Reading the fine print

The Financial Conduct Authority recently hit some of Britain's banks with huge fines for manipulating the FX market. But how are these calculated, are they justified and will they have the desired effect? asks the Review Consultant Editor Andrew Davis

One of famed fund manager Neil Woodford's best calls was undoubtedly to sell all his bank shares well before the financial crisis, and so his decision to venture back into the sector by buying into HSBC in 2013 naturally attracted attention. However, he didn't stay for long.

Last September, Woodford sold his entire stake in HSBC, saying: "In recent weeks I have started to become more concerned about one particular risk: that of 'fine inflation' in the banking industry. I am worried that the ongoing investigation into the historic manipulation of LIBOR and foreign exchange markets could expose HSBC to significant financial penalties... The size of any potential fine is unquantifiable, so this represents an unquantifiable risk."
"Anyone can throw a couple of junior traders under a bus. That is not going to change behaviour" Senior Managers Regime The FCA set out proposals last year to hold senior managers to account by making them more responsible for their firms' actions.

In July 2014, the FCA and the Bank of England Prudential Regulation Authority published a joint consultation paper, Strengthening accountability in banking: a new regulatory framework for individuals.

The proposals include a new Senior Managers Regime, which will clarify the specific responsibilities of senior managers and expand the range of senior managers within firms who are subject to standards of conduct.

The regime, which could come into effect later this year, will also, in some circumstances, put the burden of proof for compliance on senior managers.
Two months after he sold out, HSBC was fined £216.3m by the Financial Conduct Authority (FCA) for manipulating the FX markets. Four other banks - Citi, J.P. Morgan, RBS and UBS - received similar penalties, bringing the FCA's total haul to almost £1.15bn - by far the biggest set of fines the UK regulator had ever imposed. 

The five-step system (see box below) now used to calculate the penalties the FCA imposes is set out in its Decision Procedure and Penalties Manualand came into force in March 2010.

Michael Ruck, a senior associate at law firm Pinsent Masons and former legal officer at the FCA and its predecessor, the Financial Services Authority, explains that the central reasons for overhauling the previous system were to clarify how penalties are calculated and to allow the fines levied on firms to get bigger in order to ensure they have "credible deterrence". 

Setting penalties This notion is now a central part of the FCA's approach to setting penalties and inevitably draws the regulator into the political sphere, because it provides for the fine calculated on the circumstances of the individual case to be increased specifically to ensure it is big enough to deter others. Penalties are therefore determined partly by what the offender actually did and partly by their size and ability to pay. As HSBC's example shows, the levy for "credible deterrence" can be very large.

In the Final Notice issued to HSBC for the FX manipulation case, the FCA decided it was "not practicable" to work out what benefit HSBC gained from its activities. The "disgorgement" penalty was therefore zero. In step two, the FCA decided the revenues involved were £66m and that the breach was in category 5 (20%), giving a fine of £13.2m. In step three, it judged that aggravating factors justified a 20% increase in that total to £15.84m. 

At step four, the £15.84m was not regarded as a "sufficient deterrent" and so another £225m was added, bringing the total to £240.84m, which was then reduced by 30% at step five for early settlement, leaving £168.58m. Along with another £47.77m to cover the breaches that took place before the new system of calculating fines came into force, HSBC faced a final bill of more than £216m. 

Or rather HSBC's shareholders did. Given the size of fines now being imposed by regulators, only corporations - and by extension their shareholders - are in a position to shoulder such huge penalties. To the extent that shareholders have the right to hold the board to account for such breaches, this seems reasonable.

However, as Sara George, a partner at law firm Stephenson Harwood, argues, the fines agreed with the regulator are "basically what the banks are prepared to pay of their shareholders' money in order to preserve their senior management".

Executive privilege A major weakness in the present system is that senior executives are not held to account for the failings of their organisation, says George. "Ultimately it needs to be the senior individuals, not the juniors," she emphasises. "Anyone can throw a couple of junior traders under a bus. That is not going to change behaviour... When has the FCA ever succeeded in going after a senior individual at the top of an institution?"

But if, as she suggests, the whole process of fixing these fines is a "cod science" that leads to "remarkably round numbers", this is in large part due to the intensely political nature of financial regulation nowadays: the FX penalties were choreographed between the UK and the US and announced on the same day, in part to avoid the UK's fines looking puny next to the massive sums demanded by the American regulators. 

The same goes for the ultimate fate of the cash extracted, which used to help fund the regulator, thereby reducing the annual levy on law-abiding firms. No longer. First the Treasury decided to direct it to veterans' charities, and more recently the FX fines were supposedly used to bolster spending on the NHS. What more politically resonant home could the UK government have found for the sums the banks were forced to hand over? Anyone would think there was an election coming.

Going to penalties The process of calculating a penalty has five steps, says Pinsent Masons' Michael Ruck.

Step one
"Disgorgement", which means repayment of the financial gain the firm made from its misconduct. In a misselling case, for example, he explains that if there were 10,000 instances of people being missold a product, the FCA would look at a sample number of, say, 100 files. If it found 50 showing misconduct, the disgorgement would comprise only the benefit the firm gained from those 50 sales - the regulator would not extrapolate its finding across the whole 10,000.

However, in many cases, including benchmark rigging, it is difficult or even impossible to establish exactly what gain a firm has made and, as a result, the disgorgement figure is often set at zero. 

Step two
Quantifies the seriousness of the breach. "The regulator will look at the revenue that has been generated in the area of the business where the breach took place," says Ruck.

In practice, however, not every breach can be directly linked to a particular portion of a firm's revenue - lapses in the handling of client money, for example. "To be fair, in certain circumstances the wording doesn't really work," Ruck says. "But they will try to base it on something tangible that in their view is a reasonable starting point."

Having fixed on a figure, the regulator then decides which of five categories the breach should go into. Each carries a percentage: 0%, 5%, 10%, 15% or 20%. If it is placed into category 4, the penalty at this stage will be calculated as 15% of the relevant revenue figure. 

Step three
Examines aggravating and mitigating factors, such as whether the breach went on unchecked for a long time or whether the firm had been fined for similar activities in the past, and on the other side whether it identified the issue quickly itself, provided redress voluntarily and co-operated fully with the regulator's investigation. Taking these factors into account, the penalty arrived at in step two can be increased or decreased. 

Step four
Calls for an "adjustment for deterrence", allowing the fine to be increased substantially if the regulator decides this is necessary to discourage others.

Step five
Allows a reduction in the penalty (but not the disgorgement) of up to 30% as a "settlement discount", depending on how early in the process the offending company and the regulator agree the size and terms of the fine. 
Published: 12 Feb 2015
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