Regulators are focusing on reputation and legal risk as they prepare to issue guidance seeking to bolster financial institutions' controls and risk management systems that relate to complex structured transactions. Those transactions, triggering corporate implosions ranging from Enron to the more recent Parmalat, resulted in significant losses among lenders in the debt markets.
"We're optimistic about getting something out in the next couple of months," said Kathy Dick, deputy comptroller for risk evaluation at the Office of the Comptroller of the Currency.
Dick noted that the OCC, along with other banking regulators and the Securities and Exchange Commission, have been looking at structured finance transactions and the practices of large financial institutions in this arena during examinations over the last year.
"We've been looking to boil these practices down to a document that provides the industry with a summary of the better practices to deal with risk, especially reputation and legal risk," Dick said. She added that the guidance is now being vetted by top officials at the regulatory agencies, but couldn't yet say whether the document would provide guidelines for institutions to follow or stricter requirements. She said that the guidance represents the first such effort between the banking regulators and the SEC, which has more jurisdiction over investment banking activity that includes structured finance.
The issue of legal risk has come to the forefront for many of the largest financial institutions. The three largest arranger banks in the syndicated loan market, Citigroup, JP Morgan and Bank of America, face multiple suits by other lenders alleging that the big banks were aware of the doomed borrowers' actual financial conditions but allowed investors and lenders to rely on public financial statements they knew were misleading. The defendant banks have countered that the information was appropriately blocked by so-called Chinese walls from migrating to other units like syndicating lending.
The most recent suit was filed earlier this year by seven banks, including German giants Bayerische Landesbank, Dresdner and WestLB, as well as the UK's Standard Chartered Bank. The suit is seeking $200 million in damages, stemming from loans the banks' funded in various Enron transactions, and punitive award. The suit alleges that Citigroup's and JP Morgan's structured finance groups knowingly devised transactions to help Enron hide liabilities and boost revenues, and then proceeded to syndicate Enron's credit without indicating that the firm's financial statements were misleading. More than two years ago, Italy's Unicredito Italiano filed a similar suit, and several institutional investors have also filed suits of their own.
The litigation is unusual in the clubby world of syndicated lending, although most of these banks have sought for several years now to reduce their exposure to syndicated loans unless they have broad relationships with the borrowers. Dresdner and WestLB , for example, have seen the overall volume of deals they've participated in drop by two thirds or more since 2000, according to Thomson.
Despite the growing legal risk, however, the large arranger banks have not suffered long-term damage to their reputations, at least not as reflected by their stock prices, which dipped significantly in 2002 but have since rebounded sharply. The regulators' concern over reputation risk, however, appears well founded, since the top three lead banks not only arrange 60% of US syndicated loans but are central to or increasingly important in other financial markets. The FDIC's fourth quarter call reports, for example, revealed that the top three banks hold 88% of counterparty risk in the notional $1 trillion of credit derivative transactions reported to the agency by 573 banks, with JP Morgan was involved in more than half. Such a concentration of credit risk among so few banks could severely impair the financial markets should the reputation of one or more of those institutions rapidly deteriorate.
That concern may also explain why the regulators, despite several investigations concluding the large banks played instrumental roles in the fraud perpetrated by Enron and others, have left redress to private litigants. In addition, the regulators have gingerly stepped toward developing and issuing guidelines, nearly three years after Enron's demise.
In agreements with Citigroup and JP Morgan last summer, the Federal Reserve outlined components of a risk management program, such as identifying "transactions in which the counterparty relationship or the nature of the transaction with the counterparty poses or may pose heightened legal or reputational risk," and gave the banks 60 days to submit "acceptable revisions" to their written credit risk management programs.
Those programs are not public information, however, and participating lenders will have to assume regulators are sufficiently supervising the loan arrangers and securities underwriters they most frequently deal with. Indeed, the largest 23 banks have examiners stationed in them at all times, testing the banks' risk management processes and even transactions, and working with examiners from other agencies when transactions cross legal entities with the financial institution.
"We have a well established practice doing this," Dick said.