A festering SORE

On September 11th, twelve ‘Too Big To Fail’ (TBTF) banks reached an in principle settlement in a class action lawsuit to resolve investor claims that the banks conspired to fix prices and limit competition in the market for credit default swaps (CDS).

The historic settlement is estimated to cost some $1.865 billion which, as the claimants’ lawyers said [1], was “one of the largest antitrust class-action settlements” in the financial area.

The defendants were the ‘usual suspects’: Bank of America, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, Royal Bank of Scotland Group and UBS. In addition, two non-banks were part of the settlement – the International Swaps and Derivatives Association (ISDA) and a derivatives pricing service Markit.

The parties to the class action included the Los Angeles County Employees Retirement Association and claimed that these banks took advantage of their entrenched market position, making customers “pay unfair prices on CDS trades from late 2008 through the end of 2013, even though improved liquidity should have driven costs down” [1]. The claimants also alleged the banks tried to thwart the launch of a new credit derivatives exchange being developed by a subsidiary of the Chicago Mercantile Exchange (CME) and furthermore pushed ISDA and Markit not to provide licenses to trade CDS on the exchange.

Indulging in antitrust and anti-competitive conduct is clearly another example of People Risk, or “the risk of loss due to the decisions and non-decisions of people, inside and outside of the organization” [2]. Staff inside the banks appear to have taken decisions to keep prices at a level higher than they should have been and managers did not take action to ensure that markets were operating fairly for customers.

It’s not quite a re-run of LIBOR and FX manipulation, but is close.

People Risk is a sub-set of operational risk under Basel II regulations and thus the losses incurred in the settlement will have to be treated as operational risk losses for capital adequacy purposes.

But the fact that twelve of the most Systemically Important banks (SIBs) banks were involved means that the settlement is also an example of a so-called Systemic Operational Risk Event (SORE).

A recently published book [3] by the author, defines Systemic Operational Risk as

“The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events that lead to a chain of significant losses to multiple financial institutions and necessitate a systemic response from regulators”

This latest settlement fits that definition, even more so since the banks all treated the settlement as a single event.

In fact, Systemic Operational Risk Events, such as the misselling of mortgages in the Global Financial Crisis, LIBOR and FX manipulation and industry-wide scandals, such as Payment Protection Insurance (PPI), account for the vast bulk of operational losses and accounting provisions in the past five years, as documented, for example, by the Conduct Cost Project [4].

The twelve banks in the settlement are the largest banks in the so-called Group of Fifteen (G-15) derivatives dealers and are responsible for over 90% of the over $230 billion of fines and settlements in SOREs, incurred since the GFC [3].

As the settlement has to be finalised before the presiding judge, the precise breakdown of the costs is yet to be disclosed but, when agreed, the individual amounts to be paid by the banks concerned will, as is current practice, have to be incorporated into operational risk event databases such as ORX. The losses will then be used by banks worldwide to adjust their operational risk capital figures.

But under Basel II, the ‘systemic’ nature of such operational risk events is not taken into consideration. This is a serious gap in regulation as, for example, systemic regulators, such as the Financial Stability Board and the Basel Committee, are adjusting capital requirements to account for other systemic risks, such as credit and liquidity.

It’s about time the true costs of Systemic Operational Risk Events are properly incorporated into the capital models of all banks, especially those related to Systemically Important Banks. Changing regulations to recognise the central role of SIBs in generating large-scale operational risks could simultaneously increase the capital required by these TBTF banks while simplifying capital modelling for all other banks.

People Risk Management
The risk that an employee or group make bad decisions is a People Risk as it can lead to significant losses even the bankruptcy of the firm. In this case decisions to proactively work to dilute competition in the derivatives markets has resulted in a significant settlement and also damage to the reputations of banks concerned.
This blog is one of a planned series that will discuss facets of People Risk in general and bad Decision-Making in particular [4]. It is obvious that managers and assurance functions, such as Risk Management, Audit, Compliance and Human Resources, must understand the concept of People Risk, particularly the influence of individual and group biases on decision-making, because badly-made decisions may result in significant damage to the firm.

[1] See Reuters’ news report
[2] See Blacker and McConnell, 2015, ‘People Risk Management’, Kogan Page, London http://www.koganpage.com/product/people-risk-management-9780749471354
[3] See McConnell, 2015, ‘Systemic Operational Risk: Theory, Case Studies and Regulation’, Risk Books, London
[4] See Conduct Costs Project, CCP Research Foundation, London

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