Big banks and their bigger troubles

21st August 2013

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Big banks and big trouble are virtually synonymous. From Libor-rigging in the wholesale money markets to PPI scandals in retail, it is hard to find a bank that is without a regulatory threat hanging over its head writes Tony Levene.

It is just as difficult to find one that has not been fined massively by regulators, often as an alternative to their day in court.

And whether fined or not, every set of bank results comes with its familiar litany of huge write-offs of bad loans. City lawyers who specialise in dealing with these non-performing assets – they call it “reconstruction” – joke that they will not get out of bed for anything under half a billion (euros, pounds, dollars – it does not seem to matter.)

Recently, The Observer ran a listing of all the problems that British banks had. It was a great piece of detective work, garnered from the hidden corners of the bank’s regulatory filings going back over years. It listed fines for breaching money-laundering rules, penalties for rigging the Libor interest rate, dodgy dealings in takeovers, as well as the huge compensatory cash payouts to those taken in by the smooth talking PPI purveyors.

Add all this to loans to now bust companies, derivative products sold to firms which had no chance of understanding their purchase and the cost to the taxpayer of bailing out failed and failing banks and building societies, produces a total well into the hundreds of billions – perhaps as much as £20,000 for each UK citizen.

For instance, Barclays is fighting five class-action suits from US shareholders who allege the banks gave misleading statements on the value of its mortgage-related assets between 2006 and 2008. Barclays will defend but has no idea of potential losses.

HSBC is still feeling the blowback from Bernie Madoff’s $150bn Ponzi scheme. The bank acted as custodian and administrator to a number of Madoff funds. Victims allege that the bank should have checked the securities. HSBC cannot quantify potential losses. Lloyds Banking Group, where the government wants to sell its stake, has relatively minor problems. Besides PPI – and that is reaching a conclusion with compensation payouts past their peak – the listing only shows amounts of under £1bn, small in banking terms.

And all the banks face loss of profit as regulators get to grips with Visa and Mastercard over fees charged to retailers. This could lead to problems further ahead if watchdogs decide that the competition between Visa and Mastercard (both ultimately owned by similar shareholders) is more apparent than real.

It’s all a frightening list of incompetence, greed, and almighty hubris. Even worse, some of the banks admit that they have no idea where it will all go. The banks are not only unable to quantify many of their existing legal problems they haven’t even any idea of the expenses of some actions. RBS has already announced it has a fund worth £385m to cover legal costs associated with future unspecified regulatory suits. But with a government announcement that it will sell the taxpayer stake in Lloyds Banking Group expected within a few weeks, does this list mean investors should avoid the banks and shun their shares?

It comes down to the known knowns, the unknown knowns and the unknown unknowns. And as Donald Rumsfeld, credited with this whole concept, would be the first to admit, the categories are not precise. What is a known, ‘known’, to someone is an unknown, ‘unknown’ to another party.

Because The Observer listing came from freely available sources, it should be assumed that major investors such as fund managers already know about the items but that private investors (as well as Observer readers) do not. Or at least the big investors should because that is what they are paid to do. They will probably have some ideas beyond the published facts from those analyst briefings which tread the narrow line between guidance and illegal insider information although it is easier for the banks to brief large investors than for those bringing legal and regulatory actions against them.

Where an action and its outcome are known quantities, then these should be “in the price” – one or some of the many factors that come together to produce the value of an equity on any day. What is unknown about the known knowns is the effect on an organisation’s reputation. But reputational risk among banks could be considered low because all the big players have problems while bank users – depositors and borrowers – generally have little alternative. So while a supermarket group would suffer risk from a legal or regulatory action beyond its immediate costs as most shoppers have alternatives, this is not true of banks with their quasi-monopolies.

The known unknowns are areas where the problem has been listed but the amount these could cost banks are still to be calculated. Nevertheless, analysts should have good ‘guestimates’ – again thanks to those briefings they attend.

As for the unknown unknowns, they are anyone’s guess but unless their impact is in the high billions, these can be tolerated. All major organisations have lawsuits on a continuing basis. It Is one of the reasons why they run legal departments. And just because someone has brought an action against a bank, it does not mean the bank will lose. So besides any high value unknown unknowns, it is all in the price. It is why RBS with its big list of difficulties is far less ready to be sold back to the private sector than Lloyds Banking Group.

But the biggest unknown unknown is where banks go from here. Will they ride a recovery or sink into insignificance? In June, fund manager Polar Capital launched its Global Financials Trust. It believed that buying into the sector – it’s not just UK banks – when others remain pessimistic can be a smart move, the opposite of private investors buying into funds at market peaks.

“The trust is designed to take advantage of the misinformation, growth opportunities and potential for significant yield recovery in the world’s largest and most unloved sector – the banks and financial companies,” said Polar’s John Regnier-Wilson at the time.

The hope is that better regulation and stronger balance sheets will buttress the banking sector as it awaits an upturn in trade. Alan Higgins, chief investment officer at fund manager Coutts, recently said: “Until lately, we have been playing the financial sector via fixed interest. We have been big holders of subordinated bonds – bonds issued by banks to raise finance. For example, we made some decent returns in the so-called Lloyds CoCos – bonds that the bank issued when it looked to increase its capital ratios in the aftermath of the financial crisis.

“But we’re now considering tweaking our strategy by increasing our exposure to cyclical and financial stocks as the outlook for the broader economy, buoyed by the US partially resolving the fiscal cliff, improves. And with many bank bonds now paying much lower yields it may make sense to rotate financial bonds into financial equity. It is a move that I and my colleagues are investigating at this very moment.”

And here are a couple of known knowns. Where one or more fund managers go, it’s a sure bet that others will follow. At some stage, we either have to forget the past and look to the future – that’s the role of equity across the piece. And unless and until someone comes up with a replacement, banks are sure to continue in business. So it could be a case of “accentuate the positive”!

 

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