Regulatory Sanctions and Reputational Damage in Financial Markets

Abstract:     
We 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. 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. In the UK, the FSA and LSE 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 find that reputational sanctions are very real: their stock price impact is on average almost 9 times larger than the financial penalties imposed. Furthermore, reputational losses are confined to misconduct that directly affects second 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 prices. We find evidence of an enduring effect on the solvency of unlisted firms subject to second party sanctions. Our results have significant implications for understanding both corporate reputation and regulatory policy.

Number of Pages in PDF File: 49

Keywords: Regulation, Reputation, Enforcement, Corporate Law, Financial Regulation

JEL Classification: G28, G38, K22, K42, L51

working papers series