It is surprising that any allegation of fraud against a bank still has the capacity to shock.
But the launch of a lawsuit by New York attorney general Eric Schneiderman complaining that Barclays mis-represented to US equity investors that they would be protected against high-frequency traders in its dark pool while routing a disproportionately high volume of their trades into a pool full of exactly such predatory traders caused the bank’s share price to fall 8% in one day at the end of last month.
Schneiderman says: “Barclays grew its dark pool by telling investors they were diving into safe waters. According to the lawsuit, Barclays’ dark pool was full of predators – there at Barclays’ invitation.”
While the business is only a modest source of revenue for Barclays – TABB group estimates the three biggest bank-operated US equity dark pools, run by Barclays, UBS and Credit Suisse, in aggregate produced combined revenues of between $60 million to $90 million last year – the worry for investors in Barclays is twofold.
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First, as analysts at Citigroup point out: “The greatest concern among investors is that it is no longer clear whether the fines being levied in the US are proportionate and reasonable to the observed damages.” Second, as investors awaited the final figure for the fine to be imposed on BNP Paribas for violating US sanctions against dealing with Iran last month, some may have feared that the latest allegations put at risk the non-prosecution agreement Barclays struck with the US Department of Justice back in 2012.
Barclays’ share price has already been hit by declines in its signature FICC business and by concern over execution risk around its plans to shrink the investment bank. Despite a brief rally at the start of May on news that the bank would sharply reduce RWAs connected with the macro rates business, the shares fell 20% in the first half of this year.
Analysts at Credit Suisse point out: “Litigation costs are a challenge to Barclays executing its strategic plan, as they put pressure on the capital base, which based on our estimates pro-forma for litigation, is the weakest of the peer group.”
Credit Suisse has attempted one of the more comprehensive analyses of European banks’ reserved and potential litigation losses and the bad news for investors is, that far from getting better, the problem is getting worse and possibly much worse.
Credit Suisse says: “Sector litigation costs continue to be substantial and increasing – we estimated $104 billion of total litigation costs ‘[in a report published early last month], up from a $58 billion estimate the year before, and we see upward risk to this estimate. We have seen banks with legacy litigation risk starting to materially underperform those less exposed.”
That $104 billion estimate equates to almost half what European banks lost in the credit markets following the US sub-prime mortgage meltdown that led to widespread failures in the banking system and national rescues. While litigation costs will not spark such carnage, worryingly, banks’ provisions are below such costs by some $39 billion.
The list of most exposed banks, looking at potential litigation charges as a percentage of tangible net asset value, include: HSBC, RBS, Barclays, Deutsche Bank, UBS, BNP Paribas, Crédit Agricole, Julius Baer and Société Générale, with the biggest share of exposures, from a thoroughly depressing list, relating to Libor and other market manipulation, followed by product miss-selling, US mortgage related suits, US embargoes and sanctions, mis-representation of financial statements and tax evasion.
How will banks cover such charges? It has been a busy year for bank issuers in the equity capital markets in Europe but ECM bankers expect the flow of bank rights issues to decline over the coming months.
“It remains to be seen if the asset quality review and the stress test by the ECB will trigger another round of equity raising, “ says Craig Coben, head of Emea equity capital markets at Bank of America Merrill Lynch. “We’ve seen a lot of flow into periphery banks stocks from investors that were previously heavily underweight but now deem these an attractive recovery play. But my own view is that we’re coming to the end of capital raising by European banks.”
But analysts at Credit Suisse expect regulators to ensure banks have adequate buffers against litigation risk, even when they cannot designate forward looking provisions against them, by adding on RWAs for operational risk. US regulators have also pushed up operational risk RWAs at JPMorgan, Citi and Morgan Stanley in recent months.
Credit Suisse points out that the shares of banks most exposed to litigation risk have underperformed the sector by 25% since October 2013 and it expects this diversion to widen further.
