United States

Financial Crimes and Fines: A Misguided Approach

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In the wake of the Great Recession, populist opinion has responded approvingly to regulatory agencies’ stronger approach against wrongdoing by financial firms. Companies in the financial industry have increasingly found themselves subjected to fines as a result of this greater scrutiny. Yet, regulatory agencies are losing out on a superior alternative to fines. Criminal charges against individuals, including executive-level managers, should be employed as a more effective, targeted punishment that does not harm innocent employees and increase systemic risk in the process.

The U.S. Department of Justice’s recent charges against Deutsche Bank provide one example of the possible downsides of using fines as punishment. In September, the DOJ proposed a $14 billion fine against Deutsche Bank for selling mortgage-backed securities during the financial crisis without proper disclosure. The possibility of such a large fine sparked doubts in investors’ minds about the firm’s ability to pay, leading to a further decline in the already troubled firm’s share price. Fear of the ramifications of the fine was not limited solely to Deutsche Bank’s investors, either. Other financial firms became nervous at the precedent that the DOJ could set with this large fine. Some analysts were worried about the systemic risk Deutsche Bank could pose to the highly interconnected banking industry, should the fine significantly damage Deutsche Bank’s liquidity and endanger its ability to do business.

One of the main benefits of the use of criminal charges rather than general fines is that it allows regulatory agencies to avoid increasing systemic risk. Fines against a firm can reduce its liquidity, and if the fine is large enough, this reduction in liquidity could cost the firm more than the face value of the fine. In response to a liquidity shortage, the firm may have to engage in fire sales of assets, accepting lower prices to sell them quickly and damaging the value of similar assets held by other firms. Or, to fulfill regulatory capital ratios, the firm may have to issue additional equity, diluting current shareholder value. Thus, if enforcement agencies wish to avoid collateral damage to firms not implicated in a criminal investigation, then there is necessarily an upper limit as to how much they can fine guilty firms.

Criminal charges, on the other hand, hold the potential to lessen systemic risk by avoiding the more immediate losses in liquidity resulting from fines. Thus, criminal charges can limit harm to outside parties, as the replacement of even high-level executives is less likely to be as damaging to a firm as punitive fines. Furthermore, criminal punishments can be more effective deterrents to illegal behavior. In an analysis of data from 78 firms punished for financial crimes, Cindy R. Alexander finds that the “reputational penalties” firms pay are greater with criminal, rather than civil, sanctions. These reputational penalties, which take the form of lost customers or lower prices accepted by remaining customers, damage the punished firm’s profitability over time but avoid the larger, short-run costs that fines create.

However, there are some downsides to the greater use of criminal charges against firms. Alexander found that firms attempting to recover from reputational damage may shuffle employees and managers to regain reputation. This shuffling may be indiscriminate, resulting in employees not involved in criminal wrongdoing to lose their jobs. The deterrent effect of criminal charges, though, may counter this risk by discouraging firms from engaging in wrongdoing in the first place.

Historically, the use of criminal charges in response to financial firms’ misdeeds has been used sparingly by the DOJ and other enforcement agencies, especially against upper-level managers. Many were outraged when firms bailed out by the U.S. government during the financial crisis kept their executives without facing criminal charges. Regulatory authorities have, however, brought criminal charges against high-level traders in recent years. In July, the DOJ announced that it would charge two HSBC trading executives for manipulating currency prices. When firms are guilty of significant wrongdoing, as in the case of Deutsche Bank, enforcement agencies should ensure that senior executives face the same criminal charges that lower-level employees would face for their crimes, including possible jail time.

While many are happy to see regulatory agencies adopt a hardline approach with large fines like the one proposed against Deutsche Bank, such a method has unintended consequences that extend beyond just the guilty parties. On the contrary, the use of criminal charges against individuals, including high-level executives, offers an effective alternative that avoids many of the negative externalities created by fines. In a global economy that is increasingly interconnected, it is important that regulatory agencies punish wrongdoing with strong deterrents like criminal charges that do not cause wider economic harm.

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