Legal Risk Management

Welcome:
Banks in course of their operations face many potential risks. Legal risk
is one among them. Money Laundering, fair and honest lending,
monitoring potential illegal activities on the part of the customer,
disclosing a range of critical information to the clients, subjecting to
usury and predatory lending rates and such many other features of bank
operations make it more vulnerable to the legal risks. It is important to
identify , assess, monitor, control and mitigate legal risks. In this module
we will learn about legal risks faced by the banks and how they manage
them.
Welcome to the module on “Legal Risk Management – BOI”.
Learning Objectives:
By the end of the module you will be able to:
• Explain legal risks in banking environment
• Describe legal risk management for Banks
What is Legal Risk?
The Basel Committee on Banking Supervision has defined operational
risk, legal risk and compliance risk. According to Basil Committee ‘Legal
Risk’ is the risk of loss caused from Fines, Sanctions, Penalties or
Punitive damages resulting from:
1. Inadequate or failed internal process, people and systems or from
external events
2. Supervisory actions
3. Court disputes due to breach of contractual and legal obligations
4. Private settlements
5. Legal obligations
6. Risk of uncertainty due to legal actions
7. Uncertainty in the applicability or interpretation of contracts for
legal rights and obligations
Note:- The starting point while entering into any financial transaction is
the legal capacity to contract. This becomes complex to interpret in
respect of innovative financial instruments, since laws or regulators may
not have kept pace with financial innovation.
Legal Risk-Definition:
There appears to be no concrete definition for the expression “legal risk”
nor can we venture to make an attempt at defining it considering the
complexities and variations in the risks involved. The Basel II accord
covers “legal” risk under “operational” risk. Let us understand it.
1. Legal risk may vary from institution to institution depending on the
manner in which it conducts its business and the documentation it
follows.
2. The legal risks primarily arise either due to lack of clarity of the
documentation of the product or the act of the counterparty.
3. Change in legal environment due to legislative changes and Court
interpretations or proceedings also result in legal risk.
4. Legal risk also includes risk of non-enforceability of contract or in-
correct documentation resulting in the increased probability of loss.
5. Broadly, legal risks may result in:
1. Claims against institution
2. Fines, penalties, punitive damages
3. Unenforceable contracts resulting from defective
documentation, and
4. Loss of institutional reputation.
Documentation:
This complex explanation with changing definition of legal risk makes
documentation important.
Documentation forms an important part of the banking and financial
sector. For many, documentation is a solution or remedy for all
difficulties to the legal risks that may arise in banking activities.
But then, it has also been realized and widely acknowledged that
loopholes exist in these documentations.
As a result of lessons learnt from time to time, the loopholes in the
documentation are attempted to be plugged by adding further terms and
conditions in existing documents or by adding further documents
resulting in voluminous and confusing documentation.
In banking there is no end to innovation in documentation because, for
keeping pace with the changing needs and aspirations of the customers,
banks have been venturing into various kinds of innovative products.
Case Study - Hammersmith &Fulham:
Let us look at a case study to better understand the importance of
documentation.
The case of Hammersmith &Fulham, UK gives the details of risk of loss
due to non – enforceability of the contract. In this case it was witnessed
that the counter parties lack the legal capacity to contract. In this case,
the city councils had entered into a series of interest rate swaps with
banks. This turned out to produce major losses for the councils due to
increase in British interest rates. The swaps were later ruled invalid by
British Courts as the city councils did not have the authority to enter into
such transactions and were found to be ultra vires. As a result, the loss
had to be absorbed by the counterparty banks.
Legal Challenges Faced by Banks in India:
During the past decade there has been significant advances in the
banking sector in many ways. This has resulted in considerable benefits
to the customer.
On the other hand, this has also increased the relative operational risks,
legal risks and warranting capital. The recent changes which have
resulted in increasing the legal risk is are as following:
1.De- regulation and globalization of financial services coupled with the
sophistication of financial technology and its associated complexities.
2.Emergence of banks acting as very large service providers creates the
need for continued maintenance of high grade internal controls and
backup system to avoid risks.
3.Outsourcing and the use of outsourcing arrangements also present
significant risks to banks.
Key Legal Risk faced by Banks:
Along with the challenges discussed, the banks also face a few other
key legal risks. There are many causes including these challenges which
include recent global changes. The areas where banks are increasingly
exposed to legal risk are:
1. Miss – selling of complex derivatives
2. Enforceability of contract
3. Custodial arrangements
4. Repo transactions
5. Sharing of information among regulators:- Sharing of information with
overseas regulators can rise problems.
6. Need of sound legal agreements with counterparties:- Particularly
brokers and other intermediaries in FOREX and securities market
7. The rising consumer grievances about services rendered by banks.
8. Outsourcing:- This has helped banks in offering better customer
services. In spite, banks have to address the legal risks that may arise
owing to breaches. The banks are liable for their customer’s
confidentiality or any fraud that may be committed by these agents.
Management of Legal Risk:
Considering all these challenges Basel committee on banking
supervision has suggested a Legal Risk Management System. This can
be broken down in to 5 steps. They are:
A) Identification
B) Assessment
C) Monitoring
D) Control
E) Mitigation
Let us learn about each in detail in the coming screens.
Identification of Legal Risk:The first step is risk identification. This
involves the process of identifying the areas where risk has arisen or
likely to arise. The two categories of legal risk are:
a) Claims against the institution
b) Defective documentation
Assessment of Risk:
The second step is risk assessment. The legal infrastructure of any
particular jurisdiction where a bank conducts business plays an
important role in the assessment procedures.
(Few examples of risk assessment are as given on the screen)
For example:
1.Review on legal documentation: This will help to verify if it is relatively
easy or difficult to understand.
2. Review of all customer, employee and investor complaints and suits:-
This will help to identify trends that may indicate potential legal risks that
need attention.
3. Review of the final reports of all regulatory compliance examination:-
This will help to identify trends that may indicate potential legal risks that
need attention.
4. Review of proposed and enacted regulation and legislation:- This will
help to identify legal risks and to advise business lines in a timely way of
additional compliance and legal risk issues.
5. Review of litigation and regulatory actions against other banks:- This
will help to identify potential areas of legal risk that may apply to the
bank, and to advise business lines of potential exposure.
6. Review of trends in insurance coverage:- It is important to review
litigation and the terms of the banks insurance policies taken on various
assets created out of bank finance to help identify potential coverage
denial risks.
Monitoring and Mitigation:
After assessing the risk the next steps is to monitor and mitigate it.
MONITORING:
An efficient risk monitoring system is essential. It is essential to quickly
detect and correct deficiencies in the policies process and procedure for
managing legal risk. Promptly detecting and addressing the deficiencies
can substantially reduce the potential frequency and severity of the risk.
MITIGATION:
Establishing an efficient legal risk mitigation plan in place is the next
step. Here the banks need to establish a strong internal control culture in
which control of activities should be the integral part of the system.
These are the steps suggested by Basel committee on banking
supervision for Legal Risk Management System.
Legal Risk Indicators:
Now, let us understand legal risk indicators which can help in legal risk
management. They are as shown on the screen.
1. New legislation including proposals for new legislation
2. New case law
3. Significant changes in market practice and related documentation
4. Changes in key personnel
5. Feedback from regulators or other market participants which
indicate hitherto unidentified legal risks
6. Legal actions brought against other market participants that
potentially might be brought against one’s own institution
7. Legal actions or other circumstances affecting market participants
that might have a direct or indirect impact on the institution
whether or not involving litigation
8. Political changes which might be expected to result in a change in
how laws or regulations are applied
9. A significant change in advice received from external legal
advisers on a material point
10. The use of unfamiliar advisers
11. Unusual qualifications or assumptions in formal legal
opinions
12. Significant changes to the availability, or cost, of insurance
cover
13. The use of “old” standard documentation
With this you have come to the end of module “Legal Risk Management
– BOI”.