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Credits: how to factor in the risk of banks misbehaving

Credits: how to factor in the risk of banks misbehaving

09-06-2015 | Insight | Taeke Wiersma Conduct and litigation issues are a widespread phenomenon in the financial sector and because of the sheer size of the fines, they can have a material impact on a company’s ability to pay back its debt. We think that, despite recent improvements, these issues are here to stay for at least several years to come. Consequently, we spend much time analyzing related ESG factors to account for this risk in our credit investment decisions.

Speed read
  • Conduct and litigation issues are widespread among banks
  • The financial consequences (fines) can be very material
  • We look at several ESG factors to account for this in our credit investment decisions

Sizeable conduct and litigation charges
Since the burst of the credit bubble in 2007 banks have increasingly been accused of misselling practices and other forms of corporate misconduct. The list of controversies is almost endless: rigging of Libor and foreign exchange rates, violation of US trade sanctions, trading scandals, money laundering, etc. Resulting fines are often sizeable. It is estimated, for example, that since 2007 Bank of America has put aside close to USD 60 billion to settle mortgage-related claims and other legal issues. The bill for JP Morgan has surged to over USD 30 billion, while halfway through last year BNP Paribas agreed to pay almost USD 9 billion for breaching US sanctions against Sudan, Iran, and other countries.

We believe these conduct and litigation charges are not a temporary phenomenon, but something that will remain a key part of banking in the years to come. It is therefore important to take this into account into our credit investment decisions.

A bank’s governance framework and codes of conduct are important
A number of aspects are important in this respect. First of all we believe it is important to look at governance factors, such as whether the role between CEO and Chairman of the Board is split, the number of independent directors on the Board and senior management remuneration. Secondly, we look at a bank’s codes of conduct for items like corruption and bribery, insider trading and whistleblowing.

Our colleagues from RobecoSAM provide us with a lot of input on those topics. RobecoSAM has compiled a large sustainability database based on its annual Corporate Sustainability Assessment (CSA) of over 3,000 companies. As a starting point it tells us whether a bank has at least the right policies and procedures in place to combat conduct and litigation issues. The table below – derived from RobecoSAM - shows how banks, for example, currently rank on codes of conduct/compliance/corruption & bribery.

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Source: RobecoSAM Sustainability Investing Research

Based on the outcomes of RobecoSAM’s CSA it is fair to state that banks – including the ones that faced a lot of conduct and litigation charges – often rank well on these measures. So, unfortunately, having the right policies and procedures in place is not a guarantee that the bank will never end up in any controversies. This should not come as a surprise. Banks often are very large institutions. The British bank HSBC for example employs over 250,000 people, reports assets of over USD 2.7 trillion, and is active in a very large number of countries. US-based Bank of America has over USD 2.1 trillion assets and employs more than 225,000 people. To have the right culture and right policies implemented throughout the entire organization and in all countries is quite a challenge.

Investment banking is not the only one to blame
Unfortunately it is difficult to blame one part of banking as particularly vulnerable to conduct and litigation issues. Financial institutions with large investment banking operations (like trading and M&A advisory) would seem like an obvious candidate. Indeed there have been a lot of issues here. Many investment banks paid large fines to settle Libor rate rigging accusations. A lot of those banks are also being accused of manipulating FX rates. Multibillion fines are likely. On top of that there are trading scandals, which show that – at a couple of years ago – risk management systems/culture were subpar in certain parts of the banking organization.

Retail banking is not immune
However, the retail operations of banks are definitely not immune. Take the UK as an example. The bill for misselling Payment Protection Insurance (PPI) products has surged to over GBP 26 billion, of which Lloyds alone accounted for close to half. The wealth management departments of UBS and Credit Suisse have been accused of helping clients to evade taxes. Both banks have paid large sums to settle these accusations.

How do we take this into account in our credit investment decisions?
The examples above show that conduct and litigation issues are widespread throughout the banking universe and the financial consequences can be very material. So how do we take this into account into our credit investment decisions? We always start with expressing a view on the credit fundamentals of the bank compared with its current credit rating. This fundamental view is based upon five pillars. These pillars are the business position of the bank, its strategy, the financial position (including financial forecasts), the structure of the bank, and ESG factors (Environmental, Social, and Governance). This fundamental view is then expressed in a score ranging from -3 to +3. For example a negative score indicates we believe the credit fundamentals of the bank are weak for its rating. We could still invest in that bank, but will demand an above average credit spread (for its rating).

With regard to the ESG pillar we check how a bank ranks on a number of key ESG factors like governance, codes of conduct, compliance, anti-crime policies/measures, risk management, etc. By looking at a bank’s track record in terms of litigation and conduct issues we factor in how well these measures have functioned in practice. In addition, we look at cases still pending and try to get a sense of potential future litigation costs. Weighting these against reserves already established and the bank’s future earnings generating capacity gives us insight into the materiality of these ESG factors.

How does this work in practice? Take again the example of JP Morgan. We already flagged that JP Morgan reserved over USD 30 billion for conduct and litigation issues over the last couple of years. By all measures this is an astonishing amount. At the same time, however, JPM’s ‘pre provision income’ (i.e. revenues minus operating costs) is something like USD 35 billion per year. Deducting loan loss provisions of USD 4 billion – USD 5 billion per year as well as some non-recurring costs leaves a lot of room to cope with those litigation expenses.

The table below shows that of the 78 financial institutions (banks and insurers) currently under coverage, in 19 cases ESG factors contributed negatively to our overall fundamental view, in 58 cases the impact was neutral, and in only 1 case ESG factors contributed positively.

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Source: Robeco credit research

Trends so far
It is difficult to generalize, but at various banks there are now initiatives to improve the culture and reduce the vulnerability to conduct issues. In the summer of 2012 the Board of Barclays, for example, decided to ask a commission led by Sir Anthony Salz for a review of the bank’s business practices and to provide a roadmap for cultural change. The Salz Review concluded Barclays had become too focused on profit and bonuses and made 34 recommendations to improve business practices. This included, for example, the abolishment of product sales incentives for UK retail staff, but also a recommendation to let control functions report to the Group CEO instead of business heads. The Board of Barclays decided to implement all these 34 recommendations. This clearly is a step in the right direction.
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