Regulation: Conduct costs will haunt banks

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CET1 capital calculations will take a decade of malpractice into account under Basel IV.

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Deutsche Bank’s $14 billion claim from the US Department of Justice against its legacy US RMBS business is just the latest – if perhaps one of the most lurid – bank litigation claim in recent years. 

Many bankers tell Euromoney that misconduct charges are simply the cost of doing business for banks (a comment that is so revealing in itself). And while legacy issues such as Deutsche’s are still being dealt with, the fiasco at Wells Fargo shows that misconduct is a core competency of most banks, and will doubtless continue to be so.

It is for this reason that the Basel Committee has taken a firmer line on conduct costs in its final revisions to the Basel III framework – Basel IV. Basel IV states that banks will have to use the standardized approach for operating risk, which includes fraud and misconduct charges. 

Not only will using the standardized approach apply a higher capital charge to operating risk but the amount of capital that must be held against conduct charges will be in part determined by the level of losses that the bank has incurred over the previous decade.

Badly affected


According to Barclays, the impact on CET1 ratios of the new standardized approach to operating risk will be around 50 basis points. However, the addition of conduct charges to the new operating risk calculation could take between 200bp and 400bp off the capital ratio for some banks. Lloyds is particularly badly affected, with a 3.75% hit to its capital ratio thanks to conduct costs; RBS is 2.8% worse off and Deutsche Bank 1.9% (the calculations were made in May before the DoJ complaint became public).

Banks complain that by taking into account conduct charges over the previous decade the regulators are unfairly penalising banks by asking them to hold capital against business lines in which they are no longer active, such as PPI in the UK. 

Barclays says the basic mechanics for including conduct costs within the operating risk calculation sees historical operating risk losses multiplied by a factor of between seven and 19 and that European banks’ €110 billion of conduct fines will trap €65 billion of capital for a decade. They argue, therefore, that there should be a cap on the amount of conduct losses that are included in the operating risk calculation.

The way things stand, however, settlements such as the one that Deutsche will eventually thrash out with the DoJ will become part of their capital calculation for the next 10 years. That could be very expensive indeed.