European Banks Take 3Q Hit on Clean-Up Costs

Three of Europe's biggest banks suffered third quarter hits on Tuesday as the relentless rise in the cost of an industry clean up after a string of scandals shows no signs of abating.

Shares in Deutsche Bank and Lloyds Banking Group fell sharply after they set aside unexpectedly large sums to cover possible law suits and fines, overshadowing their day-to-day performance in the quarter.

UBS stock also tumbled after the Swiss bank announced it has been ordered to hold extra capital in case it has to pay out more than expected in legal settlements.

European and U.S. banks are still struggling to cast off the shadow of the scandals revealed after the financial crisis that erupted in 2008.

"Just as we thought the regulation might be over, back it comes," said Andrea Williams, European equities fund manager at Royal London Asset Management, referring to the UBS hit.

Deutsche, Germany's largest bank, set aside an extra 1.2 billion euros ($1.7 billion) to deal with potential litigation costs, depressing its quarterly pretax profit to 18 million euros from an expected 642 million. [ID:nL5N0IJ092] Its shares were down 1.6 percent at 1115 GMT.

Net profit at its rival UBS was 577 million Swiss francs ($644 million), beating analysts' consensus forecast of 537 million. However, UBS said the Swiss financial regulator was forcing it to hold extra capital to deal with possible legal costs, raising fears that it would end up paying billions to deal with claims and fines. This surprise sent UBS shares down 6.7 percent at 1115 GMT.

In Britain, Lloyds set aside another 750 million pounds ($1.21 billion) to compensate customers who were mis-sold payment protection insurance (PPI). Shares in Lloyds were down 1.9 percent at 1145 GMT, even though the bank almost doubled underlying profits in the third quarter.

Other banks have set aside billions of dollars for claims or already paid out billions in fines. Dutch mutual Rabobank could announce as early as Tuesday a settlement with U.S. and European regulators over claims it manipulated an interest rate.

"I'm sure there's a large amount of provisions still to come," said Rupert Baker, a European equity sales executive at Mirabaud Securities, speaking of the industry generally.

WAR CHEST

Deutsche acknowledged it had sprung its shareholders an unpleasant surprise. "The timing and costs of legal charges is frustrating for investors and other stakeholders," said Stefan Krause, Deutsche's chief financial officer.

Deutsche's overall litigation reserves - its war chest to deal with possible legal costs - stands at 4.1 billion euros after the charges booked in the third quarter. "We expect the litigation environment to continue to be challenging," the bank said in a statement, signaling that the worst may not be over.

The latest charges amounted to 1.163 billion euros, with the lion's share set aside for cases involving Residential Mortgage Backed Securities. Deutsche declined to give a more detailed breakdown.

Bonds backed by subprime and other risky residential mortgages lay at the heart of the financial crisis and are subject to a number of law suits in the United States.

More than a dozen banks and brokerages, including Deutsche, J.P. Morgan and Citigroup <C.N>, are under investigation by regulators over the possible manipulation of benchmark interest rates, including the London interbank offered rate (Libor), which are used to price trillions of dollars' worth of loans.

Unlike Barclays <BARC.L> and UBS, Deutsche has not yet reached a legal settlement. "The investigations underway have the potential to result in the imposition of significant financial penalties and other consequences for the bank," Deutsche said in its third-quarter report.

In Zurich, UBS said its financial regulator FINMA was forcing the bank to hold extra capital to deal with greater risk related to "known or unknown litigation, compliance and other operational risk matters".

The measure means the bank's target of achieving a 15 percent return on equity (ROE) by 2015 will be pushed back by at least a year, UBS said.

Kian Abouhossein, a London-based banking analyst with JP Morgan who rates the stock 'overweight', said the market had not priced in this target. "That's less of a worry," he said. "The real worry is that there are more litigation charges."

Several regulators have recently launched investigations into the possible manipulation of foreign exchange markets, and UBS said it was also conducting an internal review.

"We have taken and will take appropriate action with respect to certain personnel as a result of our review, which is ongoing," it said, without elaborating.

Matt Spick, a London-based analyst at Deutsche Bank who rates UBS as a 'buy', said FINMA's demand that UBS hold additional capital had "absolutely not" been expected. "FINMA are effectively saying we think you need an extra 3 billion Swiss francs in capital against litigation issues," said Spick.

UBS repeated its commitment to paying out 50 percent of profits once it hits a common equity tier one ratio, under Basel III global banking rules, of 13 percent, which it expects next year.

Analysts remained wary. "A meaningful capital return won't be until 2015, a year later than most of us were hoping," Citi analysts said.

TURNAROUNDS HAMPERED

In Britain, Lloyds has now set aside more than 8 billion pounds, far more than any other bank, to deal with the PPI scandal. This insurance is designed to protect borrowers who miss loan repayments due to illness or redundancy, but was often sold to people who were not eligible to claim.

Lloyds, which was bailed out by British taxpayers during the crisis and remains 33 percent state-owned, said volumes of PPI complaints were falling more slowly than expected. Responses to its letters to customers offering compensation had also been higher than forecast.

The additional hit took the shine off an otherwise strong performance by Lloyds, showing that this problem can hurt efforts to turn a bank around for years.

Both UBS and Deutsche highlighted difficulties in their day to day operations. Revenue from Deutsche's profit engine - sales and trading of debt - fell 48 percent to 1.2 billion euros, compared with the year-ago period.

Weaker trading income has already hit rivals such as Credit Suisse <CSGN.VX> and Goldman Sachs <GS.N> after the Federal Reserve surprised markets by deciding to keep up the rate at which it buys bonds to stimulate the U.S. economy, instead of starting to wind it down.

Analysts at Switzerland's J. Safra Sarasin said litigation costs and a weaker fixed income result had been widely discussed in the market, but the impact was still more severe than expected.

At UBS, the bank beat expectations for overall earnings. Analysts said this was largely because of one off gains including the release of deferred tax earnings, but UBS's turnaround story remained on track.

"The UBS story is still intact in terms of becoming a private bank and equities investment bank," said Spick. "All the targets are now pushed back by about twelve months because of the scale of litigation and perhaps slower rises in interest rates, but the end-point is still the same."