Will the Banks be Hit by a Wave of FX Manipulation Lawsuits?

An article in yesterday's Telegraph reports that UK farmers were hurt by the FX benchmark rigging scandal, as there is a 2.6 billion pound EU subsidy that first has to be converted from euros before paid to British farmers. An unclear reference in the article cites one day's manipulation that cost the farmers 16 million pounds in one year.

Regardless of the details here, what struck us at FinancialPests, was the wide range of potential suits with which the banks could be hit. Beyond all of the financial players, who we would expect to be more likely to file suits now that JPMorgan has settled one US suit, there may be many others as well. UK farmers would not have been on our radar screen as potential litigants(although no suit was mentioned in the article). Europe is, of course, less litigious than the US, and slower to file suits, but this reinforced to us that potentially, there may be a landslide of suits filed around the world during 2015.

JPMorgan Settles FX Benchmark Manipulation Lawsuit

Reuters reports that JPMorgan settled an antitrust lawsuit which accused 12 banks of rigging the FX markets' benchmark rates. No other bank has commented or settled as of yet, and the terms of the settlement were not disclosed. Two other lawsuits remain.

This follows the fines imposed by certain regulators on several banks late last year on the same matter. Once regulators found wrongdoing, even if only poor oversight of traders, it becomes more difficult for the banks to defend themselves. The lawsuit depended on whether the banks' behavior was uncompetitive in nature. Regulator findings regarding collusive behavior among bank traders on chat room and other electronic media may have increased the pressure on banks for settlements.

It appears reasonable to expect some of the other banks to settle in the near future. Additionally, all of the US and international regulators have not yet weighed in, and criminal charges may be coming as well, although any such charges may be limited to individual bank traders rather than the banks themselves.

What may be Coming Next in the FX Benchmark Story?

The big news in November was the settlement between a number of banks and regulators. However, not all of the large FX banks have reached settlements and not all of the major regulators were involved either.

Some recent related events:

1) Last week, New York's Superintendent of Financial Services was reported by Bloomberg to have evidence that Deutsche and Barclays had used algorithms on each of their single dealer platforms to manipulate FX rates. No details are known, but we assume that whether manipulation is involved will be as complex an issue as algorithms are themselves. Such charges go well beyond the fix, which to date has only been determined to have been manipulated by a few traders, occurring only due to poor oversight and management on the part of the banks. Last month's settlement did not include this New York regulator, as apparently the regulator was seeking tougher sanctions, including the installation of monitors on the fx desk of certain banks. What they uncover in this newly reported line of investigation will certainly be interesting and have potentially even larger ramifications for the banks.

2) As a result of their FX investigations, both the DOJ and the UK's FCA are expected to bring criminal charges against both banks and individuals, the DOJ as soon as early next year. The DOJ has already been interviewing traders in London. As far as civil litigation, so far there have been 2 antitrust class action lawsuits filed in the US.

3) WM Reuters, the company that manages the fix process planned to make changes (primarily widening the window to 5 minutes and adding Thomson Reuters rates for major currencies) to the fix as of December 15, but has now delayed implementation until at least February 2015. The company says that the delay is at the request of some customers who need more time to prepare.

From SCOTUS Blog: LIBOR Litigation

For those of you following the LIBOR litigation appeal in front of SCOTUS, here's an excellent write-up from the good folks at SCOTUS blog.   

Fixing Banking

(Adapted from Fixing Banks - Part I Industry Commentary of the Global Association of Risk Professionals)

Banks are junk credits.  Such is one conclusion of our previous post Junk Banks?!  A government’s guarantee of its banks is expensive precisely because the underlying banks are junk.  One way or another, the taxpayers and citizens bear the large expense of the government guarantee for banks.  Yet it would be disastrous for a country to lose its payment system through the near-simultaneous failure of several large banks.

Though not a “solution” to this quandary of whether and how a government should support its banks, the obvious premise for a solution is that banks should have much lower dependence on the government guarantee.  That is, underlying bank risk should not be “junk.”  To the extent that banks have very low risk of failure on a stand-alone basis, they would have low risk of government bailout.

We divide proposals for “fixing banking” into three categories:  “Nibble the Edges;” “Dramatic Change Inside the Box;” and “Banking Re-Boot into Safe Mode.”  All three have advantages and disadvantages.  The first option is easiest to implement and is the current course of global governments and regulators.  Unlike this first option, the second proposal would be highly effective.  While straightforward to implement, this option #2 is controversial and requires an old-fashioned political battle that could go either way.  Finally, we consider the third option to be the “best answer.”  But being right and winning arguments are not the same thing.  Convincing a majority to adopt this option #3 will be challenging.  In this Part I, we discuss only the “Nibble the Edges” alternative.

Option #1:  Nibble the Edges

When human organizations confront failure and must take remedial action, the prevailing attitude is often to make as few changes as possible.  The failure demonstrates the imperative for change.  Yet all organizations have vested interests that abhor change.  The result is that such institutions grudgingly concede only the incremental modifications that will supposedly eradicate future failures.

Global governments, bank regulators, and bankers constitute the large “human organization” that must address the failure of government policy, bank regulation, and banking of 2008 to the present.  True to form, this organization has enacted and proposed minimal change to banking operation.  Beyond the small number of significant banks (such as IndyMac, Washington Mutual, Lehman Brothers, and Laiki Bank) that governments permitted to fail without bailouts for all creditors, almost all players remain the same.  Leading politicians, regulatory heads and staff, bank executives – they’re all the same people.  Banks and governments still retain their political bargain as we described in Banks and Political Bargains.  It is not an exaggeration to say that the only reactions to the Credit Crisis are moderately higher capital requirements, the possibility of improved bank liquidity, a potential loose and discretionary limit on simple balance sheet leverage, and central banks’ administration of “stress tests.”  (As support, the Basel Committee on Banking Supervision proposes nominally constructive bank liquidity requirements at Basel III:  The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013.  The article M. Auer and G. von Pfoestl, “Basel III Handbook,” Accenture, 2012, shows the increased capital requirements from Basel II and so-called Basel 2.5 to Basel III in figures 2 and 3.  Though there are many “moving parts,” we quote just one aspect here:  minimum Tier 1 capital increases from 4% to 6% of risk-weighted assets.)

The great advantage of “nibbling the edges” in this manner is that the changes are politically achievable.  Political leaders can show that “they did something.”  Regulators get more apparent control over banks, larger budgets, and a longer checklist of activities.  Bankers retain their lucrative careers in exchange for following a modified set of rules.  It stands to reason that increasing capital requirements will lead to some beneficial reduction of bank default risk.  Thus, this edge nibbling should have a positive near-term impact if one ignores the increased and incalculable inefficiencies of the new regulation.

The glaring disadvantage of this approach is simply that there is no real change.  With the eraser at the end of the pencil, regulators are removing old capital requirement values and writing in some new and higher values.  The direction is right, but there’s no rhyme or reason to the old or new numbers other than what emerges from a global political agreement.  As a further criticism of the solution, there is not even a cogent statement of the problem.  That is, regulators and politicians do not state a goal of a target bank stand-alone default probability or expected loss to taxpayers.  Without a clear problem statement, there can be no solution and no intelligent discussion of a solution.

In Parts II and III of this series we will describe the “Dramatic Change Inside the Box” and “Safe Mode” alternatives to “Nibble the Edges.”  Part II will focus on the proposal of Admati and Hellwig to require multiples of additional equity capital.  Part III will explain the calls of Kotlikoff, Wolf, Kay, and many others for stark reinvention of “fractional reserve banking.”

All Announced on One Day: Five Banks Fined for FX, One for Precious Metals and BOE Chief FX Dealer Fired

As had been rumored for a few weeks, FX settlements between multiple regulators and several FX banks were announced on the same day, today. The banks prefer not to be singled out for misconduct but just to be one of many, so that this is viewed as more of a market problem. The banks were not found to have attempted to manipulate FX rates but instead found to have had ineffective controls allowing traders to engage in manipulative behavior. However, the DOJ is still looking into criminal charges, the New York regulator would not sign on to this agreement as it was felt to be too weak and penalties against many other banks by these same and other regulators will be forthcoming.

The Swiss regulator FINMA also fined UBS for precious metals misconduct, finding "clear attempt to manipulate precious metals benchmarks", particularly in the silver market. As FINMA also fined UBS for FX market violations, UBS would certainly have wanted both announcements at once.

Then the Bank of England hopped onto the bad news train today as well. They have been quiet for several months after announcing that an unnamed employee had been suspended for misconduct regarding FX. Today they announced that the chief FX dealer had been fired yesterday, but still provided little information, other than misconduct was discovered as part of the FX manipulation probe but the behavior itself was not related to the probe.

A Bank Bailout Plan to INCREASE Systemic Risk ?!

Eighteen global banks agree not to terminate derivative contracts when regulators seize their failing bank counterparty.  Is that a bad idea?

(Adapted from A Bailout Plan that Could Actually Increase Systemic Risk, a Quant Perspectives column published by the Global Association of Risk Professionals)

ISDA (the International Swaps and Derivatives Association) reports that eighteen large global banks have agreed not to terminate derivatives transactions when regulators seize the bank counterparty with the goal of “resolving” the failing institution.  Both the ISDA announcement and another news article claim that this agreement will “reduce systemic risk.”  The FSB (Financial Stability Board) had requested this accommodation in the September Consultative Document “Cross-border recognition of resolution action.”

What about the healthy banks?

But what about derivatives risk management for the healthy banks that are counterparties to the failing bank?!  Termination of derivative trades before failure has been a standard tenet of risk management for decades.  See, for example, this BIS (Bank for International Settlements) 1994 document “Risk management guidelines for derivatives” that explicitly discusses early termination.  On its face, this new FSB-ISDA opposition to early termination drastically increases risk to the healthy banks in the name of assisting resolution of the failing bank.

The risk to a healthy bank in a derivative trade with the failing bank is that the former cannot know if the latter will ultimately perform on the derivative hedge or not.  If the failing bank does default on the trade, the healthy bank will have an unhedged risk position and will lose some or all of the positive value of the trade.  The healthy bank cannot hedge its risk with another derivative counterparty as long as the original trade remains in place.  Given the critical importance of hedging to bank operations and stability, this hedge uncertainty to a large global counterparty is a huge threat to safety and soundness.  Systemic risk increases due to this hobbling of risk management at healthy banks.

One may sympathize with the dilemma of the regulators

If one believes that a proper role of regulators and governments is to control the resolution or liquidation of large financial institutions, then the FSB-ISDA initiative has its merits.  It would likely be easier to “save” a failing bank if it has all hedge (derivative) agreements in place.  Just as we noted above for healthy banks, evaporation of derivative trades would leave the failing bank with ruinous open risk positions.

The FSB resolution plan appears to be to transfer some debt, some assets, and all derivatives to a “good bank” and leave distressed assets, shareholders, and bailed-in creditors in the “bad bank.”  In this positive scenario, the healthy bank derivative counterparties would find themselves facing the “good bank” such that, in the end, they would have suffered no harm.  But there are too many assumptions here.  First, the bank resolution may fail.  Second, it is unreasonable to project that all derivative trades should go to the “good bank.”  Since some assets and debt will remain in the “bad bank,” there should certainly be “bad bank” derivatives as well.

Perhaps the goal is to guarantee the derivative trades?

The FSB and ISDA do not state or hint that governments will guarantee the performance of the derivative trades as the quid pro quo for the agreement of the healthy banks not to terminate upon regulator seizure.  But this is our conjecture.  Otherwise, it is all too clear that the FSB-ISDA removal of early termination merely aids one weak bank – which likely deserves to fail – at the risk to and expense of the entire banking system.  Surely the FSB would be averse to increasing systemic risk.  Thus, our ansatz that governments will guarantee derivative performance rings true.  Perhaps the regulators will simply squeeze bailed-in creditors to whatever degree is necessary to honor derivative contracts.

The irony splashes all around us!  Once again, we find ourselves witnesses to governments bailing out and protecting the banks!  The plan appears to be that regulators will protect the bank counterparties.  At risk of raising a past controversy without room to dissect the details, this is AIG all over again!  AIG the insurance company would have withstood the failure of AIG FP (the “financial products” affiliated entity).  The true AIG FP bailout beneficiaries were the bank counterparties.

Returning to more sober considerations, our conjecture implies that the FSB-ISDA plan gives higher priority of repayment to derivative liabilities than to senior debt liabilities.  Derivatives and senior debt are currently pari passu.  We remain unconvinced that derivatives merit such super-priority.

What about CCPs?

We wonder how the FSB-ISDA gutting of early termination impacts CCPs (central counterparty clearing facilities).  The failing bank subject to regulatory resolution might be a counterparty to the CCP or a member of the CCP or even the CCP itself.  In any of these cases, forcing a prolonged period of hedge uncertainty on all other presumably healthy parties would be chaotic.

(The author acknowledges numerous helpful conversations with Ce Shi, a graduate of the Quantitative Finance and Risk Analytics Master’s program at the Lally School of Management of the Rensselaer Polytechnic Institute.  Mr. Shi is now a candidate for a Master’s in Applied Mathematics at Rensselaer.)