Forgive me all my sins: How penalties imposed on banks travel through markets

https://doi.org/10.1016/j.jcorpfin.2021.101912Get rights and content

Highlights

  • Banks benefit from settling lawsuits due to resolved uncertainty.

  • Stock, bond, and CDS markets show positive valuation effects.

  • Banks anticipate penalty sizes as they are cash flow- but not income-effective.

  • Resolved uncertainty generates systemic spillovers to banks with similar lawsuits.

  • Banks' systemic risk increases in the size of the penalties.

Abstract

From 2005 to 2015, the 25 largest global financial institutions paid combined more than $285 billion in legal penalties. We examine the reaction of banks' stocks, bonds, and credit default swaps to the announcements of monetary penalties. We observe a reduced default risk and lower financing costs, as well an increase in the stock market valuation, suggesting that banks benefit from settling lawsuits. The positive reaction is likely driven by the resolution of uncertainty surrounding these proceedings. While the sued bank's systemic risk increases in the size of the relative monetary penalty, we also document positive spillover effects to other banks facing pending lawsuits with the same plaintiff, demonstrating the systemic effect of law enforcement against banks. Furthermore, banks appear to correctly anticipate penalties, as they are cash flow-effective but not income-effective in the year they are announced.

Introduction

Financial institutions were subject to large legal settlements during the recent past. From 2005 to 2015, the 25 largest financial institutions paid combined more than $285 billion in penalties, which corresponds to approximately 20% of their 2004 year-end market value. Prominent settlement cases include, among others, Bank of America in August 2014 for almost $17 billion with the US Department of Justice (DOJ) for financial fraud leading up to and during the global financial crisis, BNP Paribas in June 2014 for approximately $9 billion with multiple US authorities for violations of US sanctions, and UBS's $19 billion agreement with the New York Justice Department for the misrepresentation of securities in August 2008.

Banks typically resolve their legal disputes through settlements.1 The number of settlements as well as the involved penalty amounts imposed on banks rose steadily during the period from 2005 to 2015 (see Fig. 1). From 2005 to 2010, with the exception of 2008, these institutions paid between 689 million and 7 billion US dollars annually. This number increased markedly between 2011 and 2014 to approximately 42 billion US dollars annually, underscoring the relevance and magnitude of these legal proceedings. The vast majority of settlements involved US authorities. However, penalties and settlements with European authorities, particularly with the UK Financial Conduct Authority (FCA), also increased in recent years. This led European authorities to raise concerns that misconduct related penalties may become a source of systemic risk for the banking sector (European Systemic Risk Board, 2015).

In this paper, we answer the question on how these settlements affect banks along multiple dimensions by considering a bank's valuation through the equity market, its external financing costs through the bond market, and its credit default risk as reflected in the credit default swap (CDS) market. Additionally, we document how the resolution announcements travel through these three different markets, and investigate the effect resolution announcements have on banks' financial statements. We also study whether resolution announcements generate spillovers to the financial system. We do so by investigating the impact of resolution announcements on the stock prices of comparable banks facing similar lawsuits and consider the effect of penalty size on banks' systemic risk. In doing so we comprehensively investigate the effects of financial penalties on banks. Prior studies do not account for potential spillover effects to comparable financial institutions facing similar penalties or the effect on the sued bank's systemic risk and do not investigate the effect on the bond and CDS market (e.g., Gande and Lewis 2009; Karpoff et al. 2017; Armour et al. 2017; Köster and Pelster 2017). Taking into account the effect of legal proceedings on a bank's default risk, systemic spillover effects, as well as systemic risk is of particular importance in the context of the banking sector given its central role in the transmission of shocks to the real economy.

To investigate our research questions, we hand-collected data on more than 400 legal settlements that involved at least one of the 25 largest financial institutions between 2005 and 2015.2 For every event we carefully control for other stock price relevant events surrounding the settlement announcement to ensure that the measured effect is due to the settlement announcement itself, resulting in a final sample of 251 events.3

Of the 25 largest financial institutions, 23 had at least one settlement within our investigation period. Nine of these 23 institutions are from the US, the remaining 14 from Europe. The European banks include five from the United Kingdom, three from France, two from Germany and Switzerland, and one from the Netherlands and Spain. All financial institutions in our sample have global operations and are bound by the laws of the respective jurisdictions they are operating in and may therefore be sanctioned in case of non-compliance with respective local laws and regulations. We include in our database all enforcement actions against these banks from US and European plaintiffs and regulators. Fig. 2 shows the penalty amounts assigned and received by US and European law enforcers and banks. It is apparent that the US is distinctly more active than Europe in sanctioning domestic as well as foreign banks. $271 billion in penalties are assigned by US law enforcers while only $14 billion by European law enforcers, which translates into a share of 95% in terms of penalties. In terms of the number of cases the difference is still stark but somewhat less pronounced with 83% of all enforcement actions in our sample being enforced by US plaintiffs and 17% by European ones. The US is not only the most important law enforcer for US banks but also for European banks. The latter received $60 billion of their total of $71 billion, or 85%, in penalties from US law enforcers. This shows the relevance of enforcement actions against foreign defendants, particularly for foreign banks operating in the US.

Our study contributes to the literature on valuation effects of enforcement actions against banks in general, and for settlements in particular, in multiple ways. First, we go beyond the equity market analysis and also consider debt and credit default risk. This is of particular interest for financial institutions given their central role in the economy. Prior studies (e.g., Armour et al. 2017; Bhagat et al. 1994; Flore et al. 2017; Karpoff et al. 2008; Gande and Lewis 2009) do not consider debt or credit markets and frequently use cross-industry samples, therefore only allowing for limited conclusions with respect to financial institutions. Second, we investigate how financial penalties disseminate from the equity to debt and credit-default swap markets, thereby showing the interrelationship between these markets. To the best of our knowledge, this is the first study that documents the effect of financial penalties associated with legal proceedings for these markets and thereby provides first evidence on the speed of information dissemination of settlement announcements through equity, debt, and credit-default swap markets. Third, we investigate the spillover effects of settlements to comparable large financial institutions. This is to learn whether settlements generate negative contagion effects or provide new information reducing uncertainty associated with such settlements. We additionally study whether the size of the settlements impacts the sued banks' contribution to systemic risk. Finally, we investigate the effect of penalties on bank's financial statements and subsequent lending behavior. This allows for conclusions on how penalties affect banks' liquidity, profitability, but also lending activities towards the real sector.

Our results show significant positive valuation effects of 0.30%, 2.36bps, and −0.71bps for the stock, bond, and CDS market, respectively. This suggests that the settlement of law suits is generally viewed as a positive event by capital market participants. At the time of the settlement, negative information has already been priced in; the actual settlement reduces a bank's default risk, its financing costs and increases its stock market valuation. Larger settlements are associated with more pronounced stock market valuation effects, consistent with a greater reduction in uncertainty. Further substantiating this result, we document that banks with greater stock return volatility prior to the settlement enjoy larger announcement effects in stock markets. The interactions between stock, bond, and CDS markets around resolution announcements are examined using a simultaneous regression framework. The results show that the settlement affects stock and CDS markets directly on the announcement day and that these markets transmit the effect to the bond market with a one day lag.

We also find that the resolution of legal enforcement actions has positive spillover effects towards comparable financial institutions with pending lawsuits from the same plaintiff. At the same time, employing three different measures for the sued bank's contribution to systemic risk, we find weak evidence that a bank's contribution to systemic risk increases the larger the size of the relative monetary penalty. This evidence, albeit somewhat mixed, underscores the systemic relevance of law enforcement actions against banks, as pointed out by the European supervisory authorities (European Systemic Risk Board, 2015).

Finally, we evaluate whether a bank's annually paid monetary penalties have an impact on its cash flow, net income, tier 1 ratio, and lending. We document that monetary penalties reduce annual cash flows nearly one-to-one in the announcement year, reflecting the cash flow-effectiveness of these settlements. In contrast, banks' net income is unaffected by the announced penalties, suggesting that monetary penalties are not income-effective in the year they are announced. Yet, as they are cash flow-effective, this provides tentative evidence that banks appropriately account for impending penalties prior to the fiscal year of the resolution announcement. The settlement announcement effect should therefore be driven by the resolution of uncertainty. Using bank-level data, we further document that banks' tier 1 ratio and lending growth are not affected by the size of the financial penalties.

The remainder of the paper is structured as follows. Section 2 gives the general background for legal enforcement actions against banks while Section 3 reviews selected literature and develops the main hypotheses. Section 4 gives an overview of the construction of the database and offers descriptive statistics of the sample. Section 5 presents the empirical analyses for the affected banks. Section 6 considers the dissemination of penalties through financial markets. Section 7 offers insights into the effect of fines and settlements on the banks' financial statements, and Section 8 investigates the interdependence of financial penalties and systemic risk. Section 9 concludes.

Section snippets

Background

Financial institutions face multiple legal and regulatory enforcement threats that potentially lead to large penalties. Independent of the plaintiff or prosecutor, corporations in general have a strong preference for settling disputes in contrast to going to trial. Settlements significantly reduce the costs associated with lengthy court trials and are therefore an attractive option to quickly end a dispute. A settlement is usually possible at every stage of a lawsuit and particularly common in

Selected literature

Research on the equity market reaction to the announcements and settlements of fines and penalties is more developed for non-financial firms than for banks. In the context of banks, previous literature mainly investigates regulatory enforcement actions which may lead to a regulatory fine but also frequently to non-monetary restrictions. For the purpose of our paper, these regulatory enforcement actions are only included if they lead to a regulatory fine.6

Database construction and description

There are no readily accessible public databases for legal resolution announcements of financial institutions. We therefore hand-collect a database of events between 2005 and 2015 that represent a comprehensive number of resolutions of enforcement actions for the 25 largest US and European banks (as determined by either 2004 or 2015 market capitalization) that led to settlements with monetary penalties in excess of $5 million.12

Shareholder wealth effect

We analyze the short-term shareholder wealth effects of legal resolution announcements using the market model event study method, originally described by Dodd and Warner (1983) and Brown and Warner (1985). The abnormal return (AR) for company i on day t surrounding the announcement day t=0 is calculated by:ARit=Ritα̂i+β̂iRm,it,where Rit is the actually realized return of event i’s company on day t and Rm,it is the benchmark index for event i.18

Interdependency of stocks, bonds, and CDS around settlements

In this section we examine the general interdependence of stock returns, bond returns, and CDS spread changes to examine their timely interaction and succession around resolution announcements. The aim is to assess whether certain types of financial instruments lead others and thereby test hypothesis H2a. The results so far suggest that stock and CDS markets react immediately to the announcement of the resolution of legal proceedings, while bond markets lag by one day, providing first evidence

Effect on banks' financial statements

How does a resolution announcement impact on a bank's financial statement, more specifically, a bank's liquidity, profitability, capital adequacy, and lending creation? If reduced uncertainty is the main driver of the positive wealth effects, investors should already have anticipated the payment of a penalty beforehand. Investors' expectations are, however, hard to measure. Therefore, we study banks' financial statements as a proxy. It can be argued that if a bank correctly estimates pending

Penalties and banks' systemic risk

What effect do financial penalties have on the systemic risk of banks? This is a particularly interesting question for regulators, who aim to reduce the systemic risk externalities generated by banks. Financial penalties could be a way for regulators to make banks internalize the costs associated with systemic risk. To address this question we study the effect of annually paid penalties on the three most central metrics derived from financial market data in the systemic risk literature, ΔCoVaR,

Conclusion

Banks have been subject to major financial penalties over the last decade. To provide a holistic overview of the impact of financial penalties on banks, we test several hypotheses, relating to the impact on stock, bond, and CDS markets, the speed of information processing in these markets, potential spillovers to comparable financial institutions, and the effect on a bank's cash flow and net income. To this end, we use a unique data set of legal settlements of the largest global financial

Acknowledgements

We thank two anonymous referees, Douglas Cumming (the Editor), Björn Imbierowicz, Steven Ongena, and the participants of the 2018 AFFI conference for their helpful comments and suggestions on earlier drafts of this paper. We also thank Michael Zimmermann for his valuable research assistance.

This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

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