Stress tests will finally acknowledge that banker misconduct is a threat on par with credit or market risk

Who knows what evil lurks…
Who knows what evil lurks…
Image: Reuters/Toby Melville
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Bank stress tests have got a bad rap. In recent years, these periodic regulatory assessments have given banks a clean bill of health that subsequently blew up, or found their capital cushions unable to withstand relatively mild stress. And that’s despite criticism—on both sides of the Atlantic—that those worst-case scenarios devised to gauge the resilience of bank balance sheets are not nearly stressful enough.

But since the financial system’s near-death experience in 2008, the combination of tougher capital requirements, investor unease, and regular stress testing has pushed banks to boost their capital to levels that have made supervisors relatively comfortable about their ability to withstand a future downturn.

As a result, regulators are rethinking their rules for next year’s set of tests. And at least one of the proposed tweaks—from the European Union’s banking supervisor—won’t be very kind to the industry.

The European Banking Authority (EBA) wants banks to forecast specific costs related to their “conduct risk.” That is, the fines, settlements, and provisions that they will face for past and future misdeeds.

This acknowledges that legal trouble is now as serious a danger to bank balance sheets as economic downturns and market turmoil. Since 2009, big banks in Europe and the US have paid out some $260 billion in legal penalties, according to Morgan Stanley. Over that time, as loan-loss provisions have fallen, conduct-related costs have risen—fines, settlements, and the like now account for 7.5% of the average bank’s operating cost base (pdf, p. 21).

This is one of the main reasons why improving economic growth and fewer dud loans haven’t translated into better returns for banks—the average return on equity languishes in single-digit percentages at many lenders, below their cost of capital. If it wasn’t for all that pesky market manipulation, sanctions busting, tax evasion, mortgage malpractice, and insurance mis-selling, banks would be doing pretty great right now.

The EBA’s inclusion of “conduct” as a prominent factor in its stress test is an admission that hefty and persistent legal trouble is now a way of life for big banks. On the same day that the EBA published its proposal, IMF chief Christine Lagarde lamented that legal fines have become just another “cost of doing business” for banks, accounted for as routinely as non-performing loans. At the same gathering, which brought together European and US regulators with bank CEOs, New York Federal Reserve president William Dudley dubbed bank misconduct “a possible source of systemic risk.”

When the European stress test results are published late next year, we probably won’t get a bank-by-bank breakdown of future legal costs, which is understandably sensitive information. But EBA sources say the report will likely publish EU-level figures for aggregate conduct costs. Specifically highlighting banks’ transgressions in this way simply reflects the “underlying risk narrative” for the industry.

In previous tests, legal and regulatory costs were assumed under the broader “operational risk” category and didn’t receive as much attention or scrutiny as under the new proposal. In the US, the Fed somewhat curiously links projections of operational losses (including for litigation and fraud) to macroeconomic variables. The European approach will allow for more idiosyncratic, bank-specific factors.

After all, as we have seen time and again, bankers these days seem to behave just as badly in good times as in bad. As a result, the danger they pose to their companies’ solvency doesn’t follow the steadily receding economic and market-based risks of recent years.