis of Farr, Miller & Washington. “We are pretty far along in the process. They’re not making huge additions to those reserves anymore. They’re drawing down on them as settlements are reached.”
There is plenty of uncertainty as to how long banks will continue to be hit by large-scale litigation. Some predict the current issues being dealt with, such as the mis-selling of mortgages and consumer protection, and the rigging of interest rates, will be cleared within two years. Is it telling, however, that some researchers have stopped treating regulatory costs as one-off items.
“We’ll slip out things such as restructuring charges and big gains on sales of property or businesses,” says Mr Wheeler. “And we slipped out the [London Whale] loss at JPMorgan. But we decided last year to leave litigation costs in. It seems to be the cost of doing business at the moment.”
Banks have changed the way they operate as a result of the fines. One of the clearest signs of an evolution has been the increased importance of risk managers, who were often lowly regarded prior to the crisis, particularly at investment banks. HSBC promoted Marc Moses, its chief risk officer since 2010, to its main board at the beginning of this year. In the wake of the money laundering scandal, Stuart Gulliver, HSBC’s chief executive, said that Mr Moses would become the fifth best paid employee at the bank, whereas before his role “wouldn’t have been in the top 50”.
“This decade is about the rise of the chief risk officer,” says Mr Williams. “It’s the revenge of the nerds. That’s key in all the banks. These are the people who see the risks before they become losses. They are the ones that set the example for best practices and what the bank should be doing.”
Long-term impact
The bigger question is whether all the penalties will serve the purpose regulators hope they will and prevent the same misdemeanours happening again. Mr Peace of Nomura says banks have already made plenty of improvements to their systems, but adds that they cannot guarantee all their employees will act within the rules. “The banks have invested a huge amount in compliance and training to reduce these risks,” he says. “So, I would hope that the possibility of these practices recurring is reduced, but you can never say never. There will always be rogue individuals.”
Some experts have said that it is precisely to deter bankers going rogue that more individuals should have been charged with offences in the past few years. Mr Williams argues that increasing the financial penalties for bankers who act improperly will help curb their excessive risk taking. “Having stiffer fines and more aggressive regulators will get the attention of bankers,” he says. “Taking it to the next level – imposing not just civil charges, but criminal ones too – will help change bad banker behaviour.”
Others add that for future wrongdoings to be prevented, it is not just banks that need to improve their practices, but investors too. “It’s a matter of collectively becoming more fluent in risk management – investors as well as the banks,” says Mr Mazzucchelli. “If it hadn’t been for the underlying [wants] of financial end-users, most of these things would not have happened.”
The full impact of litigation costs and their effectiveness at reining in some of the most egregious practices of the past decade are still a long way off being known. But whatever the outcome, fines have become a commonplace feature of the banking sector, and are likely to remain so for several more years at least.
