Settlements Indicate Bank Health

Back En Vogue: Too Big to Fail

Settlement Fees as Indicators of Bank Health

Analyzing the Financial Market in the Face of Regulation and Uncertainty

charles-urwinCharles Urwin, MBA1 Managing Editor

Several weeks ago, reports emerged that the U.S. Justice Department was seeking $14 billion in settlement fees from Deutsche Bank AG. For the German bank, whose market capitalization at that time was $20 billion, a new crisis was beginning to take shape. Amid the highly public flight of hedge fund clients and the opportunistic maneuvers of short-sellers, parallels were quickly drawn to the 2008 run on Lehman Brothers. Moreover, DB had reportedly expected a settlement in line with analyst estimates of $2 – $5 billion; the capital implications of settling for a far higher amount brought back into publication the phrase “Too Big to Fail.”              

Since September, many of the immediate fears surrounding Deutsche Bank’s institutional health seem to have dissipated. Those fears will undoubtedly be raised again as the Justice Department moves closer to a multi-bank settlement with DB, Barclays and Credit Suisse. However, it is important to consider these developments in the broader context of bank settlements since the 2008 financial crisis. In particular, three questions arise. First, how does the current round of settlements compare to those paid by U.S. institutions such as J.P. Morgan and Bank of America? Second, are banks better capitalized now versus 2008, and does that insulate them from new crises? Third, to what degree will this current market uncertainty impact banks’ plans for growth? 

In 2013, J.P. Morgan agreed to pay $13 billion to settle claims stemming from its mortgage-related lines of business. In 2014, Bank of America Corp. paid $16.65 billion, while Citigroup paid $7 billion. Goldman Sachs, Morgan Stanley and Wells Fargo paid $5 billion, $3.2 billion and $1.2 billion, respectively, in 2016. A broad summary of these settlements is that the quantum in each case was proportional to the amount of mortgage-related business conducted during the relevant period. J.P. Morgan, for example, reported approximately $7 billion of credit exposure to consumer-related mortgage assets in its 2007 10-K. While comparable disclosures do not exist for the European banks currently under scrutiny, it is generally acknowledged that their involvement in mortgage-related transactions prior to the crisis was far smaller in scale. In this context, there is good reason to agree with the investors and analysts who believe that European settlements will likely fall below the $14 billion suggested in September.     


In terms of bank capitalization, the nearby table illustrates the tier 1 capital ratios for each major bank prior to the 2008 financial crisis versus the most recent quarter. While the higher capitalization rates encourage optimism that another market shock could be well-absorbed, it is important to note that Lehman Brothers reported an 11% capital ratio immediately prior to its demise. Stated otherwise, bank capitalization provides useful reserves in downturns but taken alone cannot be expected to prevent bank runs, should confidence in a given institution evaporate.       

The final consideration is whether bank fines of this nature have a chilling effect on growth. Deutsche Bank, for example, instituted a hiring freeze not long after the Justice Department discussions went public. Correlations between employment and settlements is too difficult to disaggregate in most other circumstances, but it seems clear that disparate settlement figures will have an anti-competitive effect between banks. Bank of America was likely wondering in 2014 whether its historically large settlement would dampen its ability to ward off rivals, at least until Citigroup et al. were faced with similar fines two years later. Furthermore, capitalization and settlements are sunk costs in the sense that dollars allocated to these expenses will not be available for reinvestment.

Friends of The Opportunity who frequent investment banking events will attest, albeit anecdotally, to a contraction in open desks. While there are too many factors in banks’ decisions to expand their workforce – Brexit-related uncertainty is a matter for another article – one factor will be that banks remain vulnerable to regulatory forces. If the settlement history of the U.S. is any indication, similar efforts in the EU should not prove existential to the major banks. On the other hand, such efforts will further impede an industry still trying to regain its footing eight years later.

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