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Fines On Banks Don’t Hurt As Much As The Associated Reputation Damage

Share-price losses after mis-selling scandals can be up to 10 times the size of the fine.

When a bank behaves badly, any fines or compensation orders it receives are amplified by losses in stock price due to reputational damage – but only when the misconduct directly affects customers, investors, or suppliers, research from the University of Oxford has found. When the misconduct involves third parties, such as other financial organisations or the public at large, the effect on stock price is neutral or even positive, offsetting the penalties imposed by the regulator.

‘Regulators need to pay greater attention to the reputational effects that follow a firm’s “naming” as a wrongdoer,’ said Colin Mayer, Peter Moores Professor of Management Studies at Saïd Business School, University of Oxford. ‘Penalties imposed without considering how likely it is that firms will also suffer major reputational losses – or reputational gains – could be seriously excessive in the first case or frankly feeble in the second.’

Regulatory Sanctions and Reputational Damage in Financial Markets by John Armour (University of Oxford), Colin Mayer, and Andrea Polo (Universitat Pompeu Fabra and Barcelona GSE), published in the Journal of Financial and Quantitative Analysis, looks at the impact of the enforcement of financial regulation by the United Kingdom’s regulatory authorities on the market price of penalised firms.

The UK is a good focus for this analysis because the entire enforcement process of the FSA (Financial Services Authority) and LSE (London Stock Exchange) involves only one public announcement, if and when a firm is found to have breached the rules and incurs a fine and/or an order to pay compensation. This makes it easier to link reputational fallout directly to the announcement, because the situation will not have been muddied by leaks or gossip before the investigation is complete.

The researchers found that announcements were followed by share-price losses nearly ten times larger than the financial penalties imposed by the regulator. However, these losses occurred only when the firms had been found guilty of misconduct affecting their customers, suppliers, or investors: for example, mis-selling of financial products and misleading advertisements (both of which harm customers), and slow announcements of information to the market where mandated (which harm the firm’s investors).

However, the losses were small and insignificant when the misconduct affected third parties, such as failure to comply with ‘gatekeeper’ obligations designed to minimise the risk of money laundering by a firm’s clients, market misconduct (e.g., trading in stocks to move the market price), and failures to comply with obligations to report transactions in other firms’ securities. In fact, the announcement of a fine for wrongdoing that harms third parties was found to have, if anything, a ‘weakly positive effect’ on stock price.

‘It is difficult for regulators to decide on sanctions that are proportional and fair, especially when the public wants to see them wield a big stick and impose punishing fines,’ said Mayer. ‘We hope that our findings point the way to more careful calculations that take into account the additional effects of reputational damage. We hope too that firms understand the damage that they are inflicting on their own reputations when they do something to deserve a fine from the regulators. This should act as a powerful incentive not to bend the rules, especially when it comes to customer relationships.’

Source: Said Business School

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