Litigation, other maneuvers against banks follow financial crisis

Marty Dolan, principal at Dolan Law, and his associate Karen Munoz represent victims of wrongful death and personal-injury. His column “Law and Wellness” appears in the Chicago Lawyer and her column appears regularly in the Law Bulletin. This week’s blog is written by Karen Munoz.

It seems that with every passing week, a new story emerges involving allegations of misdeeds by major financial institutions. The story that has received most attention recently is that of Barclays Bank settling with the U.S. Commodity Futures Trading Commission, the Department of Justice (DOJ) and the Financial Services Authority in Britain for a combined total of $450 million because of alleged interest rate manipulation during the financial crisis.

This follows many high-profile settlements in recent years involving big financial institutions. A number of these settlement concerned allegations of mortgage discrimination, where mortgage brokers would charge higher fees to minorities than it would to white borrowers with the same credit risk. Wells-Fargo, the largest mortgage lender in the U.S., settled with the DOJ for $175 million. Bank of America, last December, settled another such case with the DOJ for $335 million, and Sun Trust Mortgage also settled charges against it for $24 million earlier this year. Part of the reason these abuses took place was the huge profits that banks could make from creating securities and derivatives based on subprime mortgages.

Similar incentives were also behind the conduct that led to Bank of America’s agreement to settle claims brought by shareholders for $8.5 billion. Shareholders who were sold mortgage-backed securities claimed to have been misled by the bank because the packages were highly rated, despite being based on mortgages from borrowers with poor credit. Indeed, JP Morgan also reached a $153 million settlement related to misleading investors in a single security. Investors alleged that JP Morgan marketed the security without informing investors that a hedge fund involved in forming it took a short position on it (in other words, bet it would decline in value). Indeed, JP Morgan may face similar suits related to the recent $2 billion loss arising out of trades made by the “London Whale.”

These are but a few of the practices that went on which contributed to the severity of the financial crisis. And there have been similar settlements involving Bear Stearns, Wachovia and Citigroup and others.

One aspect of the settlements with prosecutors in the criminal suits that has troubled commentators is the practice of entering deferred prosecution agreements (DPAs) or non-prosecution agreements (NPAs) whereby the financial institutions agree to pay a sum to settle the charges brought against them and the government agrees not to prosecute as long as the institution complies with certain conditions in the agreement.

What troubles commentators – and indeed one federal judge in New York in a case involving Citigroup – is that these DPAs do not involve any admission of wrongdoing on the part of the financial institution, no matter how egregious the conduct. What is troubling to me, however, is that DPAs and indeed the high-profile civil settlements punish the institutions’ recklessness after the fact but they do not address the wider, systemic problems that led to these dishonest practices in the first place.

Chief among them, in my view, is misaligned incentives. Incentives in the financial world were, and to some extent still are, such that huge profits for financial institutions could be made from exploiting investors and customers as demonstrated by the above-mentioned cases. Indeed, some have argued that the practice of awarding huge bonuses to bankers based on short-term gains (which may actually have detrimental effects in the long run) further increases the incentives to make short-term profits without having due regard for the potential consequences. As long as similar incentives exist in the system, there is always a likelihood that individuals and institutions will act upon them.

This is not intended to be a polemic against Wall Street; far from it. I am simply trying to point out that, while litigation against banks does discourage some of the dishonest practices that contributed to the financial crisis, something more is needed to ensure similar practices are not repeated in the future and that starts with ensuring they are not incentivized.

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