Mind the gap


Key Findings

§ Regulatory misclassification of Metro Bank’s risk weighted assets has triggered investigations from the UK financial regulators

§ Recent announcements about the irregularities have caused a drop of approximately GBP 1.2bn in Metro Bank’s market capitalisation

§ Fideres’s preliminary damages model estimates shareholder damages in excess of GBP 300m


Announcement of accounting irregularities

On 23 January 2019, Metro Bank revealed that hundreds of millions of pounds of commercial real estate loans and loans to commercial buy-to-let operators had been wrongly classified in risk terms.

§ On 26 February 2019, the bank announced that UK financial regulators, the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA) are investigating the bank’s misclassification of risk weights to its mortgage lending portfolio (Forbes, 2019).

§ The bank acknowledged on 31 January 2019 that the PRA had initially pointed out the accounting problems, contrary to Metro Bank’s initial claim that the error was flagged by an internal review (Financial Times, 2019).

§ An analyst at Autonomous, Christopher Cant, had previously raised concerns that the bank’s credit risk was unusually low compared to peers such as CYBG as early as September 2017 (Financial Times, 2019).

Impact on Metro Bank’s financial position

Upon reassessment of the bank’s loan portfolios, around a tenth of its GBP 14.5bn loan book was found to have been assigned incorrect risk weightings.

§  Asset risk weightings are dependent on the likelihood of loans defaulting. Banks with higher risk weighted assets are required to hold higher amounts of capital. Metro Bank’s commercial real estate loans had been assigned a 50% risk weighting instead of 100%. Similarly, commercial loans to buy-to-let operators had been wrongly given a 35% risk weighting instead of 100% (Guardian, 2019). 

§  Metro Bank’s announcement on 23 January stated that it’s risk weighted assets increased by about GBP 900 million to GBP 8.9 billion (Reuters, 2019). 

§ Metro Bank may have breached Basel III rules by not allocating the proper amount of capital toward its mortgage portfolio (Bank for International Settlements, 2017).

Impact on Metro Bank’s securities

Shares

Following Metro’s trading statement, its share price plummeted 39% from GBP 22.02 as of the closing on 22 January 2019 to GBP 13.45 on 23 January 2019. Within days of the disclosure, shares fell further to GBP 10.87. The price then recovered above GBP 15 to fall again to a record low of GBP 9.55 on 27 February 2019, a day after the bank announced the opening of investigations from the UK financial regulators.

Bonds

Other securities issued by Metro Bank have also been impacted by the disclosures announced by the company. Metro Bank issued a bond on 26 June 2018 for GBP 250 million. This ten-year bond with a maturity date of 26 June 2028, also experienced a price drop of 6.2% following the 23 Jan announcement.

Metro Bank's shareholders

As of 27 February 2019, according to the official filings, Metro Bank’s top 20 shareholders are:

Legal claims

It is too early to determine whether Metro Bank’s behaviour may give rise to liability under section 90A of the Financial Services and Markets Act 2000 (FSMA).

Section 90A of FSMA imposes a liability on the issuer of securities in England to pay compensation to a person who acquires, continues to hold or disposes of the securities in reliance of published information and who suffers loss in respect of those securities as a result of either:

§ untrue or misleading statement in that information; or 

§ the omission from that information of any matter required to be included, where it can be shown that the issuer of the securities knew or ought to have known that the statement was untrue, or misleading or reckless as to its truth (or that the same effect would be caused by the omission of that information).

Damages estimate

In England, there is no established methodology framework for calculating damages arising from breaches of securities laws. Fideres has therefore estimated damages using an event study methodology widely used in the US other jurisdictions for this type of claims.

One of the principles behind the event study framework is that the issuer of the security should only be liable for the portion of damages based on the impact on the share price arising from the misleading statements made to the public. The use of regression models to strip out the effect of the industry-wide and market-specific price factors, allows one to construct a but-for share price, that is to say the share price that would have prevailed in the absence of misrepresentations.

The chart below compares Metro Bank’s actual share price to the ‘but-for’ share price calculated by Fideres’s model. The difference between the two lines represents the amount of artificial price inflation due to the misrepresentations.

Using this methodology Fideres estimates that Metro Bank share investors may have incurred damages in excess of GBP 300m.

Appendix: how to calculate risk weighted assets and regulatory capital ratios

International banking regulations implemented by the Basel Committee (also known as the Basel Capital Accord, currently on its third version, also known as Basel III) mandate that banks in OECD countries must meet minimum capital standards. The minimum amount of capital required by each bank is calculated as a function of the riskiness of its assets: the riskier a bank’s assets are, the higher the bank’s capital must be.

The first step in determining a bank’s minimum capital requirement is to calculate the risk of the banks’ assets.

In order to guarantee a level playing field, the regulations provide for a standardised methodology for the determination of the riskiness of the assets in the form of standardised risk weightings, allocated to each asset type. Higher risk assets are allocated higher risk weightings and vice versa. So, for example, while US government bonds bear a 0% risk weighting factor, as they are considered risk-free, corporate loans are allocated risk weightings that vary between 20% and 150%, depending on the borrower’s rating. On the other hand, commercial real estate loans bear a 50% risk weighting factor.

A regulatory capital ratio can then be calculated as the ratio of the bank’s capital (share capital, plus other equity-like financial instruments) divided by the sum of its aggregate risk weighted assets.

This ratio must be above certain thresholds mandated by the financial regulators. The higher the ratio, the higher the solidity of the bank.

Regulatory capital ratios are widely monitored by regulators, investors and financial analysts and, as such, their integrity is of crucial importance to maintain confidence in the banking system.