Bank losses are boosting the profile of legal risk

NEW YORK -- Faced with an increasingly litigious business environment, financial institutions are finding that mitigating legal risk increasingly requires more than their general counsels’ attention. Banks are posting considerable fourth-quarter charges as they settle allegations on a broad swathe of issues, including research analyst independence and other conflicts of interest, initial public offerings allocations to officers and directors, and credit exposures related to the collapse of Enron and other corporations. Within the past few weeks, two of the US’s largest banks -- Citigroup and JP Morgan Chase -- each reported fourth quarter charges of $1.3 billion. Meanwhile, Credit Suisse First Boston reported a charge of $600 million to both settle current litigation and establish reserves for ongoing and future legal liabilities.

Added urgency

The issue of legal risk, while hardly new to banks, has taken on added urgency as financial markets remain unstable and investor confidence with these firms is easily shaken by such losses. In addition, more stringent regulations imposed by the USA Patriot and Sarbanes-Oxley Acts in the US and the Proceeds of Crime and Enterprise Acts in the UK further increase the pressure on firms to more effectively manage legal risk. However, banks have traditionally relied primarily on their general counsels to deal with this issue; now, various factors are extending the scope of the issue beyond banks’ counsels to their operational risk managers. Indeed, the Basel II bank capital adequacy accords, scheduled to be implemented in 2006, require banks to consider legal risk as part of their overall operational risk, thus making it extremely difficult for firms to determine their capital requirements without anticipating and quantifying legal liabilities.

Exactly how banks should begin quantifying legal risk, however, remains largely unknown. Paul Smith, senior counsel at the Washington-based American Bankers Association (ABA), explains that no methodology currently exists for calculating this type of risk. "There are no industry benchmarks for this," he says, adding that no major external efforts to quantify legal risks had yet occurred. "The dollar amount itself is so variable. The odds of getting a settlement or going to litigation -- there are just so many things that influence that."

Smith notes that although the issue of quantifying legal risk remains daunting, he anticipates more consultations between banks’ general counsel and operational risk divisions. "You have more dialogue from the op risk people and the general counsel people, but I don’t think there’s a good methodology for evaluation of the actual risk." Smith also expects the threshold for reporting possible legal risks to banks’ boards of directors to have dropped during recent months.

Miles Everson, partner at consultancy firm PricewaterhouseCoopers, based in New York, echoes Smith’s last point. "There is obviously increased attention by boards of directors, around understanding specifically how management is running their compliance and risk functions," he says. "It’s not just a cursory discussion -- I think there’s a movement for tenaciousness at the board level."

Reputational risk is now being considered alongside legal risk. Damage to corporate reputation stemming from legal fallout can be minimised if addressed promptly, according to Chris Karow, partner at Ernst and Young’s risk management and regulatory financial services office. "Citigroup went to great lengths separating out investment and research," he says. "By aggressively doing that before it was mandated by the market, they were perceived positively -- that had much less negative impact on their stock price."

Banks have two processes for dealing with legal risk -- minimising the risk to begin with through risk assessment and compliance measures to avoid litigation, and responding to liabilities that do materialise in such a way as to minimise damage to reputation. "A lot of organisations are realising that how they respond to those liabilities will determine greatly what impact it will have on their customer bases and market values," Karow says.

Future predictions

As far as the roles of banks’ counsels and risk managers dealing with legal liabilities, Karow doesn’t expect a major shift of responsibilities to the latter, but greater degrees of co-operation will likely occur. Karow notes that the scope of legal risk management is expanding not only to risk managers, but to business lines as well. "Organisations haven’t always acknowledged that business lines are creating the risk in the first place and hence they need to be more actively managing that risk." At some larger firms, counsels participate in every business line and are consulted as decisions are made, not just when legal issues arise. In addition, Karow anticipates more widespread use of business process reviews to identify and prevent practices and decisions that increase risks of liability.

Both Karow and Everson expect legal risk to be addressed more actively, going forward. Karow notes that while short-term fixes are in order, banks should bear in mind the effects of recent financial scandals and regulations -- reporting requirements for fraud, ethics violations and greater disclosure. Karow adds "That’s not this week’s problem -- that’s going to stay for years," OpRisk

--Stewart Eisenhart