Regulatory Sanctions and Reputational Damage in Financial Markets

John Armour is the Lovells Professor of Law and Finance at the University of Oxford.

In the paper Regulatory Sanctions and Reputational Damage in Financial Markets, recently made publicly available on SSRN, my co-authors (Colin Mayer and Andrea Polo, both at the Said Business School in Oxford) and I study the impact of the announcement of enforcement of financial and securities regulation by the UK’s Financial Services Authority and London Stock Exchange on the market price of penalized firms. A primary function of regulation of financial markets is to uncover and discipline misconduct. In the absence of effective monitoring and enforcement of rules of conduct, financial markets are particularly prone to abuse. The imposition of penalties on firms is an important part of the armoury available to regulators and, following the financial crisis, regulatory authorities have shown a greater willingness to employ them. Our paper reveals that they are only one—and a surprisingly small—component of the overall sanctions available to regulators. We show that reputational sanctions are, for some categories of misconduct, far more potent than direct penalties.

A firm’s reputation reflects the expectations that its partners have of the benefits of trading with it. In general this is difficult to measure but the release of new information provides an opportunity to do so. In the paper, we study the effect on firms’ reputations of the announcement by a regulator of corporate misconduct and examine whether following a firm’s ‘naming’ as a wrongdoer by a regulator, it suffers ‘shaming’ in terms of lost reputation.

Understanding enforcement is crucial to making sense of the links between legal institutions and financial development, much emphasized in the ‘law and finance’ literature. Whilst there is agreement that accurate indexing of the efficacy of legal institutions requires account to be taken of enforcement, there is as yet no clear consensus as to the best way to measure its intensity or efficacy. One important component of such enforcement may be reputational sanctions. The difficulty lies in measuring them. Prior literature on reputational penalties has suffered from the existence of a number of confounding factors that render it hard to disentangle reputational from other losses.

We present findings from a uniquely clean dataset of enforcement actions drawn from the UK: those taken by the UK’s Financial Services Authority (‘FSA’) and the London Stock Exchange (‘LSE’). The FSA and LSE investigate firms respectively for possible violations of financial regulation and listing rules, but only make the investigation (and its result) public if and when the firm is found to have breached the rules and incurs a fine and/or an order to pay compensation. This means that the announcement of a breach is an exceptionally clean signal to the market about the extent to which the firm in question abides by its legal obligations.

We conduct an event study of the impact of the announcement of such enforcement notices of breach on the stock price of the disciplined firm. We find that reputational sanctions are very real: their stock price impact is on average ten times larger than the financial penalties imposed by the FSA. In view of their scale, this paper points to the need for regulators to have a greater awareness of the reputational consequences of their actions than they have demonstrated to date. Still more strikingly, reputational losses are confined to misconduct that directly affects parties who trade with the firm (such as customers and investors). The announcement of a fine for wrongdoing that harms third parties has, if anything, a weakly positive effect on stock price. Hence, in the first type of case (harm to trading partners), reputation massively reinforces the penalties imposed by regulators; in the other (third parties) it negates or reverses them. Regulatory penalties that do not recognize these differences will be seriously excessive in the first case and deficient in the second.

The full paper is available for download here.

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