How banks can prepare for the ever-growing risk of litigation

Given the recent high-profile bank collapses and restructurings, it is logical to consider the similarities between the current situation and 2008, and if recent events will lead to industry-wide litigation to the same extent that we saw previously.

As a starting point, we should remind ourselves what happened in 2008. On one level, the Global Financial Crisis (GFC) happened because a property bubble, inflated by the availability of cheap and easy credit, burst when interest rates rose. This resulted in widespread borrower defaults and negative equity which caused several lenders, especially those most exposed to the subprime market, to collapse.

Also impacted were banks that had bought securities backed by these loans – particularly Collateralised Debt Obligations (CDOs) and Mortgage Backed Securities (MBS). These are financial instruments which were deemed and rated as low risk. Given the potential profits available from investing in these instruments, many banks leveraged heavily to buy them.

As things started to go wrong, panic ensued and banks desperately clung on to what funds they had, bringing interbank lending to a halt. As liquidity dried up, many more banks failed including some very large ones - most infamously Lehman Brothers.

One of the many consequences of these bank failures and bailouts was a huge amount of litigation against banks, some of which is still going on today.

How similar is what we are seeing now to 2008? Thankfully, as things stand, there are a number of key differences. That raises the question whether those differences will mean that banks can avoid the onslaught of litigation that we saw in the years following the GFC.   

First, let’s consider the similarities between the current situation and the GFC. For the last few years, as with the run-up to the GFC, cheap credit has raised property prices and many loans are still packaged into debt-backed securities. This means that lenders and investors would be hit by borrowers failing to repay their debts or property prices collapsing.

With inflation and interest rates both rising, it is not unrealistic to take the view that property prices could well decrease. However, there are also reasons to believe that the impact would be far less than it was in 2008 and that banks would be better placed to withstand it. 

Since 2008, the largest banks have been required to hold more capital and diversify their revenue streams, which is intended to better insulate them against the risk of widespread defaults, substantial drops in share prices and large capital outflows.

In addition, the issues suffered by the banks which have collapsed or needed to be rescued recently are by-and-large specific to those banks, rather than something which would impact all banks.

Combined, these factors suggest that while confidence in the industry might have been dented, we are unlikely to see the sector-wide contagion that we saw in the GFC.

However, that does not necessarily mean that there are not some dark, litigious clouds on the horizon.

Is a storm brewing?

In the aftermath of the GFC, banks were a massive target of litigants. As explained above, there is little to suggest that we will see the widespread contagion that we saw following the GFC. It is therefore reasonably to assume that we are unlikely to see a similar level of litigation.

However, there are a number of potential risks facing the banks which could lead to a rise in claims.

A large proportion of the litigation post-2008 came on the back of negative findings by regulators. Regulators are likely to increase their scrutiny of the banks and their management following the recent issues and, should there be a rise in enforcement action by regulators, this could be used as the basis for bringing claims.

In addition, banks might be more focused on maintaining capital and, to that end, could look to cut costs or withdraw from less-profitable or riskier areas of business. This again could lead to an uptick in claims, such as from employees who have lost their jobs, third parties whose contracts have been terminated or borrowers who have lost access to finance.

Banks might also be more keen to take action to recover monies owed by borrowers in default. This could involve an increase in margin calls, accelerating loans, terminating finance agreements or triggering cross-default provisions. Each of these could be challenged and result in disputes.

There are also a number of issues completely unrelated to the recent bank failures which could result in claims. We could see more challenges from parties who lost access to finance because banks considered them to be caught by sanctions.

ESG-related litigation is likely to increase. We might see an increase in claims against banks either in their role as ‘secondary infringers’, in that they provide finance to polluting industries, or arising out of arguments over the terms of agreements governing green and sustainable financing and how those terms are enforced.

The threat that an increase in interest rates and higher inflation could result in borrowers adopting a “can’t pay, won’t pay” approach may not be as significant as it was in 2008, but that does not mean it can be ignored. Such an approach from borrowers could result in an increase in mis-selling claims as borrowers try to avoid paying back loans. This risk is also heightened due to the rise in class action lawsuits, both in the UK and across Europe. Accordingly, banks simply cannot afford to become complacent about the threat of litigation.

What can FIs do to prepare for litigation risks?

The good news is that there are a number of steps that banks and other financial services institutions can take to prepare for any increase in litigation.

An obvious one is to ensure that all relevant documents are preserved, easily identifiable, and accessible. Following the GFC, a large proportion of claims against the banks succeeded not because the banks had necessarily done anything wrong, but because they could not access the relevant documents to prove they hadn’t.

Another key point is to take care when conducting internal investigations. Given the high-profile issues hitting some banks recently, other banks are likely to want to review their own processes, systems, and controls. However, it is important to manage how these investigations are carried out to avoid negative creating findings reports which can then be used by potential claimants as the basis on which to bring claims.

Before taking any action such as terminating agreements or calling in loans, it is important to review the relevant contractual provisions carefully. If not applied properly, this can result in a liability for the banks for any losses suffered by the other parties. 

Engaging early if it looks like disputes could arise, ideally to bring matters to an amicable conclusion, will not only save legal fees but also avoid court proceedings which can cause significant reputational damage. After all, settlements can be kept confidential – court cases cannot. Further, although some claims must be defended at all costs, especially if losing would open the floodgates to further claims, litigation is an expensive and uncertain proposition.

Consider whether any of the risks of litigation can be mitigated, for example, through insurance. As risks grow and evolve, so should the insurance cover that is in place.

These are only a few ways to address the risk of ‘known unknowns’ in relation to the threat of litigation. It is not an exhaustive list, but the overall message is be prepared and do not leave it until the claims start to pile in.