Banks must update their tactics as the clouds of litigation gather

Fifteen years on, memories of the global financial crisis still haunt the banking sector. The banks that survived have faced years of legal claims, some of which are still ongoing.

But how similar is the turmoil we’re seeing now to 2008? The simple answer is ‘not very’, but there are signs to suggest banks are again facing a significant risk of litigation. 

It is true that years of cheap credit have raised property prices and that many loans are still packaged into debt-backed securities, meaning that many lenders and investors would be hit by defaults or a big fall in property prices. 

There is also reason to expect borrowers to default and property prices to fall as inflation and rising interest rates bite. However, as lending criteria were tightened after 2008, banks have been insulated against these risks. 

Unlike in 2008, however, the largest banks are now subject to more conservative capital requirements and have been forced to diversify their revenue streams, making them better prepared for the risk of widespread defaults, drops in share price or capital outflows.

As a result, though recent bank failures have spooked the market, the causes of those failures are specific to particular banks and therefore unlikely to impact the entire market, especially the largest banks subject to the strictest capital requirements. Banks are, in a sense, reasonably well inoculated against financial contagion.

Sources of potential claims

Following 2007-08, banks were targeted by litigation. In the absence of similar market-wide contagion, it’s fair to assume that we’re unlikely to see the same scale of claims against banks. 

However, there are a number of headwinds hitting the sector that could result in anti-bank litigation. In fact, the sector may now be in the calm before the storm, with a swelling wave of litigation about to break – a break that will only come sooner if banks rely on out-of-date tactics.

For one, the recent bank failures will concern regulators, increasing scrutiny over how banks are run. Should regulators reveal adverse findings, these will be seized upon as a basis for claims against banks. 

To maintain capital, banks may consider cutting costs, reducing their lending or exiting riskier business lines. But this itself may spur litigation, not least from employees who have lost jobs, parties whose contracts have been terminated, or borrowers who have lost access to credit. 

There might also be a need for banks to recoup money from borrowers. Whenever banks make margin calls, accelerate loans or terminate financing, there is a risk of claims from borrowers. Significant falls in share prices, meanwhile, are likely to lead to claims from shareholders.

Challenges to decisions by banks to rely on sanctions to withhold funds are likely, and the scope of environmental, social and governance-related litigation now encompasses not just primary polluters but also ‘secondary infringers’. This includes banks that finance environmentally unfriendly projects and industries. Litigation arising from the application and enforcement of criteria relating to green and sustainable finance should also be expected. 

Although not on the scale of 2008, the increase in interest rates and higher inflation could result in borrowers adopting a ‘can’t pay, won’t pay’ approach, which will in turn cause an increase in mis-selling claims, as borrowers try to avoid paying back loans. 

Any or all of these could become class action lawsuits, which are on the rise in the UK and across Europe, meaning that banks are in no position to become complacent about potential litigation.

What is vital is that banks do not turn back to the tactics of retrenchment and retreat used in 2008. A policy of ‘every bank for itself’ might bring some short-term relief, at least for those banks not in immediate danger, but panic is contagious. One does not need to look past the events of 2008 for an example of that.

Forewarned is forearmed

Every claim is different, and banks will have to adopt appropriate defensive tactics on a case-by-case basis. However, before claims arise, there are steps that all banks can take to protect themselves, particularly if this crisis rumbles on. 

Many claims in 2008 arose not from wrongdoing, but an inability to access documents within the required timeframe – good record keeping is essential.

In the wake of bank failures, others will likely want to review their own processes, systems and controls. But these reviews must be protected by privilege (or the equivalent), otherwise banks run the risk of their own findings being used against them in litigation or even ending up as the basis of a claim.

Banks must also be certain they understand the relevant contractual provisions before terminating any dealings with third parties. Without a clear understanding of their rights to do so, and what must be done to exercise those, terminations can be challenged and potentially result in damages claims from third parties. 

Engaging early if it looks like disputes could arise, ideally to bring matters to an amicable conclusion, will not only save legal fees but also avoid reputation-damaging court proceedings. 

Further, while some claims must be defended at all costs – because losing could open the floodgates to further litigation, for example – there are also many which are best settled early and privately.

Litigation will always be a threat, but a prepared bank can meet it head on. The fate awaiting the unwary is less certain.

Tom Webley is a partner at law firm Reed Smith.