Op risk past is prologue for UK banks

“The wheels of justice turn slowly, but grind exceedingly fine” goes the ancient proverb. Risk managers at the top five UK banks had reason to recall this axiom last year, as they pondered the income-sapping effects of an aggregate £6.5 billion of legal charges – most of them relating to misdeeds committed during the financial crisis.   

The US Department of Justice (DoJ) has levied hefty fines on Barclays, HSBC and RBS for mis-selling residential mortgage-backed securities in the run-up to 2008. The high street banks have also shelled out millions of pounds in compensation to customers that were mis-sold payment protection insurance, a product range discontinued over a decade ago.

Legacy misconduct issues place banks in a double-bind. Once the wrongdoing is uncovered, banks must put aside legal provisions to cover their expected fines. This cash is locked up for an uncertain amount of time, while regulators ponder the penalty, rather than being put to work elsewhere in the business.  

And when the fines are handed out, they show up in the banks’ operational risk capital requirements. Past op risk losses are a key input in the advanced measurement approach (AMA) used by most large banks to calculate their risk charges. Once a fine is incurred, it sits in a bank’s loss history, influencing op risk capital requirements for years after, even when the process, system and governance failures that typically caused such losses in the first place have been fixed.

Once a fine is incurred, it sits in a bank’s loss history, influencing op risk capital requirements for years after, even when the process, system and governance failures that typically caused such losses in the first place have been fixed

This feature of the op risk framework is not going to go away once the final Basel III package comes into effect. The reforms ban the use of AMA models and replace them with a revised standardised approach (SA). One of its main features will be a 10-year lookback period for historical losses. Crucially, it’s the date on which an op risk loss or legal fine is incurred that matters in this lookback period, not the date on which the misconduct that led to the fine occurred.

This means the huge DoJ fines shouldered by HSBC, RBS and Barclays last year will factor into their op risk capital calculations until 2028 – two decades after the mis-selling scandals that triggered them took place.

The shift to the revised SA is expected to cause European banks’ op risk capital to soar, partly because this is a cruder measure of op risk than the AMA. In anticipation of the new regime, which starts to come into effect from 2022, some banks have already started abandoning their models.

Barclays started setting its op risk capital according to the current standardised approach last year. Other UK banks may follow this year in order to frontload the capital shock. The one thing they won’t be able to do, however, is escape the past.