Litigation Surge Could End TBTF

The "too big to fail" problem remains unresolved more than five years after the start of the financial crisis. Domestically, it mainly concerns banks with more $500 billion in assets, a group that includes Citigroup, Bank of America, JPMorgan Chase, Goldman Sachs, Wells Fargo and Morgan Stanley. These banks have become even larger over the past five years despite regulatory and legislative top -down measures like the Dodd-Frank Act and Basel III. The $6 billion "London Whale" trading loss at JPM, the supposedly strongest and best managed of the big six, illustrates the risks still inherent in mega-financial firms.

Lawmakers and regulators have failed to curtail these banks because they are too powerful. Together, the big banks have mounted a well-financed lobbying effort to block effective reform. It is highly unlikely any meaningful regulatory or legislation solution to TBTF can pass when the regulated are more powerful than the regulators.

Ordinarily, there are market limits to firm size due to complexity. Large institutions suffer from bloated overhead expenses, governance and control breakdowns, poor resource allocation decisions and bureaucratic inflexibility. Essentially, management becomes an off-balance-sheet liability reducing the intrinsic value of the bank as it become too big to manage.

TBTF banks are complex, global vertically integrated financial conglomerates seeking to manage disparate businesses such as retail and investment banking along with asset management. They often suffer from mediocre returns and lagging stock prices. The break-up or sum-of-the-parts value of their various divisions exceeds the value of their market value. Proponents justify their existence based upon alleged cross-sell synergies. The synergies turn out to be conflicts and cross subsidies among business units. Furthermore, customers often seek more cost effective unbundled products from smaller specialist providers.

TBTF represents a government, not market problem. These firms would not exist but for the implicit government funding subsidy based on their status. There may be a difference of opinion over the exact size of the subsidy. Nonetheless, it represents a material portion of their profits. The subsidy offsets the negative synergies associated with being TBTF. Additionally, it reduces market discipline of big bank activities.

These banks have suffered from numerous mishaps, including robo-signing foreclosures, faulty mortgage-backed securities as investment products, Libor-fixing and money laundering. Regulators, investors and prosecutors have successfully litigated these matters. The associated settlements, litigation and overhead expenses are huge. It is estimated the big six have incurred over $100 billion in settlements alone since 2008, and the amount is growing.

JPM has incurred over $21 billion in settlement-related expenses since 2008. These and other expenses are exhausting previously established reserves.

The costs related to this type of litigation go beyond just direct legal and settlement expenditures. They include associated preventive measures such as compliance, consulting and training costs as well. This is highlighted by JPM's recent announcement to commit an additional $4 billion and 5,000 employees this year to risk and compliance issues.

The monetization of the TBTF expenses through litigation constitutes a bottom-up solution to issue. It is converting a taxpayer problem into a shareholder concern. Also, it is immune to lobbying efforts. Combined with top-down efforts like higher capital rules and liquidity buffers, the funding subsidy is being steadily eroded. Some analysts are labeling the litigation surge as a vendetta against banks. Instead, it is merely reflecting the true costs of their size.

These banks will continue to suffer rising legal expenses and constrained performance, which should raise shareholder concerns. Ultimately, a litigation surge will lead to restructuring efforts, including spinoffs, as managers seek to simplify operations and improve performance.

A full-scale restructuring, however, is unlikely to happen with current management teams. Organizational inertia in large firms inhibits change. Restructuring efforts should increase in intensity once the funding subsidy is further eroded and the current management teams retire or are replaced.

It appears there may be hope for solving TBTF. We may achieve a market-based solution leading to institutions small enough to fail and the return of market discipline. Things may be getting better despite our efforts to improve them. The lawyers may end up being part of the solution instead of the problem.

J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.