Libor’s Double Whammy for European Banks

Different accounting standards could mean a quicker and bigger hit on the balance sheets of European banks than those of their American counterparts.
Andrew SawersNovember 19, 2012

European banks at the center of the ongoing Libor regulatory investigations may have to take a hit in their accounts before American banks do, because of differences in the way accounting standards deal with potential class-action liabilities. And the impact on European banks could be bigger as well.

International Financial Reporting Standards (IFRS) has a lower threshold for bringing potential litigation risks onto the balance than does U.S. GAAP, notes a report by Moody’s Investor Service. In both cases the liability needs to be “probable” and “reasonably estimable,” but the two standards define those terms differently. Under IFRS, “probable” means “more likely than not,” whereas under US GAAP it means “a cash outflow is likely to occur.”

As for the measurement of such a liability, if there is a range of equally likely possible losses that might occur, “the mid-point of this range would be recognized as a liability under IFRS, whereas the low-point of the range would be recognized under U.S. GAAP.”

To date, only Barclays has settled legal action with regulators in the United States and United Kingdom, agreeing to a $453 million (£290 million) settlement with the Commodity Futures Trading Commission and the Financial Services Authority. Lloyds Banking Group, RBS, HSBC, UBS, Deutsche Bank, JPMorgan Chase, and Citigroup are all “cooperating with regulators.” Moody’s said the expected level of any fines against the other banks should not be significant enough to affect their credit ratings.        

By far the biggest financial damage to the banks will come from the 20-plus class-action suits filed by derivatives holders or corporate borrowers or depositors. The plaintiffs believe that traders’ alleged manipulation of Libor rates (whether up or down to suit their books, or downwards so as not to send a negative signal to the interbank markets) has left them disadvantaged. Moody’s says litigation costs for these could be more likely than fines to have “credit-negative rating implications.”

While Moody’s doesn’t attempt to quantify the potential impact of class-action litigation against the banks, the credit rater doesn’t have faith in estimates based on the sheer scale of the interest rate derivatives market, which has a notional value in excess of $500 trillion, according to the Bank for International Settlements. That’s because of “the more sophisticated institutional nature of those markets and the fact that institutions are equally likely to benefit as to be damaged by Libor rate manipulation,” Moody’s says. “While such institutions may still seek to litigate for damages, if they are successful, we believe that any benefit they had also realized would likely reduce the size of the final award.”

Much more likely is that banks will be sued by sovereigns, corporations, and municipalities that used Libor in the capital markets as the basis for either floating rate instruments swaps. However, the legal hurdles facing plaintiffs are formidable: the burden of proof is onerous “because they will need to show a sufficient causal link between a defendant bank’s false rate submission and the harm alleged by plaintiffs,” Moody’s says.

“For example, because of the way Libor is calculated, a false submission by any one bank on any particular day may not have distorted Libor in a material way.” For sterling Libor, for example, of the 16 panel banks’ submissions, the highest four and lowest four rates were ejected and Libor calculated as an average of the remaining eight submissions. “In addition, some legal theories require that there be a sufficiently close transactional relationship between the plaintiff and defendant to justify liability.”

So there’s a long way to go, but investors – and Moody’s – will be keeping a particularly keen eye on European banks’ balance sheets.