VoxEU Column Competition Policy Financial Regulation and Banking

Regulatory sanctions and reputational damage in financial markets

Following the Global Crisis, regulators around the world have shown a greater commitment to investigating and sanctioning corporate wrongdoers. This column argues that fines are only one (surprisingly small) component of the overall sanctions available to regulators. Reputational sanctions are, for some categories of misconduct, far more potent than direct penalties.

A primary function of financial market regulation is the uncovering and disciplining of misconduct.  In the absence of effective monitoring and enforcement of rules of conduct, financial markets are particularly prone to abuse. Indeed, Dyck et al. (2014) estimate the probability of a company engaging in fraud in any given year at around 15%. The imposition of penalties on firms is an important part of the armoury available to regulators and, following the Global Crisis, regulatory authorities have shown a greater willingness to employ them.  However, they are only one component of the overall sanctions available to regulators and should be considered alongside the reputational damage that can result from investigations (Karpoff and Lott 1993). In a recent study (Armour et al. 2016), we study the effect of an announcement by a regulator of corporate misconduct on firms’ reputations. We examine whether a firm’s ‘naming’ as a wrongdoer by a regulator leads to a ‘shaming’, in terms of lost reputation.

Prior studies, mostly based on US data (Karpoff et al. 2008, Murphy et al. 2009), suffer in that information about misconduct and associated penalties is typically revealed over an extended period that “can stretch over several years”. The first announcement is often that the regulator has commenced an investigation and it may be preceded by speculation in the press of a potential investigation. Later announcements relate to the evolving investigation, finishing with information about whether the defendant has been found guilty and the size of associated fines. Furthermore, consequent on the regulatory ruling, there may be subsequent private litigation by investors. One way to address this issue is to cumulate market value impacts across all identifiable announcements, but this is subject to information leakages and confounding news that can make it inaccurate.

We have been able to address this concern by looking at the UK, where the entire enforcement process involves only one public announcement that includes information about associated legal penalties. During the period of this study (2001–2011), UK regulators only made public announcements on completion of the enforcement process. The Financial Services Authority (FSA) and the London Stock Exchange (LSE) investigated firms but only made their investigations public once misconduct had been established and a fine and/or order to pay compensation had been determined. Moreover, and again in contrast to the US, the announcement of an FSA/LSE enforcement action was unlikely to trigger any private litigation. This is highly significant for our purposes, because it gives a much more precise and complete picture of announcements of regulatory sanctions to the market.

We conduct an event study of the impact of announcements of regulatory sanctions on disciplined firms in the UK. We split the sample into sanctions where the prohibited conduct imposes losses on customers and/or investors, and sanctions where the injured parties do not trade with the firm. Where a firm is revealed to have abused the confidence of its customers, suppliers or investors (‘second parties’) its reputation and the terms on which it can trade with these parties in the future are likely to be adversely affected.  On the other hand, where a firm has profited at the expense of persons who are not connected with it (‘third parties’) then its customers, suppliers and investors are not directly affected and the terms on which it trades with them would not be expected to alter (Alexander 1999).

We find that reputational sanctions are large – stock price reactions are on average nine times larger than the financial penalties imposed by the regulators. We also report that reputational losses are confined to misconduct that directly affects ‘second parties’. The announcement of a fine for wrongdoing that harms ‘third parties’ who do not trade with the firm has no impact on stock prices (Figure 1). Hence, in the first type of case (harm to trading partners such as mis-selling of financial products or accounting fraud) reputation substantially reinforces the penalties imposed by regulators; in the other (third parties wrongs such as tax evasion or environmental crime) it negates or reverses them.

Figure 1. Reputational loss

Notes: This figure shows the reputational losses calculated by subtracting the financial penalty (fine and compensation as a percentage of the market capitalisation) from the market reaction (Cumulative Abnormal Reaction, or CAR) in the three days around the announcement. In the first vertical bar we report the results for the entire sample; in the other two bars we split the sample between wrongdoings against second (customers/investors) and third parties.

Regulatory penalties should therefore be much greater in third-party than second-party wrongs.  The last few years have seen sanctions being imposed on banks for misconduct in LIBOR and foreign exchange markets that dwarf those previously observed during the period of this study.  The need for more effective sanctioning of third party wrongs does therefore appear to have been recognised


Alexander, C R (1999) “On the nature of the reputational penalty for corporate crime: Evidence”, Journal of Law & Economics, 42: 489­–526.

Armour, J, C Mayer and A Polo (2016) “Regulatory sanctions and reputational damage in financial markets”, Journal of Financial and Quantitative Analysis, Forthcoming.

Dyck, A, A Morse and L Zingales (2014) “How pervasive is corporate fraud?”, Working paper No 2222608, Rotman School of Management.

Karpoff, J M and J R Lott, Jr. (1993) “The reputational penalty firms bear from committing criminal fraud”, Journal of Law & Economics, 36: 757–802.

Karpoff, J M, D S Lee and G S Martin (2008) “The cost to firms of cooking the books”, Journal of Financial and Quantitative Analysis, 43: 581–611.

Murphy, D L, R E Shrieves and S L Tibbs (2009) “Understanding the penalties associated with corporate misconduct: An empirical examination of earnings and risk”, Journal of Financial and Quantitative Analysis, 44: 55–83. 

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