Large US banks are finding the billions of dollars they paid in recent years to settle lawsuits and fix broken businesses are coming back to haunt them in another place: their capital requirements. Under the new global rules known as "Basel III," banks like J.P. Morgan Chase & Co and Citigroup Inc must hold more capital to account for potential losses from trading scandals, regulatory probes and related issues.
Regulators are concerned that such potential problems, known as "operational risk," can be severe enough to hobble banks. In recent tests, the Federal Reserve estimated that losses from operational risk and related problems reduced earnings during a period of market turmoil by about a third. "It speaks volumes that some of the most significant losses banks have sustained in the last several years were attributable not to the loans they made but rather to lapses in operational risk management and the ensuing legal judgements, regulatory fines and reputational damage," the US comptroller of the currency, Thomas Curry, said in a speech last month.
These losses have come at most big banks: J.P. Morgan Chase lost over $6 billion on bad derivatives trades in 2012; large mortgage lenders have struggled to foreclose on homes because they could not find critical paperwork; and Bank of America Corp has agreed to pay over $50 billion in crisis-related legal settlements. Although Basel III rules were finalised for US banks last year, they are still coming to grips with the level of capital they need to set aside after US regulators in February said eight big US banks can use their own models to determine the riskiness of their assets and operations.
For individual banks, the extra capital can be enormous. Regulators told J.P. Morgan Chase it needed to hold over $30 billion in capital to offset operational risk exposures, almost four times the level it needed in 2010 and around twice the capital it holds for market risk, finance chief Marianne Lake said in February. That $30 billion is about 20 percent of the bank's current Basel III capital. Executives argue that regulators' demands are excessive. Bank of America finance chief Bruce Thompson told investors in April the bank received no capital relief from businesses it exited, like packaging and selling private-label mortgage bonds.
People familiar with regulators' thinking said that even if banks have shed problematic businesses, they have often not addressed factors like poor oversight of employees or vendors that resulted in the losses. Higher capital requirements reduce profitability, encouraging banks to push their regulatory capital as low as possible. The US government had to rescue banks during the financial crisis because many of them had insufficient capital.
Fed officials fear that the banks' ability to use their own models allows them to understate risk, and instead they view the Fed's own test of how assets perform under stress as the main measure of safety. But the "stress tests" also account for operational risk. Even if the Fed shifts to another risk measure, banks will hold more capital to account for it.
For years most US banks paid scant attention to operational risk because earlier versions of Basel neglected it. Additionally, such risks, like the possibility of a rogue trader, are highly unpredictable. "Operational risk is really a bear to model," said Mayra Rodriguez Valladares, managing principal of MRV Associates, a consulting firm. Many banks now acknowledge that measuring and managing operational risk has become a top priority.
"We probably are spending in orders of magnitude more time exploring the whole area of risk, and particularly operational risk" at the board level, Wells Fargo lead director Steve Sanger said at the bank's May investor day. Julie Solar, an analyst at Fitch Ratings, said, "It's going to be an ever-escalating bar, and banks will have to spend more money on operational risk management."
J.P. Morgan is talking to regulators over how much capital to set aside for operational risk losses since the bank has already addressed many of its legacy exposures through write-offs and fines. Finance chief Lake, speaking in February, said, "It's a priority for us... to develop a framework (with regulators) that will allow that capital to be properly adjusted to better reflect current risk exposures."
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