Libor scandal: Counting the cost of the fix
Estimates of the impact of the Libor scandal have so far focused on potential direct costs in the form of fines and litigation expenses, tied to speculation about which investment bankers will be forced to follow Bob Diamond and Jerry del Missier of Barclays into unscheduled retirement.
There could also be a longer-term impact in the form of erosion of rates-trading revenues, undermining the single-biggest product revenue line for many top investment banks.
Fixed-income sales and trading still accounts for roughly half of all investment bank revenues, despite regulatory headwinds and a move towards increased automation. Rates trading accounts for about 36% of fixed-income revenue, with 60% of that total coming from derivatives, according to a report issued by Citi analysts on May 30, just before the Libor scandal metastasized into an issue threatening careers and franchises for many bankers.
Citi estimated that "normal" annual fixed-income revenue might recover to roughly $135 billion across the industry, after a disappointing 2011 when the revenue pool slid to $105 billion, largely on the back of credit-trading losses. The analysts reached the $135 billion total after concluding that run rates around the levels seen in 2006, 2007 and 2010 were achievable, despite the cost of increased regulation.
Senior bankers had already dismissed the possibility of a repeat of the industry record of $190 billion of fixed-income revenue in 2009, which was fuelled by a government-sponsored directional rates-trading bonanza.
The Libor scandalhas now put a serious dent in the chance of a move back to a level anywhere near the annual total of $135 billion that the Citi analysts saw as conceivable just a few months ago.
Analysts admit that attempts to put a number to the potential direct costs of the Libor scandal involve hefty assumptions, even for an industry where earnings and risk visibility is always extremely limited.
Morgan Stanley analysts stuck their heads above the parapetwith guesstimates that the scandal might cost the industry $15 billion to $20 billion, while allowing that they were extrapolating from the initial Barclays settlement number for fines and applying ratios to rates derivatives books to come up with litigation totals for each bank.
This approach led Morgan Stanley to estimate potential litigation costs – on top of fines – that were highest for Deutsche Bank and RBS, but in a tight range of around $1 billion for a group that also included Bank of America, Barclays and JPMorgan. Citi and Credit Suisse came top of a second group where Morgan Stanley estimated litigation costs in excess of $700 million. Bank stock analysts can rarely resist the temptation to arrive at spuriously detailed estimates and this report was no exception – its Deutsche Bank total came in at $1.041 billion, for example. A group of Nomura analysts were a little franker when they cheerfully admitted that litigation costs might range from a few billion dollars to a potential total in the hundreds of billions.
Revenue at risk from a slowdown in rates client activity linked to the Libor scandal is also hard to estimate, as is the potential for a reversal in the trend in recent years for the top dealers to increase their market share.
Barclays, Deutsche Bank and JPMorgan are the current big three in rates trading, with each firm believed to have earned $3 billion or more in revenue from the sector last year despite a tepid market backdrop. Goldman Sachs and Morgan Stanley might hope to win rates market share while the big three are embroiled in legal and reputational turmoil in the coming months. Goldman and Morgan Stanley were not contributors to Libor during the periods of fixing abuses, as they were classified as brokers until their emergency conversion to bank holding company status when they were on the point of failure during the 2008 credit crisis.
This gives them an opportunity to distance themselves from the Libor scandal and angle for business from any clients that feel they have to be seen to punish the biggest rates dealers as further evidence emerges of fixing malpractice.
While they will not be directly implicated in manipulation of Libor, Goldman and Morgan Stanley might eventually be caught up in any broader investigations of interest rate setting. Both firms are involved in panels to set interest rate swap quotes for fixing purposes. And Goldman was such an aggressive trader of interest rate swaps on its own behalf until the approach of the Volcker restrictions on proprietary dealing that few in the industry would be surprised if it is caught up in future rate setting investigations, at least tangentially.
Morgan Stanley took a less buccaneering approach to interest rate derivatives trading in the past, which helps to explain why it was a laggard in fixed-income revenue generation. It is struggling to maintain momentum in a push to win fixed-income market share because of client questions about its creditworthiness, however. Morgan Stanley’s fixed-income revenue slumped in the second quarter of this year, falling almost 70% from the same quarter in 2011. A $224 million charge for credit valuation adjustments on derivatives, mainly interest rate trades, was tangible evidence of the cost of the firm’s credit-rating downgrade in the second quarter. But a more fundamental problem seems to have been the amount of time Morgan Stanley fixed-income staff had to spend trying to convince clients that it remains a viable derivatives counterparty. That does not augur well for any attempt by the bank to win rates market share from bigger rivals such as JPMorgan or Deutsche Bank. And other banks that might theoretically win market share from the big three in rates are either under investigation themselves, or battling to cut their risk-weighted assets.
Managers at the biggest rates dealers will not be resting easily, however. Client confidence in banks has taken yet another blow, which will slow down business as customers make a belated move to increase due diligence. And experienced staff can have limited confidence about retaining their jobs. As investigations into Libor developed momentum, most senior bankers appeared to think that the scandal could be managed along familiar lines. A fine is paid, junior staff members are sacrificed, contrition is expressed, and an attempt is made to carry on business as normal. The wave of revulsion over the Libor scandal that cost the chairman, CEO and COO of Barclays their jobs upended these assumptions.
Harry Harrison, global head of rates at Barclays, and Guglielmo Sartori di Borgoricco, head of sales for the investment bank, might well have been surprised to find that it was their superiors COO del Missier and CEO Diamond who took the rap for the Libor scandal. They and other Barclays staff will soon have to cope with a new CEO and further business upheaval, however. Their peers at other banks might also find that changes in the executive suite are coming their way.