Bleeding the banks

These costs are proving huge. Indeed, Morgan Stanley (US:MS) has estimated that the US and European banks have so far been hit with fines and litigation costs of around $210bn £131bn) in total since 2009. Yet the lenders don't appear to be even close to the end of this process. This year, in particular, has seen an escalation in the level of fines being imposed - as demonstrated by BNP Paribas' (FP:BNP) unexpectedly severe $9bn fine in July - and a significant number of issues remain to be tackled. "We believe there are at least 15 major issues outstanding that could result in individual bank fines of more than €100m [£78m]," says Berenberg Bank.

Berenberg highlights FX market manipulation, Libor rate-rigging and US mortgages as the three areas where the exposure is greatest. But other issues, such as the apparently never-ending PPI mis-selling scandal, remain costly threats. There are also a range of more focused threats - from fines related to the Bernard Madoff Ponzi scheme to the European Commission's probe into the credit default swap market - that are, in aggregate, far from insignificant. In fact, analysts at Macquarie Securities think an additional $41bn of fines and settlements (see table) could be facing the main UK banks alone.

US mortgage misery

As we now know, mortgage-backed securities helped trigger the financial crisis and it was the sale of such products to investors that's now driving perhaps the greatest collection of settlements facing the sector. That, of course, reflects the unexpectedly poor quality of the underlying mortgage loans backing these products.

Big claims are therefore being made against those lenders that peddled these securities by the US Department of Justice (and other federal and state bodies) as well as America's Federal Housing Finance Agency (FHFA). The FHFA oversees the US secondary mortgage market and is acting for such US government-backed secondary mortgage operations as Fannie Mae and Freddie Mac. But lenders are also having to enter into national mortgage settlements, to compensate for such issues as inappropriate foreclosures, and are also facing big claims from private sector participants in the mortgage market.

To date it has largely been the big US banks that have been the most publicly affected. For their part in mis-selling mortgage-backed securities, for instance, Bank of America (US:BAC), Citigroup (US:C) and JP Morgan (US:JPM) have agreed settlements with federal and state authorities worth $16.65bn, $7bn and $9bn, respectively. But some 15 lenders, still predominantly US banks, have also settled with the FHFA so far - the total fines paid to date exceed $17bn. Action against banks by investors, meanwhile, is ongoing and a good example of the risk here was seen last November when JP Morgan reached a $4.5bn settlement with 21 institutional investors. While in March 2012 the Department of Justice announced a deal covering national mortgage settlements for $25bn in total with Ally Financial (US:ALLY), Bank of America, Citigroup, JP Morgan and Wells Fargo (US:WFC).

So far, then, the European lenders - including UK banks - appear to have escaped relatively unscathed from the US mortgage quagmire. That, however, looks set to change. "Among the UK banks, we believe that RBS (RBS) has by some margin the highest potential liability arising from its substantial US mortgage business (Greenwich)," reckons Macquarie. HSBC (HSBA), though - by virtue of the sheer range of its operations - is also perceived to be at significant risk. Indeed, Macquarie has estimated that total US mortgage-related settlements could reach $5.6bn at RBS and $2.5bn at HSBC.

FX - the great unknown

Compared to the US mortgage settlements - which have been rumbling on for years - regulatory interest in alleged manipulation of the $5.3trn a day foreign exchange (FX) market is relatively recent. It began in the spring of 2013 and was initially focused on whether banks' FX traders had colluded to manipulate the market. The probe has since shifted focus to include an analysis of whether traders may have defrauded customers and on the adequacy of banks' internal oversight system. But the scale of bank's exposure remains unclear. "Considering the size of the market and potential fine inflation that has occurred over the last few years, we see this as having potentially significant ramifications," notes Berenberg.

Investigations are still generally at an early stage. Late last month, the FCA held preliminary settlement talks with Citigroup, JPMorgan, Barclays (BARC), RBS, HSBC and UBS (VX:UBSN). Significantly, the lenders were told that they should each eventually expect to pay the UK regulator more than UBS's £160m fine in 2012 for Libor-rigging. But, crucially, those discussions haven't included the US regulators, a number of which are also conducting their own investigations. Overall, then, analysts are finding it hard-going attempting to quantify the scale of the likely fines: Berenberg, for instance, says the ranges of expectations vary from"c.$1bn up to $10bn". Moreover, Berenberg adds the risk of potential civil litigation seems higher than with the Libor scandal"due to a likely easier burden of proof of loss."

Macquarie, however, has attempted to quantify bank exposure to this issue. Adding both regulatory civil-related costs together it calculates that Barclays, HSBC and RBS are each facing a £3.5bn hit, while Lloyds (LLOY) could be facing a £1bn hit.

Libor - not done yet

In contrast to the FX probe, which is only just beginning to gather momentum, the Libor-rigging investigation is increasingly perceived to be coming to a close. After all, it was back in mid-2012 that Barclays received the first big fine (£290m) for this - an event that led to the departure of its chief executive at the time, Bob Diamond. That perception, however, may be premature. Just this month, for example, JPMorgan UBS and Credit Suisse were fined a total of E93.7m for rigging the Swiss franc Libor rate.

In fact, the longevity of the issue has also encouraged a great many regulatory agencies to become involved. International regulators focusing on Libor now include two from the UK (the FCA and the SFO) and six from the US. There are also several of European regulators probing the issue, as well as a smattering of significant Asian ones: including those from Hong Kong, Japan, Singapore, Thailand and South Korea. Naturally, such inflation of regulatory interest carries the capacity to generate more fines over and above the settlements reached to date. That tally itself is not insignificant. The total US and UK fines levied against just Lloyds, RBS, and Barclays have already reached £818m. Interestingly - and significantly reflecting the sheer number of bodies that seem able to get in on the act - US regulators have been responsible for around three-quarters of the total Libor-related fines levied against each lender so far.

There's also the problem of civil litigation. Essentially, bank customers could yet bring civil cases against lenders arguing that they were made materially worse off because the Libor rate had been artificially manipulated. It is unclear just what burden of proof would be needed to support such a case, but the issue is not an insignificant one: just one successful plaintiff could set a painfully expensive precedent for future litigation.

Neither is Libor-rigging the only probe in this general category: there's also the manipulation of benchmark interest rates. The European Commission, for instance, has levied fines against lenders for rigging Euro interest rate derivative (EIRD) and yen interest rate derivative (YIRD) benchmark rates of €1.7bn and €3.2bn, respectively.

US bugbears: sanctions and tax

As the world's only superpower, the US can sometimes be perceived as being a tad too zealous regarding the enforcement of its laws on the rest of the world. In the world of banking, America's focus on sanctions against such"rogue states" as Iran or North Korea is a minefield that has snared more than few major international lenders.

Most recently, France's BNP Paribas was forced in July by America's Office of Foreign Assets Control (OFAC) to cough up a huge $9bn fine for US sanctions violations involving Iran, Cuba and Sudan. The bank itself had set aside a provision of just $1.1bn, which demonstrates the near impossibility of accurately estimating potential fines. Some UK banks have also fallen foul of American rules. HSBC, for instance, was forced to shell out a hefty $1.9bn fine in December 2012 for money laundering systems failings. While Standard Chartered (STAN) was forced to pay a $340m fine in August 2012 (followed by a further $300m two years later) to New York regulators relating to breaches of US money laundering rules involving transactions with Iran. Other big banks are under investigation by OFAC for sanctions-related offences, including Commerzbank (DE: CBK), Crédit Agricole (FP: CNF), Deutsche Bank (DE: DBK), Société Générale (FP: GLE) and Unicredit (MI: UCG).

Dodging US tax is another area that upsets US regulators. At this stage, however it's the Swiss banks that are under the spotlight. Indeed, in August 2013 the Department of Justice launched an offshore programme to combat non-compliance with US tax laws and has so far launched criminal investigations into 14 Swiss banks including UBS, Credit Suisse (VX: CSGN) and Julius Baer (VX: BAER).

Mis-selling redress - no end in sight

The mis-selling of payment protection insurance policies (PPI) has become the largest consumer scandal ever seen in the UK. The claims really began taking off in 2011 and the pain for the UK's banks has been immense. Lloyds is easily the lender that has been hit the hardest and has, so far, set aside a huge £11.33bn in aggregate provisions to cover redress for customers. But all of the big banks are affected and, across the sector, around £24bn has been set aside to cover PPI redress with around £16bn having been paid out to date.

The trouble is that the pain never quite seems to end. True, payments have been following a downwards trend since 2012 but "at a much slower pace than forecast by most firms", notes Berenberg. What's more, further payouts are expected as, in August, the FCA announced that 2.5m claims processed in 2012 and 2013 are to be reopened. Indeed, all of the big banks further bolstered their PPI-related provisions at the half-year stage. And at the third quieter stage, HSBC set aside a further $234m, RBS raised an additional £150m and Barclays bolstered its PPI provision by £900m. While at the third-quarter stage, Lloyds raised a further £900m provision.

Similarly, redress to cover mis-sold interest rate hedging products - while a far smaller issue than PPI - is also proving costly for the UK banks. The big four UK banks have so far set aside around £4.5bn in provisions in total to cover redress claims for this but analysts think some banks appear to have underestimated what's needed. RBS, for instance, has about half the cases under review but only holds around a third of the sector's cumulative provision. HSBC's provision - at just above £1bn - also looks low given that it has the second highest number of cases. Still Berenberg thinks that redress here will at least be finalised by the end of the year"unlike PPI which appears to have an indeterminate life."

Can banks cope?

Given this background, the question inevitably arises as to whether banks can afford such huge redress-related costs. After all, on the one hand, prudentially-focused regulators are pushing banks to become more secure by forcing them to bolster capital cushions. Yet, on the other hand, a raft of consumer-focused regulators and government agencies appear to be undermining that capital building process by triggering huge compensation payouts and imposing painful fines.

Banking analyst Ed Firth of Macquarie points out, however, that banks are potentially"huge capital generators", significantly reflecting their ability to generate cashflow as legacy loan books are run down. That has left most banks still able to grow capital and - with the exception of those that are constrained by having received state bailouts - also paying reasonable dividends. HSBC is a good example. Even though the lender has been hit with some nasty redress-related costs - and Macquarie forecasts its possible outstanding liabilities here as easily the largest of any UK bank - HSBC has made impressive progress with selling non-core operations and cutting costs. The net result is one of the healthiest regulatory capital ratios of its international peer group and a prospective dividend yield for 2015 of over 5 per cent.

That said, fines, litigation and redress provisions remain a "pretty major headwind" says Mr Firth. Indeed Macquarie sees this as the biggest issue currently facing the European bank sector. Given the scale of the costs, that's hardly surprising: the misconduct-related liabilities estimated by Macquarie to still be facing RBS, as an example, represent a chunky 11 per cent of its 2014 forecast tangible book value. So while the banks may be able absorb hefty redress costs, and even make progress, the issue remains big enough to weigh on share prices.

BOX: What happens to the money?

Perhaps bizarrely - given the pariah status that banks have for their role in inducing financial crisis - voices are beginning to be raised about the unfairness of bank fines. That's especially so for US fines being slapped on non-US banks. Indeed, back in July Ulrich Grillo, the head of Germany's BDI industry federation, accused the US of attempting to"starve" European banks. Given that US and European taxpayers were forced to bail out the banks, the general public may find such sentiments difficult to comprehend. Still, precisely what happens to the money being raised can seem opaque and we'll answer that question by focusing on the two jurisdictions that have done most so far to make banks pay: the UK and US.

The UK

In the UK, it's essentially fines levied by regulators - rather than US-style multi-purpose settlements - that dominate. The UK lenders' huge PPI-related costs, it's worth remembering, are not determined by regulators: these comprise provisions decided by the banks themselves to cover claims. Accordingly, the amounts being levied by UK regulators can seem modest compared to those in the US. For example, total FCA fines during this year so far have reached just over £307m. That looks like small change compared, say, to the combined near-$33bn settlement reached between the US federal and state authorities and just three banks: Bank of America, JP Morgan and Citigroup.

But it's still a lot of money and, up until a few years ago, UK regulators could use the funds to offset the cost of regulation by reducing the fees that firms pay. That changed in April 2012 when the new Financial Services Bill became law. As the FCA points out in its business plan, under that legislation it must"pay the Exchequer all financial penalties received, apart from certain enforcement costs incurred in generating these penalties". Bank fines therefore go into the consolidated fund - basically the government's current account for general expenditure - to be used at HM Treasury's discretion. Still, attempts are sometimes made to ring-fence a portion of the funds. Last year, for example, the government said that Libor-related fines would be used to support military charities.

The US

The situation in the US is complicated by the sheer number of regulatory, federal and state authorities involved. Moreover, the US approach goes well beyond fines. There is also the hugely expensive matter of paying restitution to an array of perceived victims to consider, ranging from mortgage borrowers to the likes of America's big state-backed secondary mortgage players (such as Freddie Mac and Fannie Mae).

To give a snapshot of how funds are distributed, it's worth looking at the near-$33bn settlement with the three US banks mentioned above relating to mortgage-backed securities. From that, $11bn went to the US Treasury, $13.5bn is earmarked for consumer relief and the rest was essentially divided up between payouts to six US states and several regulators. This, of course, is unconnected to the more than $17bn of fines levied on around 15 banks by the FHFA on behalf of Freddie Mac and Fannie Mae. It's also separate from the $25bn paid out so far by US banks in national mortgage settlements - of that, almost a quarter went to state and federal authorities and the rest went to provide relief to borrowers.

Just how effective the huge consumer relief elements of US settlement eventually prove to be is a matter of debate. Looking again at the $33bn of mortgage-related settlements, banks have three years to deliver the consumer relief aspect of this - primarily through reducing interest rates or principals on mortgages. But banks are in no rush: by end-March, for example, JPMorgan had modified just 100 mortgage loans (worth around $6m of relief). Moreover, banks don't have to give direct relief to existing homeowners and can use the funds to support new mortgages to those considered worthy of support - such as first-time, low income borrowers. Arguably, making new loans - from which the banks will generate earnings - is a peculiar way to make restitution.