Libor Scandals, Risk and Profits: The Changing European Banking Model

European banks reported a mixed set of results for the first half of the year, after capital requirements, the on-going sovereign debt crisis, diminishing investment banking returns and of course high-profile trading scandals weighed heavily on profits.

While the notable trend for banks paring back on risk has been an incremental nuance in the changing world of finance, the results from the second quarter of this year have been remarkably dire.

Investment banking units have caused the most distress, after banks slashed risky actions and assets, while client activity declined in line with unfavourable market conditions and the on-going sovereign debt crisis.

In tandem with all banking trading woes, the groups are being forced to increase capital bases in line with regulatory requirements under Basel III.

It doesn't help that some banks that reported an increase in its investment banking activities have suffered from global interest rate manipulation investigations, convictions and fines as well as, in HSBC's case, a significant and questionable future over money laundering issues with terrorists and drug cartels.

Fines, Compensation and Technical Glitches

A number of banks, mainly UK-listed banks, have had to report substantial losses or forecasted costs incurred from the London Interbank Offered Rate (Libor), fixing investigations and convictions, mis-selling of derivatives, money laundering and technical glitches.

RBS was the latest bank to report dire earnings for the first half of this year with an operating profit drop of 7 percent to £1.8bn, with profits at the investment banking division dropping 21 percent to £1bn. Overall, it revealed a half-year loss of £1.5bn, compared with £794m a year earlier.

The 83 percent government-owned group said it was hit by an accounting charge of £3bn after it had to change the valuation of its debt and most notably, listed the amount it has set aside for payments, improvements on technical systems and forecast more trouble to come under the Libor scandal investigations.

RBS has set aside £135m for the mis-selling of Payment Protection Insurance (PPI) and put a further £125m aside to pay compensation to customers affected by the recent breakdown in its computer systems.

It also added that it has initially siloed £50m to cover claims from small businesses who were mis-sold specialist insurance, known as interest rate swaps, after the Financial Services Authority (FSA) banned Barclays, RBS, HSBC and Lloyds Banking Group from selling interest rate hedging products to small-to-medium enterprises (SME) following the conviction of mis-selling derivatives products.

While £50m seems relatively low compared to some of the other fines and compensation the bank can incur, the situation for RBS and the other banks echo the a damning indictment of some of the industry's practices last year, when a six-year probe by the FSA in to the selling of PPIs resulted in a potential £10bn in compensation claims.

So far the UK's five biggest lenders have set aside £10bn to cover PPI claims, making it one of the most costly consumer scandals ever. Sixteen financial firms paid out £1.9bn in claims last year, according to FSA figures.

In addition, RBS could face substantial future fines from regulators across different jurisdictions after it revealed that it had dismissed a number of employees for misconduct as a result of its investigations into the Libor interest rate rigging scandal.

"The Libor situation is on our agenda and is a stark reminder of the damage that individual wrongdoing and inadequate systems and controls can have in terms of financial and reputational impact," Chief Executive Stephen Hester said.

In a similar vein, while HSBC showed that in the second quarter of this year that its profit before tax rose by 11 percent to US$12.7bn on a reported basis, its underlying pre-tax profit fell 3 percent to $10.6bn.

As another bank marred by scandals, the group revealed that it has set aside $700m to cover fines and other costs after a US Senate report criticised it for allowing money laundering from clients linked to terrorism and drug cartels.

It has also set aside another $1bn to compensate UK customers for mis-selling them PPI and another $237m to cover pay-outs to small UK businesses wrongly sold interest-rate swaps.

However, much like RBS and Barclays, the group has invested a substantial amount in its systems and controls to mitigate future risks and hopefully detract from future incidences like these.

HSBC said it had increased its spending on compliance to more than $400m last year, which is more double its $200m in 2010.

HSBC's story is not dissimilar to Barclays Capital either as both banks reported reasonable overall group profits but have been marred by fines, compensation claims and future costs incurred on various questionable incidences.

Barclays revealed in the second quarter of this year, its adjusted profit before tax up 13 percent to £4.2bn with improvements of 11 percent in Corporate and Investment Banking and 38 percent in the Wealth and Investment Management.

However, the group settled with UK and US regulators for a record fine of £290m, following its involvement of manipulation Libor and Euribor. It could incur most fines, as the group is still under investigation in other regions, such as Asia and Switzerland.

It also added that it has set aside £450m to cover potential compensation to small businesses sold interest rate swaps as well.

Movement Away from Investment Banking

While scandals and fines have dominated headlines, the core change to the banking model needs to be addressed.

Since the credit crisis in 2007, and now with the on-going sovereign debt crisis, the banking model has transformed from previous years. With tightened lending, severe market conditions, risk appetite waning and less client money being invested, profits in previously risky trading and more widely investment banking has fallen.

Changing global regulation has also meant that banks have been forced to shore up capital and reduce the amount of risk-weighted assets it has on its books.

UBS has faced significant costs and fines following lax systems and controls in risk management, which has meant that investment banking profits have been wiped out from scandals.

UBS' reputation in risk management controls have been questioned over the years and has caused fluctuations in investor confidence, which stem back to before the alleged rogue trading scandal of September 2011, which made UBS lose around $2.3bn in "un-authorised trades."

This wasn't the bank's first experience with compliance failures.

In April 2008, UBS admitted to failings in its risk management structure, in a 50-page report requested by the Swiss Federal Banking Commission, following big losses across many divisions in 2007 and the following year. The fallout resulted in a substantial decline in wealth management clients, with the net outflows increasing quarter after quarter as investor confidence waned.

Fast-forward to November 2009 and the UK's FSA fined UBS £8mn for "systems and controls failures that enabled employees to carry out unauthorised transactions involving customer money on at least 39 accounts, which took place between January 2006 and December 2007."

Coupled with this, it was seen guilty of manipulating Tokyo interbank offered rates (Tibor). The Securities and Exchange Surveillance Commission (SESC) UBS "is also acknowledged to have a serious problem, since the approaches have been overlooked for long periods and no appropriate measures have been taken."

Switzerland's biggest bank is scaling back its risky investment bank which suffered huge losses in the credit crunch to focus on private wealth management instead.

The CEO Sergio Ermotti, said UBS is shrinking its balance sheet to help meet Switzerland's tough new capital rules and the new dynamic in its banking model has clearly changed. He said that the investment banking industry is "in a mid-nineties environment," while the bank reported a second quarter loss that included a $356m hit from Facebook's initial public offering.

UBS's second quarter profits were 425m Swiss francs, compared with 1bn francs a year earlier.

But the bright spots were in wealth management.

Net new money at UBS increased by 2.8bn Swiss francs to 9.5bn Swiss Francs on strong inflows in Asia Pacific, emerging markets and Switzerland, as well as on a global basis from ultra-high net worth clients. Its annualized net new money growth improved to 4.9%, at upper end of target range.

Wealth Management Americas pre-tax profit increased to a record $211m, with net new money inflows now at $3.8bn and with a cost/income ratio improvement of 86.6 percent.

Furthermore, other banks, such as Societe Generale revealed that its shrinking investment bank sapped most of its Q2 profit after second-quarter net income fell 42 percent to €433m, missing consensus at €677.9m. Revenue also fell 3.6 percent to €6.27bn.

Profit in its investment banking unit plunged by 70 percent in the second quarter this year and the global economic slowdown, the cost of selling loan portfolios and losses from toxic assets left over from the global financial crisis all weighed on profits, the group said.

France's largest bank, BNP Paribas posted similar results with a second-quarter net income fall of 13.2 percent to €1.85bn. The group's corporate and investment bank bore the scars of cost cuts and volatile markets, with pre-tax profits sinking 40 percent and revenue down by a quarter.

It did show however that retail banking provided a lucrative counterweight to market turmoil, saw pre-tax earnings slip by a milder 2 percent.

Germany's largest bank also suffered at the hands of its investment banking unit.

Deutsche Bank investment bank profit plunged 63 percent, which previously for years was a main profit driver of the Frankfurt-based lender.

Profits dropped to €357m in the second quarter from €969m in the year-earlier period.

Capital requirements

In the face of several crises, regulatory changes have meant that banks have had to pare down their risk-weighted assets and boost their capital bases under Basel III requirements.

Basel III levels effectively triple the size of the capital reserves that the world's banks must hold against losses, since it was written into law in 2010, while also trying to turn a profit and give a boost to its share price.

Basel III capital ratio levels will be phased in from January 2013 through to January 2019 and it requires banks to hold a key capital ratio (ratio of equity capital to risk-weighted assets [RWA]) of 4.5 percent, plus a new buffer of a further "conservation buffer" of 2.5 percent, meaning banks must hold a total core capital equal to 7 percent of their RWA.

The penalty for any other bank, if it doesn't fall in line with Basel III requirements, includes restrictions on paying dividends and discretionary bonuses.

With these restrictions, banks face the challenge of paring back its risk assets that are mainly found in their investment banking divisions and had previously gathered a substantial amount of profit from. However banks also need to shore up their balance sheets.

While all banks have shown that they have shored up significant capital in their earnings statements, the focus has largely fallen on the Swiss banks, after the Swiss National Bank (SNB) put pressure on Credit Suisse to bolster its capital base by halting dividends and issuing shares in order to safeguard against the risk of an escalation of the Eurozone banking crisis last month.

At the time, the Swiss bank's share price fell by over 11 percent at one stage.

In the central bank's annual financial stability report, SNB warned that "for Credit Suisse, given the low starting point and the risks in the environment, it is essential that it already substantially expand its loss-absorbing capital base during the current year."

The group added that "apart from the planned reduction of risk, these improvements can also be achieved in other ways, such as by suspending dividend payments, or even by raising capital on the market through share issuance."

The SNB added that despite Credit Suisse, as well as UBS, both holding more capital than its European counterparts, the banks still fall behind in capital requirements under international Basel III rules, which are coming into force in 2019.

Credit Suisse unveiled plans last month to boost its capital base by 15.3bn Swiss francs, by issuing debt, selling assets and cutting costs.

In its second quarter earnings report, the Swiss bank revealed that it was taking decisive measures to "improve efficiency and to strengthen its capital position in preparation for Basel III regulatory requirements".

"Unquestioned capital strength is of paramount importance to the Group," said Urs Rohner, Chairman of the Board of Directors at Credit Suisse. "Given the current environment, we decided to accelerate the implementation of our capital plans in a manner which eliminates any doubts raised by the 2012 SNB Financial Stability Report."

Credit Suisse said its immediate steps include issuing 3.8bn Swiss francs in convertible bonds to existing investors such as Qatar and the Olayan Group, as well as new investors like Singapore-based Temasek.

The bank will also bring forward plans by one year, to exchange of 1.7bn Swiss francs of hybrid securities into contingent convertible notes (CoCos) to big investors. It will also be selling real estate assets and it has asked staff to exchange future cash bonuses into shares and offload illiquid private equity investments.

UBS also confirmed that Basel III RWA1 reduced to 170bn Swiss francs, achieving adjusted 2012 target of 175bn Swiss Franc ahead of schedule; RWA targets reduced from around 150 billion Swiss franc to 135bn Swiss franc for 2013 and 2016.

It also confirmed Basel III common equity tier 1 ratio1 rose to 13.1 percent from 11.8 percent on a phase-in basis, reaching this milestone well in advance of the more stringent capital requirements' implementation in 2013.